Netflix: Winning Moments of Truth?

“[By week 3] people are watching TV the way that God intended” — that is, via traditional, linear viewing”

- Alan Wurtzel, NBC Executive, remarking on the emergence of SVOD

Armed with this knowledge, I have been asked to answer the question: “Netflix?”. Quite frankly, everyone from FX President John Landgraf and Amazon Founder Jeff Bezos to the leaders at Regal, Cinemark, and AMC Theaters are interested in what Netflix’s future holds. Because Netflix sits at the center of entertainment and technology, they have thus caused many to fear for the future of their business. Well, if you are one who prefers TL;DR to the New Yorker, I can answer your question right now and save you the trouble of a deep dive: “Netflix?…NETFLIX!”

Those that evolve to compete will survive as the market happens to not be winner take all. However, if, like NBC President of Research & Development Alan Wurtzel, you believe that linear TV is “TV like God intended,” then you will be left behind and fairly quickly at that.[2] A new generation of content consumption is on the horizon and its one where Netflix not only competes with TV, but with any leisure activity. For this reason, Netflix is focusing squarely on “winning moments of truth,” which exist whenever a subscriber has an hour of free time.[3] Does that subscriber watch linear TV or Netflix? Read a book or Netflix? Go see a film in theaters or Netflix?

You already know the answer.

CONTENT

As an on-demand internet streaming provider, Netflix has had to cater to many different viewing tastes since it began offering content in 2007. CEO Reed Hastings and Chief Content Officer Ted Sarandos, who have both been with company since it began offering streaming video on demand, have followed a three-phase model to building Netflix into an internet TV powerhouse:

Phase 1: License Content

Phase 2: Produce Original Content

Phase 3: Distribute Owned/Licensed Content Globally

The first phase allowed Netflix to become a relevant, but underrated, competitor in the Television and Film industries. In an era where broadcast networks (CBS, ABC, NBC, and FOX) and cable channels (the CW and AMC) worked under the assumption that the revenue generating lifespan of a television series coincided with its run on linear TV, Netflix worked to amass an impressive and expansive library of old television shows and films. Netflix spent hundreds of millions of dollars creating licensing agreements to become the online owners of compelling shows like Breaking Bad, Lost, and Scrubs for a specified window of time (anywhere for 1–5 years). If you like metaphors, Netflix turned trash into gold. Film and TV titles that were once considered good as dead now provided studios with ancillary revenue streams and Netflix with the content that could convince new people to subscribe to its service.

“Become HBO faster than HBO can become Netflix”

— Ted Sarandos

This of course leads us to phase 2 in Netflix’s road to world dominance. As Netflix grew its subscriber base, the major TV networks realized the value of their content that they were essentially giving away. Because Netflix’s subscriber base already existed, the licensing deals didn’t go away immediately, they just became more costly. Instead of spending $200 million dollars, by 2013, Netflix was spending $1.3 Billion on licensed content.[4] In addition, services like Hulu and Amazon Prime began amassing titles of their own, further driving up the price of titles. Inevitably, Reed Hastings and Ted Sarandos moved to originals.[5] The success of original programming like House of Cards and Orange is the New Black pushed Netflix into a whole new stratosphere of relevance in American culture. Almost literally overnight (Sarandos released all episodes of Season 1 of House of Cards at once), Netflix became a sensation; and more importantly, a service worth paying for.

“More good content equals more viewing, more viewing means more subscribers, more subscribers means money to spend on more programming, which means more subscribers.”

- Rich Greenfield, BTIG Research

With an eye to the future, Netflix is producing an unprecedented amount of original content. In Q4 2015, Netflix launched five new original series, including Marvel’s Jessica Jones, Master of None, and Making a Murderer, which became, undoubtedly, the must-watch show of the holiday season. Add these titles to Narcos, Sense8, Marvel’s Daredevil, and Bloodline, and Netflix has established itself as an important source of entertainment for people around the world. In 2016, Netflix is slated to “launch over 600 hours of original programming” (150 hour increase over 2015), including “eight original feature films, 35 new seasons of original series for kids, a dozen documentaries, and nine stand up comedy specials,” according to the company’s Q4‘15 letter to shareholders. As BTIG Research analyst Rich Greenfield eloquently described to the New York Times in April 2015, “[m]ore good content equals more viewing, more viewing means more subscribers, more subscribers means money to spend on more programming, which means more subscribers.”[6]

With control of their own content library, Netflix will have the leverage and flexibility to move to the third phase, becoming a true global internet television network. Rather than worry about domestic versus international rights issues and pay windows, Netflix will have the ability to release their programs worldwide simultaneously. This is a huge development. Soon, viewers around the world will have access to the programs that they want to watch without having to pirate shows. Netflix will be their most accessible resource for entertainment. Distribution costs will be lower than ever as will spending on marketing. The sheer scale of the platform combined with the quality of content that Netflix is working towards will be extremely difficult for competitors to compete with.

PRODUCT

Netflix is a company that has strived to combine technology and entertainment. To have successful in doing so, Netflix has continued to innovate and optimize their platform. What began as a DVD rental service in 1998 transformed into an online streaming service in 2007 that can now be accessed on a smart TV, laptop, tablet, and mobile phone.

“Subscribers had a voracious appetite for content directed by David Fincher and starred Kevin Spacey.”

- Bernard Marr, SmartDataColletive

Even more than cross-platform functionality, Netflix continues to separate itself from its competitors by leveraging its user data. From its inception, Reed Hastings, who himself has a background in artificial intelligence, has understood the importance of combining data analytics with industry experience to make smart decisions regarding content acquisitions and investments. Beginning with a contest that the company held in 2006 that offered $1 million to the person who could come up with an algorithm that best predicted people’s movie rating habits, the company has sought ways of using data to increase the odds that their content would appeal to its customers. When Netflix pivoted their core offering to streaming, new data became accessible, such as time of day that movies were being watched, time spent selecting movies, and the frequency of playback. Additionally, Netflix hired viewers to tag the movies they watched, essentially indexing their entire catalog of movies and tv shows. By combining the newly accessible data with predictive models, Netflix was able to improve their product experience and engagement.

As Netflix has transitioned to producing its own original series, they have called on data analytics to help them find the next “smash-hit series.” For example, Netflix’s data showed that “subscribers had a voracious appetite for content directed by David Fincher and starring Kevin Spacey.”[7] With this in mind, Netflix outbid HBO and ABC for the rights to House of Cards and immediately ordered two seasons before a single episode aired, a decision that was unprecedented in the linear TV world. Lowe and behold, House of Cards was wildly popular and the main catalyst for the platforms widespread growth.

As the company expands internationally, Netflix will continue to rely on technology to reinforce its competitive advantage in user experience and platform performance. Unlike in the United States, where many subscribers watch Netflix on a smart TV or laptop, in international markets (think Middle East, India, and Africa) most people are accustomed to viewing content on mobile devices. For this reason, Netflix will continue to optimize how users sign up (now in app on iOS), authenticate themselves, and how rollover credit cards are handled (still a work in progress).

More importantly though, in Q4’15, Netflix introduced complexity based encoding, a new way of compressing content data that identifies the content being shown rather than the available bandwidth that the consumer happens has at the moment to improve streaming efficiency.[8] This alternative approach to data compression is extremely important as Netflix’s share of internet traffic continues to increase. According to research conducted by Sandvine, Netflix now is responsible for 37% of all internet traffic in North America during peak times when people are in normally watching TV. Though complexity based encoding was only rolled out in the last quarter, it should ultimately allow better looking videos to be watched at 20% slower speeds — something that will absolutely differentiate Netflix’s user experience from its competitors.

BRAND

The marriage of a strong platform with engaging content has resulted in Netflix earning its place as one of the most influential and trusted companies in the world. Beginning with the release of House of Cards in 2013, Netflix has been on a quest to become a global TV network and has largely succeeded by producing shows worthy of Emmy and Golden Globe nominations. Just this past year, Netflix led all networks with eight Golden Globe nominations for Narcos, Orange is the New Black and Master of None.[9] The explosion of original content and subscriber viewing time on Netflix influenced the company being ranked as the second best-perceived brands of 2015, according to a survey conducted by YouGov.[10]

Despite the incredible success and growth of the company’s streaming service in the last decade, Netflix will nevertheless have to overcome significant challenges to maintain its strong reputation among investors and subscribers alike.

CHALLENGES

In the face of strong competition for other SVOD services like Amazon Prime, Hulu, and HBO Now/HBO GO, Netflix has maintained its status as the leading player through 2015. However, with that being said, investors in the stock market are starting to question whether Netflix’s reign can continue.

“The last time Netflix stock traded at what might be deemed reasonable valuations was in mid-2012, back when the stock was going nowhere.”

- Chris Fraley, InvestorPlace

To send you on your way, here are two questions Netflix must answer for its public investors:

1. Will Netflix reach their goal of being profitable internationally by 2017?

CEO Reed Hastings announced at CES in early January that the company is now available in virtually every country in the world, except China. Their international expansion boosted the number of total subscribers to 75 million (45 domestic, 30 international), an impressive number for the company.[11] However, it remains to be seen whether Netflix can penetrate the foreign markets with the same success as they have enjoyed stateside. The addressable market has skyrocketed from 360 million to 550 million homes. For now, Reed Hastings has acknowledged that they are more focused on the high-end, english-speaking market. In a few instances, like Saudi Arabia, Netflix has spent time and resources to translate their entire catalog into the local language. However, it remains to be seen how successful Netflix can be in places like Russia, where English a foreign language to most of the addressable market. Netflix finished 2015 with -$289 million in free cash flow. If they can scale quick enough internationally to the point where they are cash-flow positive, consider that a great accomplishment for Reed Hastings and Netflix.

2. Is Netflix’s stock priced to high right now?

For the investor who seeks to analyze Netflix’s stock based on its Price-to-Earnings ratio, the conclusion is simple: Netflix is severely overpriced. No one believes Netflix to have profits 348.41x their earnings. In fact, according to Chris Fraley of InvetorPlace, “the last time Netflix stock traded at what might be deemed reasonable valuations was in mid-2012, back when the stock was going nowhere.”[12] However, for the investor who wants to evaluate and understand the company as Reed Hastings does, the P/E ratio is irrelevant. Rather, we must understand Reed Hastings’ strategy until 2020.

Step 1: Increase Netflix’s domestic operating margin to 40%.

Step 2: Increase the international operating margin to 40%.

Step 3: Scale globally.

In other words, it is paramount that somewhere between 25% and 50% of Netflix’s addressable market, or approximately 200 million subscribers, by 2020. For a company that has just 75 million subscribers heading into 2016, this is a tall order. Whether Netflix will make it 200 million subscribers by 2020 is up to the investor, but regardless of your opinion, the P/E ratio does not today give a good indication of the health of the company’s stock.

Who am I?

Born in Los Angeles, I am now a senior in the Goizueta Business School at Emory University, where I’m working towards a BBA. I have passion for tech, media, what’s next…and I also happen to be looking for a job!

If you would like to reach me, my email is: Maxlevinson5@gmail.com