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.

Disney+

Thursday was a big day for Disney as the company announced the much anticipated streaming service called Disney+. You can learn more about it from this link. The top executives went through a lot of aspects of the new service, including programming, roll-out plan, pricing, investment in future original content and forecast financial impact. The service will offer users ad-free access to an incredible library of content owned by Disney, such as Marvel movies, Pixar, Star Wars, Disney and National Geographic. Users will also be enjoying some new original content such as WandaVision, Loki or Falcon and The Winter Soldier. The price is very attractive at $6.99/month or $69.99/year with all content downloadable for offline consumption.

It is a serious challenge to Netflix as Disney has plenty of content that can appeal viewers across demographics, the brand name, the marketing expertise and the financial resources. It can be argued to some extent that Netflix also has a brand name (apparently “Netflix and chill” is quite popular in our society), content (it invests billions of dollars in originals) and the marketing power. But there are two things that Disney has going for them: additional revenue streams and the ability to bundle more.

Firstly, below is the segmentation of Disney’s revenue and operating income. (Figures are from Disney 2018 & 2017 annual reports and in $ millions)

Metric2018201720162015
Revenue – Services        50,869         46,843         47,130         43,894
Revenue – Products          8,565           8,294           8,502           8,571
Revenue – Media Networks        24,500         23,510         23,689         23,264
Revenue – Parks and Resorts        20,296         18,145         16,794         16,162
Revenue – Studio Entertainment          9,987           8,379           9,441           7,366
Revenue – Consumer Products & Interactive Meida          4,651           4,833           5,528           5,673
Operating Income – Media Networks          6,625           6,902           7,755           7,793
Operating Income – Parks & Resorts          4,469           3,774           3,298           3,031
Operating Income – Studio Entertainment          2,980           2,355           2,703           1,973
Operating Income – Consumer Products & Interactive Media          1,632           1,744           1,965           1,884

In 2018, Parks and Resorts’ operating income is almost three times that of Netflix in total, let alone other segments of Disney.

Source: Netflix

I think it’s great for Disney to offer an attractive penetration pricing model to quickly sign up viewers and scale up. Additional revenue streams, in my opinion, can help finance the play. Meanwhile, a Netflix plan is almost twice as expensive as Disney+, at least in the US market. I doubt that Netflix will lower its price to match Disney+’s, given their increasingly big investment in content and troubling negative free cash flow.

Source: Netflix

It’s not a zero-sum game. I believe that a lot of viewers will have both streaming services or even have Netflix exclusively, but on the other hand, some will likely choose Disney+ over Netflix. If the economy is still strong and folks have disposable income to spare, I think it will be beneficial for Netflix. However, if the economy contracts in the future and spending cut is required, I suspect that Disney+ at this current price will appeal more than Netflix.

Secondly, Disney now also has ESPN+, a sports subscription, and Hulu. Disney already said that there was a chance they would bundle Disney+, Hulu and ESPN+ together. It will be even more attractive to viewers.

With all that being said, execution matters. Though it seems Disney has a lot going for them, this is a new territory for them while Netflix is the trail blazer in video streaming services. I am excited about this competition in the future and Disney+ itself, as a big Marvel fan.

Disclaimer: I have Disney in my portfolio, but this post stems from my curiosity and is not an investment suggestion or anything more than just my opinion.

New Netflix price surge. Should Netflix livestream sports?

Yesterday, Netflix announced their new price structure. Per WSJ:

Netflix will increase the price of its most popular plan 18% to $13 a month from $11. That plan allows users to stream from two screens at the same time. The most basic plan, which allows a single stream in standard definition, will go up one dollar, or 13%, to $9 a month. The new rates will go into effect immediately for new customers and be applied to the accounts of existing customers in the next few months, according to a person familiar with the plans.

The increase in price is not really surprising in my opinion. Netflix has been investing heavily in original content. WSJ reported that the investment would amount up to $12 billion this year. Netflix needs to enlarge its war chest and the additional revenue from the new prices will help with that. It doesn’t hurt that Netflix has some wriggle room to up its prices, according to Priceintelligently. Additionally, as some content owners such as Disney or Warner Media plan to launch their own streaming services, Netflix will likely have to pay more to retain popular shows or movies.

But there is only so much room for increase in subscription prices. If Netflix pushes too hard, they may lose viewers. Consumers will have more options with the arrival of Disney, Warner Media and NBC, in addition to major current players such as HBO, Amazon, Hulu and Showtime. A normal user should not be expected to pay so much for subscriptions every month. Netflix may need to find another area to grow its user base and revenue.

Should Netflix go for sports?

Sports is a hugely important part of our life and hence it is important to businesses that want our money and attention. To see how important sports become to social media and streaming services, here are a few headlines:

The last headline is very interesting. Coming from Vietnam, I can tell you that football (as millions of people in the world outside the US call it) is a religion in my country and hugely popular in that region. Premier League, in particular, attracts football fans in Vietnam in a way that few leagues do. We have to or at least, used to pay for cable TVs to be able to see the games. The service is subpar, and the fees are slightly cheaper than a Netflix subscription. Vietnamese users pay around $8-9 a month for a Netflix subscription while a cable subscription costs around $5-7. If the fans can stream games from their laptops/computers or project games onto TV through Netflix, it will be a game changer. Fans will strongly consider the service, especially with hours of shows and movies as well.  

But does it make sense for Netflix to do so from a business and financial standpoint? Let’s run a scenario.

Together, Vietnam and Thailand have 165 million people in population. The total number of Netflix subscribers in the two countries are just 500,000 (300,000 for Vietnam and 200,000 for Thailand). If we just assume that 40% of the two countries’ population are young from 15 to 40 years of age, fitting the target demographic, I presume, for Netflix, the Total Addressable Market (TAM) is around 66 million for Vietnam and Thailand. I don’t have the number of subscribers in Laos and Cambodia, but if we apply the same assumption to those countries, the TAM is 9.2 million potential subscribers. For the four countries, the TAM is around 75 million.

If a subscriber is worth $8/month and Netflix gains around 100,000 subscribers a year each in Vietnam and Thailand, as well as 50,000 each in Laos and Cambodia, the total revenue can be around $230 million in 3 years, $30 million less than what Facebook pays for its exclusive rights. Also, the total number of subscribers should be at least 1.7 million, barely a fraction of the TAM mentioned above (75 million).

If we increase the subscription price by $1 in the original scenario, the revenue will be around $259 million, almost as much as what Facebook paid.

If the number of subscribers in that scenario goes up by 30%, the revenue in 3 years will be around $300 million and the subscriber count in 4 countries for Netflix will be around 2.06 million, still a small fraction of the TAM.

Of course, all of the above are assumptions which can be way off the mark, but to me, it seems that it is an opportunity there for Netflix. Besides the financials, gaining more subscribers can make Netflix more valuable due to network effect and give them more data about the users. Netflix paid $100 million to keep Friends on its network for a year. Given that amount and the potential upside of providing sports to international markets, I believe Netflix should give it a try. Plus, it can’t afford to see competitors add sports to their selection without doing anything.

I admire the consistency and focus of Netflix. They have been very consistent on their long-term view as a video streaming service. Nonetheless, the situation may necessitate some changes in the future.