What Netflix Needs to do to Stay Relevant
The stock market did not hide its disappointment after Netflix released its most recent Q1 earnings.
Netflix has been one of the most exciting companies to watch over the last +20 years. What began as a US-centered DVD rental company in 1997 has evolved into a multi-national entertainment conglomerate with hundreds of millions of subscribers, Hollywood studio partnerships, and award winning content.
Under the stewardship of its maverick founder and CEO, Reed Hastings, Netflix has managed to hold its own in an extremely competitive marketplace. Coming up against the likes of Disney (with Disney+ and Hulu), AT&T (with HBO Max), Apple (with Apple TV+), Amazon (with Amazon Prime), Comcast NBC Universal (with Peacock), and dozens more across the globe, Netflix’s rise to prominence has been nothing short of specatular, to say the least.
The pandemic lockdowns was also a crowning moment for Netflix, helping it grow its subscriber base and become a staple of more and more living rooms across the globe. With less time spent commuting and more time spent at home, Netflix was perfectly positioned to fill the void left in the lives of many. Thanks to its massive content spend in the years prior, Netflix’s catalogue and new pipeline of shows and movies was primed and ready for global consumption.
With years of success, however, comes expectations of continued improvement and some observers are beginning to think that Netflix’s best days in terms of platform growth may be behind it. Competition for consumer attention is heating up like never before and the easing lockdowns and vaccination roll outs are getting more and more people out of their homes and away from their screens. In many ways, Netflix was the victim of its own success during the pandemic.
Will people still be as interested in staying in and watching television this summer when the restaurants and bars re-open and sporting events allow patrons again? More crucially, with all the (cheaper) options out there, will people still be willing to pay a premium for Netflix programming? How can the streaming giant that revolutionized the way consumers watch TV retain its place as an innovator in an increasingly crowded space?
These are existential questions that have rocked Netflix’s business model to its core over the last few weeks.
So what can Netflix do to prove skeptics wrong?
Focus on User Growth — Not Streaming Revenue Growth
If Wall Street’s reaction to FAANG company earnings is any guide, Netflix seems to have had the roughest start to 2021.
Facebook’s year-over-year revenue increased by 48% and management reported that 2021 growth will be driven by higher ad pricing, pushing its share price to new all-time highs.
Amazon surprised everyone with earnings and revenue growth that topped expectations, reversing a downward trend that has held its stock down over the last three months.
Apple again demonstrated that it can grow both its hardware and services business, with yet another blowout quarter. While Apple’s stock did not see sustained upside over the last few days, its share price declines were muted due in large part to continued profitability and sales volume providing assurances that Apple’s business model remains sound heading into re-opening.
And, of course, Google parent, Alphabet, set records, with YouTube reporting an eye-popping $6 billion in the last quarter alone. Alphabet stock continues to soar, up over 30% since the start of 2021.
Netflix’s earnings were, for all intents and purposes pretty good:
- Earnings per share (EPS): $3.75 (actual) vs. $2.97 (expected)
- Revenue: $7.16 billion (actual), up 24% year-over-year vs. $7.13 billion (expected)
Management even forecast that the company will be cash flow neutral by the end of 2021 — something that seemed impossible only a year or so prior.
The streaming giant, however, dropped the ball on the most closely watched of all its KPIs: net new paid subscribers. And Wall Street let it know how disappointed it was, with its stock falling over 10% in after-hours trading after its announcement on the 20th.
Historically speaking, the first quarter of each year have traditionally shown the most significant growth for Netflix’s business, benefitting from the December holiday season. This year, however, net paid subscriber additions were muted: 3.98 million (actual) versus 6.2 million (expected).
To add insult to injury, management is forecasting it will only add another 1 million paid subscribers in the current quarter. Wall Street, again, was not impressed.
Clearly, top-line revenue growth alone will not impress investors. Netflix needs to grow subscribers and quickly. This means investing more in marketing in growth areas like Latin America and Asia-Pacific. Netflix may have reached a saturation point in North America and there are signs to suggest that its business has also slowed in Europe.
This is all the more reason to go all-in with these non-traditional markets, perhaps offering discounts for viewers in those regions so that it can achieve the penetration it needs to outcompete local offerings and those of the likes of its more capitalized rivals (e.g. Apple and Amazon) whose content slate is less successful outside of North America. Discounts should be offered to existing customers as well as new customers so as to minimize churn — a metric that often gets ignored when a company is in growth stages.
Discounts will marginally increase Netflix’s cost of services but will help grow gross revenues. Wall Street may not be giving Netflix credit for improving its top line performance but it will give them credit for improving new net premium subscribers.
Double-Down on Consumer Products
For years, Netflix has been a pure-play content company. Its revenues are almost entirely derived from premium subscribers to its online streaming platforms.
One way that Netflix can diversify its revenue mix is to make a more concerted push towards consumer products licensing opportunities. While licensing businesses are lower margin and, therefore, attract a lower P/E multiple than streaming would, the predictability of licensing revenues will give Netflix a steadier cash flow source that can be used to finance its investments in content. Developing a large consumer products footprint will also elevate the brand equity of Netflix properties and provide indirect marketing.
Netflix certainly has properties that would seemingly have a fair chance at being successful from a licensing perspective. Stranger Things is the first that comes to mind. Given its resonance amongst millenial and Gen Z audiences and the nostalgic vibes it gives off, the show seems like a natural fit for consumer products.
In fact, Stranger Things has made a splash in the apparel segment and has a toy line that is also fairly popular.
Having a greater footprint on a merchandising front will give the company a method for further monetizing its position within North America. As previously mentioned, its streaming penetration may have peaked but, in order to maintain its grip on audiences, consumer products can help keep its properties ubiquitously in front of its most profitable audiences.
Netflix, however, fumbled its opportunity to capitalize on the success of some of its breakout hits from 2020 like Queen’s Gambit. The show’s rise in popularity brought about a spike in chess-related items and Netflix could not meet the demand quick enough. Unfortunately, given that the show is slated to be a one-season-and-done phenonemon, its window for turning Queen’s Gambit into a consumer product legacy brand is closing quickly.
For Netflix to truly establish itself as an entertainment juggernaut, it must take a page of Disney’s playbook and focus on turning its on-screen product into iconic consumer product businesses. Disney’s launch of the Mandalorian was a remarkable example of why the company is the gold standard when it comes to IP. Granted, Star Wars is a mammoth multi-billion dollar, multi-generational legacy brand but Disney was wise to put the full weight of its marketing team behind what it immediately identified as a winning consumer product character: Baby Yoda.
Disney has a tried-and-tested approach of hyping its films with marketing dollars, profiting off box office, and — at the same time — pushing merchandise sales throughout. This has led to not only improved long-term profitability but has also produced some of the most storied and lasting franchises in all of entertainment. Disney has done the same with Micky Mouse, Frozen, Toy Story, and countless others.
Continue Investing in Top-Quality Original Content
Netflix spent less on content in 2020 than it would have liked. Owing to the shutdowns in studio production, new content pipeline will be below expected capacity until the second half of 2021. In a letter to shareholders, Hastings pointed out that Netflix is on track to spend over $17 billion to produce new content in 2021 — a figure that is well above its historical spend of $11.8 billion in 2020 and $13.9 billion in 2019. The spend will focus on existing series but also on new programming.
The rationale for going full-throttle into new productions is obvious. To compete in the content wars, you have to be prepared to outspend your competition, plain and simple.
But it is not enough to buy one’s way into success. For a streaming company to be successful, the content it produces and distributes to its viewers must be at a quality level that matches the expectations of its audiences. The emphasis on quality-market fit is crucial to creating lasting brand affinity.
Quality means not only hiring top talent to star in shows but also using the latest animation techniques and creating intriguing storylines. It means giving people a reason to stay in on a Saturday evening to binge an entire season’s worth of TV on a Saturday evening instead of going out to a restaurant or bar. It means releasing a movie that becomes the topic of conversation at work on Monday and trends on Twitter for weeks thereafter.
It also means impressing the industry critics. Hastings underscored how the critical acclaim that Netflix has generated over the last few years sets the company apart from its peers:
Netflix led all studios for recent award nominations including the Oscars, Golden Globes, SAG Awards, BAFTA and the NAACP Image Awards, among others. Heading into the Academy Awards this weekend, we have 36 nominations across 17 films including two nominees in each of the Best Picture (Mank, The Trial of the Chicago 7), Best Documentary Feature (Crip Camp, My Octopus Teacher), and Best Animated Feature (Over the Moon, A Shaun The Sheep Movie: Farmageddon) categories. Mank led all films with 10 nominations.
Netflix is expected to take home some brass from the Oscars, where it has mustered up 33 nominations.
To justify its premium pricing, Netflix must deliver quality content — the kind of content that wins awards and keeps audiences glued to the screen. And it must do so at all costs. If it doesn’t, it can expect to lose some customers to other quality content providers like HBO Max and Apple TV +, both of which were well represented at this years Hollywood awards.
Consider Horizontal M&A Opportunities
Sometimes, the best answer to a well-capitalized company’s problems is to leverage its financial position and buy itself a solution. With its P/E trading at nosebleed levels, a stock acquisition of a lower P/E company would be accretive to Netflix’s shareholders and give management an opportunity to test different segments within the entertainment industry.
Vertical integration seems cliche given all the capabilities that Netflix has already built in-house or obtained through acquisition. While bolstering its video production capabilities is clearly an important step in maintaining its position within the TV and film market, for Netflix to grow its business overall, it will need to look elsewhere. A horizontal merger with a company in an industry tangential to Netflix’s core streaming offerings provides the blueprint for delivering long-term growth.
Some potential targets that would make sense when viewed from this prism include: SiriusXM’s subscription podcast service, Stitcher, or (if Hastings et al. really want to make a splash) Spotify. The business models of streaming audio companies are very analogous to Netflix’s existing business and provide another means of retaining customers. This would also give Netflix an edge in competing with the likes of Apple and Amazon, who are both heavily invested in audio offerings and are vying for more exposure in that space.
It also goes without saying that both Stitcher and Spotify match the quality levels that Netflix expects of its content. Moreover, Spotify in particular brings to the table a fairly advanced ad-supported model, which is something Netflix has yet to attempt for its video offerings. Spotify has the additional bonus of having star power from a talent perspective (e.g. Joe Rogan, the Duke and Duchess of Sussex, Michelle Obama), something that Netflix could leverage for TV opportunities.
While Stitcher and Spotify seem the most analogous in terms of business model fit, Netflix could also set its sights on data science companies as a way to help improve its algorithms or VR/AR developers. Ventures into these emerging fields are more speculative in nature and may require a shift in terms of company culture but should also provide testing grounds for new offerings and for enhancing their customer experiences for future media consumption.
