Why Netflix’s enormous cash losses are necessary, not reckless (NETFLIX IS NOT A BUBBLE, PART 1)
News coverage today of Netflix’s financials isn’t complete without a great deal of fearful fascination over the billions in cash losses that the company endures each year, which CEO Reed Hastings stated will continue for many more years to come. Quite predictably, a legion of doom-and-gloom commentators has grown over the years, asserting that Netflix is speeding on an unsustainable path to a ruinous ending.
In this article, we will:
- Go over how Netflix’s enormous spend on content is the driver behind its cash losses
- Understand why Netflix spends so much on content (a level that’s unprecedented in video entertainment)
- Examine the profound advantages that the Netflix platform has over Legacy Media in leveraging content to acquire subscribers and engage them
- Finally, tie all of the above together to see how the “sky’s the limit” for Netflix when it comes to content spend and growth in subscribers and revenue
- The ultimate goal here is to help us see how Netflix is playing to win a game that the general public doesn’t fully understand, and which offers incredible rewards
Let’s start by going over the basics of Netflix’s enormous debt-fueled spend on content.
At the heart of Netflix’s cash losses lies its enormous spend on content: $9 billion in 2017, $12 billion in 2018, and an expected $15 billion by the time 2019 closes.
This content spend isn’t just enormous, it’s also record-setting within the entertainment industry: Netflix isn’t just outspending all other OTT subscription video services, but also all Legacy Media companies with the exception of the recently combined Disney-Fox and Comcast-Sky entities.
The latter point is significant in that that Legacy Media companies have far more avenues than Netflix in distributing content to audiences. While Netflix relies purely on OTT subscription to bring its content to audiences, Legacy Media companies can do this through traditional TV (still the most wide-reaching avenue globally), TV Everywhere, theatrical runs, and home video, in addition to their own (still nascent) OTT subscription services. And when a company operates more distribution avenues, it predictably translates into it being a larger organization — just compare Disney-Fox’s 150,000 headcount (excluding parks & resorts) to Netflix’s 8,000. And yet when we look at their content spend divided by headcount, a proxy that captures the intensity of their content spend per operating resources, they pale in comparison to Netflix.
And because Netflix, a relatively young company that currently doesn’t generate enough cash to cover the billions its spending on content (and marketing), it resorts to borrowing billions in cash from the debt markets at a high interest rate. As of March 2019, Netflix was $10.3 billion in long-term debt.
And with each quarter-end release of Netflix financials, doom-and-gloom commentators become more confident that Netflix is spending itself into a corner. Wedbush Morgan analyst Michael Pachter rarely misses an opportunity to call Netflix “unsustainable”. Doubts over the company’s debt-fueled strategy are now echoed far beyond the business trades, now finding their way into The Atlantic and The New York Times. Aswath Damodara, a professor of finance at NYU smused how “Netflix’s fundamental business model seems unsustainable…” and “I don’t see how it is going to work out.”
But this debt-fueled spending isn’t a bubble. Instead, it’s a base for a future that’s bigger than the present.
Netflix is playing the long-game, which means investing in a future that’s far bigger than the present. Let’s start by clarifying an important concept: Netflix spending $15 billion in 2019 on content doesn’t mean $15 billion worth of content will become available to Netflix audiences in 2019. If the two meant the same, then Netflix’s Cost of Revenue in 2019 would be $15 billion (in fact, probably more, since content spend isn’t the only component of Cost of Revenue), which would surpass Netflix’s gross revenue in 2019. This would result in the company being negative on its income statement (or P&L statement, however you want to call it), in addition to being negative in cash flow.
But that’s not the case. More and more of Netflix’s spend is on content that won’t be available to audiences until further and further in the future. This truth is captured by the increasing ratio of content spend to amortization.
To translate this into layman terms: although Netflix’s content spend appears to be frightfully large today, it’s meant to ensure that the company is armed with a powerful content arsenal for tomorrow and beyond. And Netflix isn’t being too aggressive in its far-sighted thinking when you consider that content is only going to be more expensive in the future, especially with so many players who are all willing to spend billions in the long-term to secure the best shows, biggest stars, most Emmy awards, and largest content libraries in order to jumpstart their own OTT subscription services (i.e. Disney+ or Apple TV+). Better to seize as much content today while it’s still relatively cheap compared to what it will be 2–3 years from now, when the competition will have fully ramped up their spend levels as well, and is competing for the same finite pool of production staff and resources.
Of course, it only makes sense to invest heavily today in a bigger future if there’s plausible reason in the first place to believe there will be a bigger future at all. The extraordinary growth in Netflix’s subscriber base over the last 10 years, which has been pacing even faster in recent years and showing no signs of slowing down, overwhelmingly suggests that Netflix’s future will be much larger than its (already massive) present. The charts below show the rapid growth in the number of Netflix’s paying subscribers from 2010 until the present. While traditional television is still considered the most pervasive medium in the media landscape (at least for the time being), Pay-TV subscriptions in the U.S have been slowly eroding ever since reaching a peak of around 100M in 2011. But by 2017, the number of paying subscribers on Netflix surpassed that of U.S households subscribed to Pay-TV. And by the end of 2018, Netflix had reached a whopping 140M paying subscribers.
Netflix can also expect the rate of subscriber growth to continue to speed up. This is a logical assumption, given that its seen 7 consecutive years where year-over-year growth has increased dramatically. If 2019 were to follow the same escalating rate of growth seen since 2012, we can expect an additional 32M subscribers in 2019, ending the year with over 170M paying subscribers on the service.
Of course, this brings us to the million-dollar question: what’s the ceiling on Netflix’s subscriber base growth? A conservative estimate of the total addressable market size for Netflix subscriptions puts it at more than twice its current base of 140M subscribers. When we consider that there are 770M people in developed countries, and 6.9B in developing countries, and then divide that by the average number of people per household (2.5 for developed countries, and 4 for developing) to estimate total households (this point is important because most households will share 1 Netflix subscription account among all its members), we wound up with 300M households in the developed world, and 1.7B in the developing world. Next, we have to consider the percent of households with broadband internet, an indicator of high-speed internet and sizeable disposable income, necessary prerequisites for subscribing to a streaming service and reliably accessing it. As of 2018, around 75% of households in developed countries and 15% of households in developing countries have broadband internet. This brings us to a total estimated 500M households with broadband internet, which represents a conservative estimate of Netflix’s addressable market.
There’s a lot of distance between Netflix’s current subscriber base of 140M and its addressable market of 500M. This means Netflix can continue to see enormous subscriber growth through the next decade and beyond as long as it continues to invest in robust content libraries that broadband internet users around the world are willing to put down subscriptions for. The steady growth in broadband internet usage around the world over the next decade will only further push Netflix’s addressable ceiling upwards.
While the enormous size of Netflix’s subscriber base (current and future) is impressive in and of itself, it also obfuscates several major advantages of Netflix’s OTT subscription model that are absent in traditional media formats. These advantages, by themselves, justify enormous content spend.
Netflix’s impressive trajectory in subscriber growth gives it the rationale to continue investing heavily on content, but it still doesn’t quite explain why it’s spending the sheer incomprehensible amounts that we outlined earlier (far exceeding all other players, across both Legacy Media and subscription OTT). Content is certainly the main driver of subscriber growth, but couldn’t Netflix still achieve long-term growth using more moderate spend levels? Sustained subscriber growth, without $10+ billion in long-term debt and with significantly less cash losses each year, would certainly make investors sleep better at night. Investors would be eager to point out that even HBO, the most profitable TV network in the world and the poster-child for high quality original content, is fairly moderate in its content spend. From 2015 to 2017, it only grew its annual content spend from $2.04 billion to $2.26 billion, or in other words, a growth of around 3.3% a year. Now compare that with Netflix’s content spend in the same period, which was $4.6 billion in 2015, $6.9 billion in 2016, and $8.9 billion in 2017 (and for what’s it worth, it ballooned to $12 billion in 2018). In other words, the amount by which Netflix increased its content spend each year, which comes to $2 to $3 billion, was greater than HBO’s total content spend in each year.
So why is Netflix so determined to spend unprecedented amounts on content, and creating a mountain of debt along the way? The answer lies in the fundamental advantages that Netflix’s OTT on-demand streaming format has over the linear formats of Legacy Media. These advantages are systemic, unchangeable, and self-reinforcing.
As a service that offers video content through an on-demand format, Netflix frees its audiences from the constraints of fixed programming schedules, which have plagued audiences of linear television since time immemorial. And because Netflix lives purely within the OTT environment (OTT stands for “over-the-top”, which is weird industry lingo to describe internet-based services), it’s freed from the cumbersome legacy infrastructure (cable lines, satellite dishes, installation personnel, partnerships with MVPD distributors) that prevents linear television networks from expanding outside specific regional territories and reaching a global audience. Since linear television remains Legacy Media’s most wide-reaching audience platform by far, responsible for 60 -70% of Legacy Media revenue, understanding its downsides is crucial to understanding why it can’t match Netflix’s spend trajectory on content (even if it wants to).
We can start with the disadvantages created by fixed programming schedules. First, they create a disconnect between content spend (where more spend means more content) and its availability to audiences. Fixed programming schedules can only squeeze in a finite number of dayparts in a 24-hour schedule (examples: 6 am to 10 am Early Morning, 10 am to 4:30 pm Daytime, 4:30 pm to 7:30 pm Early Fringe, etc.), of which only a few even have substantial viewership (such as Prime Time from 8 pm to 11 pm), and where each hour of any daypart can only squeeze in 2 programs at most (since the shortest program is around 30 minutes). In other words, fixed programming schedules make real estate severely limited and precious. Which means that even if a television network doubles the size of its content arsenal (by doubling content spend), the amount of content that it can actually squeeze into its fixed programming schedule (i.e make available to audiences) remains totally unchanged. And this is precisely why television networks never release all episodes of a new series all at once, thereby robbing their audiences of the joys of “binge watching” — the physical constraints of fixed programming schedules make it literally impossible to do that. Second, fixed programming schedules give users no control on when and where to watch something, but only on how often to flip through different channels. And because any given channel will be bundled together with dozens of others from rival networks, increasing a channel’s available content by 100% (if that were even possible) will never correspond to a 100% decrease in the likelihood that the user will simply flip to another channel the moment his or her attention span wanes. Competing channels will always be one click away.
All this is a far cry from Netflix, where the on-demand video format means there’s no limit on the amount of content that can be made available to audiences — doubling the size of the content arsenal can actually mean doubling the amount available to audiences for their viewing pleasure. And as Netflix substantially increases the amount of content available to audiences, it drives a substantial increase in hours streamed per subscriber, a metric that captures stronger and longer engagement. A metaphor that best captures this dynamic is operating an ice cream buffet — the more flavors you offer, the more scoops of ice cream flavors people will eat. As Netflix substantially increased the amount of content for audiences from 2012 to 2018, it nearly doubled the average hours streamed per subscriber. At the end of 2018, Netflix’s 140M subscribers streamed an average of 2 hours per day.
2 hours per subscriber per day actually represents a historically unprecedented volume in user engagement: while the 5 hours that the average household spends in front of a TV each day is fragmented between 200+ channels, with no single network able to achieve a dominant share of viewing time, the 2 hours that the average Netflix subscriber spends on the service each day represents a pool of attention that’s entirely owned by Netflix, and shared with no one else. So this is an unprecedented amount of attention ownership in the video landscape.
And this gives Netflix the leverage to increase subscription prices. It did so in January 2019, hiking the standard monthly plan from $10.99 to $12.99, and will continue to do so in the future, which in turn means improving margins.
Next, the revenue upsides from improving margins are magnified a hundredfold by Netflix’s global growth tear in new subscribers. This global growth tear is made possible by Netflix being a purely OTT service, which means that the only infrastructure a user needs to access it is (fast enough) internet. In other words, Netflix’s maximum limit in subscribers is the number of households in the world with broadband internet. And the more Netflix spends on content, the more originals it unveils, and that drives more excitement around the world over the Netflix brand and results in more subscribers. Legacy Media, on the other hand, is prevented by its dependence on domestic-focused MVPD distributors and regional-bound cable/satellite infrastructure from replicating the internet-enabled global growth tears that turned Facebook, Youtube, and increasingly, Netflix, into household brands in both domestic and international markets.
The upsides from rapid subscriber growth and higher subscription prices are reflected in Netflix’s ballooning gross revenue and profit margins each year.
And this is where we can truly comprehend the positive feedback loop in the OTT on-demand business model: the more revenue Netflix makes, the more it justifies additional spend on content, which in turn drives more subscribers and engagement per user and justified price hikes, all of which means more revenue which again justifies additional spend on content, etc. In other words, the limit on Netflix’s content spend is its limit on revenue, which the company is still a long way from reaching.
Other giants in subscription streaming also partake in the rapid escalation in content spend — Amazon spent $1.2 billion in 2013, $2.7 billion in 2015, and $4.5 billion in 2017. These numbers should give you a worrying sense of the extent to which the television networks of Legacy Media are being dwarfed in the race to have the biggest slate of content readily available to audiences for consumption, a race that Netflix is far ahead of everyone. Unable to achieve global growth in subscribers or to trigger addictive user engagement, television networks can only expect terminal decline in an industry where scale has become everything.
Netflix is playing for such massive scale that it’s plausibly competing against everything that takes up people’s screen time, from Pay TV to video games to Youtube and more.
Cue its moniker that “sleep is my biggest enemy”.