Mixed Feelings from Netflix’s Earnings Report

Netflix released its earnings yesterday. There are causes for optimism and concern from what I have seen.

Important metrics improved YoY significantly

This quarter, Netflix added 517,000 domestic paid subscribers and more than 6.2 million international paid members, bringing the total subscriber count domestically and internationally to more than 60.6 million and 97.7 million approximately.

Contribution margin for domestic and international streaming is 41% and 20% respectively, resulting in the margin for streaming to be around 30%. Contribution margin of Domestic DVD is around 61%. Contribution margin represents what is left of revenue after all the variable costs to pay for fixed costs and to generate profit.

On a year over year basis, revenue, operating income and paid memberships saw remarkable growth for a company this size

Cause for concerns

Even though domestic paid memberships increased, Netflix missed its own expectation by almost 300,000, making it the second consecutive quarter that it did so. The company blamed the miss on the higher pricing elasticity than expected

That’s really on the back of the price increase. There is a little more sensitivity. We’re starting to see the – a little touch of that. What we have to do is just really focus on the service quality, make us must-have. I mean we’re incredibly low priced compared to cable. We’re winning more and more viewings. And we think we have a lot of room there.

But this year, that’s what’s hit us. And we’ll just stay focused on just providing amazing value to our members in the U.S. And I think that gives us a real shot at continuing to grow net — long-term net adds on an annual basis. But we’re going to be a little cautious on that guidance and feel our way through here.

CEO – Reed Hasting in Earnings Call (Per Seeking Alpha)

I saw a sentiment floating around on Twitter a while back that argued that Apple TV+ and Disney+ aren’t really competitors to Netflix. I mean, to some extent, they may differ a bit from Netflix, but if we want to talk about competing for viewers’ attention, time and disposable income, how can they not be? Sure, boats move different from trains, but if patrons can choose either to go from point A to point B, how can they not compete with each other? Now Reed Hasting admitted the challenge from other streamers, especially Disney+

From when we began in streaming, Hulu and YouTube and Amazon Prime back in 2007, 2008, we’re all in the market. All 4 of us have been competing heavily, including with linear TV for the last 12 years. So fundamentally, there’s not a big change here. It is interesting that we see both Apple and Disney launching basically in the same week after 12 years of not being in the market. And I was being a little playful with a whole new world in the sense of the drama of it coming. But fundamentally, it’s more of the same, and Disney is going to be a great competitor. Apple is just beginning, but they’ll probably have some great shows, too.

But again, all of us are competing with linear TV. We’re all relatively small to linear TV. So just like in the letter we put about the multiple cable networks over the last 30 years not really competing with each other fundamentally but competing with broadcast, I think it’s the same kind of dynamic here.

Source: Seeking Alpha

Chief Product Officer Gregory Peters made an important point below

I would say our job and then what we think our pricing for a long-term perspective is continue to take the revenue that we have that our subscribers give us every month, judiciously and smartly invest it into increasing variety and diversity of content where we really want to be best-in-class across every single genre.

And if we do that and we’re successful in making those investments smartly, we’ll be able to continue to deliver more value to our members. And that really will enable us to, from time to time, ask for more revenues so that we can continue that virtuous cycle going

Source: Seeking Alpha

Quite an important “if” condition there. In short, Netflix borrows capital to invest in content to the tune of billions of dollars every year and hopes that their subscriber base growth and revenue will keep enabling them to do so. In essence, every streamer will do that. Every single one of them needs to churn out quality content to convince viewers to choose their service. Failure to produce quality content to justify expensive investments will be costly for these streamers.

For Netflix, the stakes seem to higher. Other competitors have additional revenue streams apart from their streaming service. Netflix essentially relies on their subscription revenue. As this quarter shows, the price elasticity already has some negative effect, and it’s BEFORE other heavy-marketed competitors such as Apple TV+ and Disney+ debut in 2-4 weeks. The new challengers price their services at much lower points than Netflix. The room to increase price to recoup their investments faster is getting smaller. I do think a price hike will negatively affect Netflix.

Some may say: oh Amazon kept investing heavily in their early days as well and Netflix can be the same. They are not, as I wrote here. Their free cash flow continues to be in the red while Amazon was in the black for years.

The expensive bidding war for content may play into Netflix’s favor. Their huge subscriber base enables them to spread the cost much better than competitors, especially new ones that have to acquire subscribers from scratch. Hence, it can be argued that Netflix will be one of the only few standing after the dust settles. It does make sense to think about the streaming war’s future that way. As does it make sense to think that there is a possibility that the game Netflix is playing may not work out for them, given the intense competition, the decreased price inelasticity, the huge debt they have incurred and the continuous negative free cash flow.

I think that we will have more clues around the next earning call or two as we’ll see how Netflix will fare after the arrival of Apple TV+ and Disney+. Even then, we won’t know definitively who will win in the end. Fascinating times ahead.

Weekly readings – 5th October 2019

Grab Accounts for 73% of Ride-Share Trips in First Half of 2019 in Vietnam.

Retailer Adoption of Apple Pay Quickens. Since I was able to use Apple Pay on my phone, I have been using it as the first payment method, even in a city as small as Omaha. I have been a pretty happy user ever since.

Source: Loup Ventures

Comparison of smart digital assistants by Loup Ventures

Meet the Women Leading Netflix Into the Streaming Wars

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WeWork Used These Documents To Convince Investors It’s Worth Billions. A long but good article on the accounting jujitsu that WeWork employed

Jiro Ono Documentary

I came across Jiro Ono when I was reading the latest book by Bob Iger, which I wrote about here. I decided to restart my Netflix membership to watch this and it’s worth it.

Jiro Ono lived on his own at the age of 9 without his parents. For almost 75 years, he has been making sushi and doesn’t show any signs of abating. He is still working day and night; and he shows energy of a guy much younger than his age. His dedication to make the perfect sushi and improve every day is so inspiring. Watching him find the perfect suppliers for fish, wasabi and rice as well as prioritize simplicity in his sushi making is exciting.

He is the oldest 3-star Michelin chef in the world and Michelin said that 3 star is the only rating adequate to Jiro’s restaurant. If you are looking for something great to watch on Netflix, I highly recommend it

Are money-losing companies similar to Amazon?

A bullish argument for money-losing companies (companies that have negative operating income) I have seen so far is that they are following the footsteps of Amazon in the early 2000s before the juggernaut became what it is today. Set aside the differences in business environments, the nature of industries and technological advances, there is one important caveat; even though Amazon reported negative net income for a few years before turning profitable, it had POSITIVE free cash flow during that time.

Per corporatefinanceinstitute, Free Cash Flow (FCF) “represents the amount of cash generated by a business, after accounting for reinvestment in non-current capital assets by the company”. It’s equal to, simply speaking, cash generated from operations minus Capital Expenditure (CAPEX). It is a metric to show investors how efficient a company is generating cash and whether the company at hand has enough to pay investors after operational needs and capital expenditures.

This is what Amazon’s annual and quarterly free cash flow looks like over the years. Data is from macrotrends:

Over the years, free cash flow noticeably grew bigger for Amazon, but it was positive even before the introduction of AWS in 2006, which has been the margin maker for Amazon recently. Hence, if a company has negative operating income and still makes capital expenditures to grow, they are NOT similar to Amazon.

A particularly intriguing case is Netflix. The streaming king debuted its streaming service in 2007 and has grown to become the de facto leader in the market. It has had positive operating income, but increasingly invested a massive amount of money in original content, much more than the cash it generates from operations every year.

Since Q3 2014, Netflix hasn’t had a single quarter with positive FCF. The challenge Netflix is facing compared to its competitors is that Netflix has only one source of revenue. Disney, Amazon and Apple, to name just three competitors, have different sources of income. In the case of Amazon and Apple, their streaming services can be argued to be add-on services that function to lock in customers. It is true that given its almost 150 million subscribers, Netflix can spread its content costs across more subscribers than its competitors. Nonetheless, it has to keep investing every year in original content to appeal to consumers. If there is no change in how Netflix can generate revenue besides subscription, I struggle to see how its FCF outlook will differ. Hence, Netflix’s story is NOT similar to Amazon’s in the early 2000s.

Weekly readings – 21st September 2019

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Remarkable story about small Vietnamese community and its transformation

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Creativity Is the New Productivity

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The Cost of a Mile

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Silent Skies: Billions of North American Birds Have Vanished

Netflix: how will the story end?

Notable notes from Disney’s earning call

Today, Disney released their 2019 Q3 result. Below are a few points that stood out for me

  • Hulu got 28 million paid subscribers while the figure for ESPN+ stood at 2.4 million
  • The integration of 21 Century Fox had negative impact on Disney’s earning, including the subpar performance of movies such as Dark Phoenix
  • Direct-to-Consumer & International segment expected to make $900 million loss in the next quarter, due to investment in the launch of Disney + and support for Hulu, ESPN+
  • Fantastic results for the studio as per Bob Iger

The studio has generated $8 billion in global Box Office in 2019, a new industry record. And we still have five months left in the calendar year with movies like Maleficent: Mistress of Evil, Frozen 2 and Star Wars: The Rise of Skywalker still to come. So far this year, we’ve released 5 of the top 6 movies including four that have generated more than $1 billion in global Box Office. Avengers: Endgame is now the highest grossing film in history with almost $2.8 billion worldwide. Captain Marvel, Aladdin and The Lion King have each surpassed $1 billion. And with more than $960 million in Box Office to date, Toy Story 4 will likely cross that threshold in the coming weeks. And all of these movies will be on Disney+ in the first year of launch.

SeekingAlpha
  • The leadership behind the studio will manage the film strategy for 21 CF as well
  • Deadpool, Fantastic 4 and X-Men will be part of Marvel Studios
  • Come this November, users can have access to Disney+, Hulu (ads-supported) and ESPN+ as a bundle for $12.99 a month, well below the total sum of all threes, if subscribed separately
  • “Hotstar had more than 300 million average monthly users, served an unprecedented 100 million daily users and delivered a high-quality streaming experience to 25.3 million simultaneous users, which is a new world record”
  • Disney is discussing deals with Apple, Amazon and Google as distribution partners, deals that are expected to close
  • Focus on marketing for Disney+, per Bob Iger

Disney+ marketing is going to start to hit in later this month, later in August. We’re actually going to allow members of D23 to be the first to subscribe. I’m actually going through a comprehensive marketing plan with the team next week. Comprehensive probably is an understatement. It is going to be treated as the most important product that the company has launched in, I don’t know, certainly during my tenure in the job, which is quite a long time. And you will see marketing both in traditional and nontraditional directions basically digital and analog also significant amount of support within the company on basically company platforms. And then of course all of the touch points that the company has, whether it’s people staying in our hotels, people that have our co-branded credit card, people who are members of D23, annual passholders, I could go on and on. But the opportunities are tremendous to market this. And I feel good about some of the creative that I’ve already seen. But you won’t start to see it until later this month.

SeekingAlpha

Quick Thoughts

I cannot wait to see the battle of the streamers and how well Disney+ will fare. As a student of business, I am fascinated to see the strategies and execution of Disney+ vs Netflix. Netflix has a huge subscriber base as advantage over Disney+, in addition to a household name (ever heard of “Netflix and chill”?) and some great original content. But Disney has its own strengths as well, including marketing expertise, household name, a great content library and additional revenue streams.

I am thrilled to see how fast Disney+ will be able to sign up folks. The emphasis on marketing, the aggressive pricing of the streaming service, the bundle and the focus on exclusive content in spite of loss from licensed deals show that Disney is dead serious. It will be interesting to see how viewers will react and whether there will be some market share loss by Netflix at the hands of Disney+ and other upcoming streamers.

I honestly don’t know how it will go. As a fan and a consumer, I cannot wait to see.

Disclaimer: I own Disney stocks in my portfolio.