Last week, Netflix ($NFLX) missed their subscriber target by 2.3 million. Also, they lost 100k subscribers in the U.S., and their stock fell ~16% on the week, the largest weekly decline in years.
After the miss, a narrative started to develop:
- They are losing two of their most popular shows — “The Office” and “Friends.” How will they replace them and keep subscribers from churning?
- They have reached the upper limit on their ability to raise prices.
We will address those narratives in a minute. But first, let’s back-up and go over some standard terms used when describing various OTT players and get a snapshot of the current landscape.
- VOD-Video on Demand. A programming system that lets viewers watch TV or movies anytime. Rather than at a scheduled time, like traditional TV shows.
- OTT-Over the Top. Lets users watch content via the internet; instead of using a cable provider. All of the new streaming services, from Netflix to Sling TV, use some OTT versions to deliver their content.
- SVOD-Subscription Video on Demand. Think Netflix. Users pay a set amount each month to access the content.
- AVOD-Advertising Video on Demand. Think YouTube or Hulu. The service is free, but the content is monetized through ads. (Hulu does have a premium subscription that lets you skip ads.)
- TVOD-Transactional Video on Demand. Think Apple TV or Roku. A platform that lets you pay based on the amount of content you watch.
- MVPD-Multi-Channel Video Programming Distributor. Think traditional cable companies like Comcast, Direct TV, and Cox.
- Virtual MVPD-Similar to traditional MVPD, but with one difference. The bundles are delivered via the internet. And are commonly referred to as “skinny bundles.” Think Sling or YouTube TV.
Netflix, Amazon, and Hulu are the existing players in this space. AT&T, Apple, Disney, and Comcast/NBC Universal are launching their own OTT services in short order. Here’s a summary of what each company is attempting to do.
- Netflix-The giant and undisputed leader. They spend more on content than the rest of the companies combined. They will spend ~$15 billion on content in 2019.
- Amazon Prime Video-Second behind Netflix in content spending. Jeff Bezos has given Amazon Studios the green light to go after major projects. They paid $250 million for the rights to the Lord of Rings TV series. And will spend another $750 million making it.
- Disney+-The best IP in the business. However, they are starting with zero subscribers. Our guess is they will be the #2 player in SVOD within five years.
- Hulu-Majority owned by Disney with Comcast/NBCU holding a 33% stake. They offer both a free tier (ad-supported) and a premium tier (monthly subscription).
- HBO Max from AT&T/WarnerMedia-Like regular HBO, but with a more extensive content library. Subscribers will have access to some or all of WarnerMedia’s extensive catalog (includes Friends and DC Comics).
- Apple-They have been light on details. Oprah, Steven Spielberg, and Jennifer Aniston are creating shows.
- Comcast/NBC Universal-Again, they are light on details. This will be the new home for The Office when their contract with Netflix is up in 2020.
It’s crucial to remember Netflix’s LONG-TERM ambition. And it’s not to make “a few good shows.” They aim to replace your entire TV viewing experience (excluding live shows like sports and news).
And that means making large amounts of content. And most of the content will be average. And that’s ok. Their subscriber base is large enough that one person’s average show is another person’s favorite show.
Cable TV enables niche. That’s what makes it great. Lifetime, the Food Network, the Hallmark, and History channel. All niche channels created for a specific viewer.
Netflix is recreating this experience. Like the Food channel? Here’s Chef’s Table or the Taco Chronicles. Enjoy cheesy Lifetime movies? Check out Secret Obsession (released last week). Thrillers? Yep. Stand up comedy? Of course.
Not only does Netflix want you to hire them for all your video consumption. They let you do it for a lower price. And that’s the key. Delivering shows you love, and it’s cheaper than cable (the average cable bill is $85. Netflix’s most expensive tier is $16).
If they can get you to hire them for your cheesy Lifetime movies and food documentaries, they’ve hooked you. And every minute you spend on their platform, they’re learning more about what you like and what you don’t like. So they can create an experience so good that browsing Netflix becomes a habit — and sooner or later — that $85 you spend on cable, can be put to better use.
Quality vs. quantity
Now let’s address points (i) and (ii) from above: (i) They are losing two of their most popular shows — “The Office” and “Friends.” How will they replace them and keep subscribers from churning? And (ii), they have reached the upper limit on their ability to hike prices.
These points are a common reason why bears believe Netflix is overvalued and due for a pullback. Also, for Netflix to address point (i), they need to spend more money to make or acquire content. Or, have a better batting average when it comes to making hit shows.
Those are valid points, and the bears may turn out to be right. Losing The Office and Friends is a big blow. Those shows are the definition of a Rewatchable.
And it’s not a sure thing that viewers will migrate to other content on Netflix (When asked about it on their most recent earnings call, Netflix executives believe viewers will consume other content when The Office and Friends are pulled from their platform).
But the first episode of Friends aired in 1994. The first episode of The Office in 2005. Both were created before Netflix made the big jump into original content. Both shows are decade-defining and will command an audience twenty or thirty years after their creation.
In our view, what Netflix has been lacking is a decade-defining show, specifically in comedy. A Rewatchable, like The Office or Parks and Rec. A show that will not only attract new subscribers but also keep them from churning. What’s the likelihood that Netflix will create a show of that caliber in the next five years?
Another question: What’s the best way to produce high-quality anything? Writing, TV shows, software, whatever?
To answer the question, let’s refer to this story about a ceramics class.
On the first day of ceramics class, the teacher divided students into two groups. The group on the left would be graded on the quantity of the work they produced. The group on the right would be graded on quality.
His procedure was simple: on the final day of class, he would bring in his bathroom scales and weigh the work of the “quantity” group: fifty pounds of pots rated an “A,” forty pounds a “B,” and so on. However, those being graded on “quality” needed to produce only one pot – albeit a perfect one – to get an “A.”
Well, grading time came, and a curious fact emerged: The highest quality works were all produced by the group being graded for quantity. It seems that while the “quantity” group was busily churning out piles of work – and learning from their mistakes – the “quality” group had sat theorizing about perfection, and in the end had little more to show for their efforts than grandiose theories and a pile of dead clay.
In other words, the group that took more swings ended up producing the highest quality work.
Despite the worry about Netflix spending gobs of money creating content, they will have taken more swings than anyone. They will learn from their mistakes (hopefully), improve, and take another swing. And in doing so, have a fighter’s chance of creating the next decade's defining shows.
And if they can pull that off, would you pay more than $16 bucks a month?
The most important question: Is Netflix a good investment at these prices?
Even though we like their chances at remaining the dominant streaming player, we wonder what their ceiling is, and how much growth has already been priced in?
Currently, their market cap is ~$135 billion. A double from here would put their market cap at $270 billion, which would make them a top twenty company in the U.S.
If they double in five years, that’s a CAGR (compound annual growth rate) of 14.87%. If it takes ten, the CAGR is 7.18%. Those aren’t the growth rates Netflix investors have come to expect.
If their ceiling is $270 to $300 billion in market cap, is that enough upside to justify taking a long position, considering there is some chance the bears are right? And competition, debt levels, and lack of hit shows could stunt Netflix’s growth for the next decade?
Good, even great companies can make bad investments if the price paid is too high.
The question we’re grappling with: At these price levels, is Netflix a mispriced security, based on our read of the future, and the current expectations embedded in the price?
Additional questions and reading material
- How will 5G affect video viewing? I couldn’t find a consensus on whether 5G will be faster than WiFi. The general answer was, “it depends on where you are.” Faster in certain areas, slower in others. Similar to the cell phone coverage we have now. But let’s assume it’s comparable. Instead of checking Twitter or listening to a podcast on your 30-minute commute, would you instead watch Netflix or YouTube if the experience was just like watching at your home?
- The Streaming Wars: Its Models, Surprises, and Remaining Opportunities: Mathew Ball is my favorite writer on the subject of media and entertainment. He lays out what I did, but in greater detail.
- Also, check out his eight-part series called “Netflix Misunderstandings.” Here’s part 8:Netflix Won't Be Felled by Recession, Bond Markets, Debt, or Cash Losses (Netflix Misunderstandings, Pt. 8 ). He addresses two points. (i) Why Netflix won’t collapse during the next recession. And (ii) Why the issue around Netflix’s negative free cash flow is overblown.
- Q2 2019 shareholder letter | Earnings call transcript.
- Netflix has an entire site dedicated to research. They lay it all out there. After reading through the website, it's apparent to us just how far behind the competition is.