This article is contributed by Jun Hao from our Superstocks Seekers team.
After Netflix (NASDAQ:NFLX) reported its Q1’22 results, the share price tumbled 37%. You might ask, what exactly had happened to warrant such pessimism and drastic drawdown?
Well, you’ve come to the right place. Here's what we are going to be covering today in this article.
2020 and 2021 were massive years for Netflix as there was an acceleration in the adoption of digital streaming services. However, as the pandemic severity starts to wind down, and people start to spend more time outside, the elevated demand will be reduced to more normalized levels.
Competition in the industry is also heating up with the influx of streaming services such as Disney+, Hulu, Apple TV+, HBO Max, and Amazon Prime.
This means that users today are spoilt for choice. Companies that fall short of consumers’ expectations, such as the lack of quality content, will find it more challenging to retain these users. The ever-increasing inflation rate has also significantly reduced consumers’ purchasing power, and they are likely to stick with a few core services that are able to attend to their needs. Reports by The Guardian and iMore showed that Apple TV+ and Disney+ have seen huge churn while categorizing Amazon Prime and Netflix as “must-haves”.
However, this is not the time to be complacent just yet.
Companies like Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) have a highly competitive edge over Netflix as they possess highly profitable core businesses financing their investments in curating more content. This puts pressure on Netflix's ability to invest and compete for the long-term while also focus on profitability at the same time.
As soon as Netflix reported its Q1’22 quarterly results, all eyes were on its revenue growth and subscriber count. Subscribers are important as costs can be spread over a larger base, and that contributes to the bottom line.
However, the results were shocking, to say the least.
Instead of reporting 2.5 million new subscribers as guided in Q4’21, the company reported a loss of 200,000 subscribers, making it the first decline in a decade. As a result, the revenue grew at a disappointing single-digit rate of 9.8%, down from the double-digit growth they experienced in FY21. Investors ought to be horrified.
This is attributed to a few reasons:
COVID tailwinds wearing off
The suspension of service in Russia resulted in the loss of subscribers
Factors like the adoption of Connected TVs & on-demand entertainment, which is outside of its control
The inability to monetize the 100 million non-subscribers using Netflix’s password sharing
To re-accelerate its double-digit revenue growth, here’s what the management has laid out to address investors’ concerns:
To reinvest by coming up with more big-hit content that users want to see
To monetize on 100 million households using password sharing
Offer a low-priced plan with advertising
However, we think that the strategies are questionable. Let us share our thoughts.
The management claimed that there is a huge Total Addressable Market (“TAM”):
...while hundreds of millions of homes pay for Netflix, well over half of the world’s broadband homes don’t yet, representing huge future growth potential.
This sounds like they are confident that Netflix has a long runway to grow, and that the majority are to come from international markets. However, instead of reinvesting in the business, why are they focusing on monetizing?
This news came after Netflix announced that it was going to raise the subscription fees in various countries like the US, Canada, the UK, and even Singapore, where we reside. This highlights its inability to find additional income sources, so it had to resort to raising its prices. These increases were not well-received as customers were unhappy with the multiple price hikes and the crackdown on password sharing. During the Q1’22 results, the subscriber count in the UCAN and EMEA regions (the US and Canada) fell by 640,000 and 300,000, respectively.
Coincidence? We think not.
In our view, increasing prices should be a late-game monetization. This is especially so when Netflix is the market leader with a huge TAM. Eventually, it comes to a point where it is impossible to squeeze its customers without it being at the expense of their happiness.
Digital streaming services have been adopting a hybrid model of Advertising-based Video On Demand (“AVOD”) and Subscription Video On Demand (“SVOD”) as seen on platforms like Hulu, HBO Max, and most recently, Disney+.
But, what’s the appeal of a hybrid model?
It is about offering users more control and choices. Users that do not mind seeing ads or are price-sensitive tend to opt for an ad-tier plan, whereas users who prefer a seamless experience are willing to pay more for an ad-free plan. At the same time, the company can generate additional revenue from advertisers by leveraging their massive audiences.
This creates a win-win-win situation.
Operating under a pure SVOD model has limitations – there is a cap on how much it can continue to raise its prices before users get frustrated and leave. Prices are increased to cover the rising cost of creating content, and this makes it harder to juggle the balance of reinvesting in content while also offering it at affordable pricing.
Now, with Netflix jumping on the bandwagon, what does it really mean to its business?
Netflix is very likely to see existing subscribers churn and switch over from a higher-priced plan, cannibalizing their own subscribers. This in turn may affect revenue in the short term. Could this also be the way to win back price-sensitive customers? More churns will lead to lesser revenue, and less money to compete on content, putting pressure on Netflix to compete with players like Apple and Amazon with strong internal financing, and Disney with valuable franchises.
Strangely, this decision was made rather abruptly as back in March 2022 (a month ago), CFO Spencer Neumann resisted coming up with an ad-supported tier model as they didn’t feel it was necessary:
But that's not something that's in our plans right now. We think we have a great model in the subscription business. It scales globally, really well…and again, never say never, but it's not in our plan, but other folks are learning from it. So it's hard for us to kind of ignore that others are doing it, but it now doesn't make sense for us.
Did the management's inability to foresee the slowdown in growth, lack of revenue streams, pressure from shareholders, and increasing competition cause Netflix to succumb to the decision of moving into an ad-supported model, hoping to curb the slowdown in growth to restore investors’ confidence?
During the earnings call, the management talked about reinvesting in its content while also pulling back on its spending to reflect the realities of its revenue growth. Here, you can see that its marketing expenses have declined by ~30% sequentially.
As a result, its Gross Margin and Operating Margin have increased to 45.5% and 25.1%, respectively, during the quarter. Over the next 2 years, they are expected to maintain an Operating Margin of 20%.
This means moving forward, they are going to rely on funding from ads and also increase the revenue per account since it cannot rely on acquiring new subscribers.
Netflix still has lots to prove to justify its price increase. Without more value added, these increases may drive customers away.
This brings us to the next part - its inefficient marketing spend.
In Q1’22, the management spent a total of $556 million on marketing dollars, yet 200,000 subscribers churned during the quarter and a further 2 million expected in the next quarter. This is $555 million down the drain; and worse, they are losing money for every subscriber they acquired!
Furthermore, in the last 2 quarters, its Operating Leverage has started to go downhill as its Operating Profit is growing slower than its revenue growth. This indicates a lack of marketing efficiency as its marketing spend is not translating into revenue growth. In our view, this screams a dire call for change for the marketing team to review its marketing strategies.
At this time, there is no clear visibility ahead as to whether those strategies being laid out can be implemented successfully to resume its Operating Leverage growth.
Netflix has done really well over the last decade to bring a huge amount of content that viewers want and need at an affordable price.
However, the story has drastically changed as existing subscribers are increasingly unhappy with Netflix’s decisions to monetize the platform, and we think their strategies are questionable.
These red flags do not sound like a growth story to us - at least, for the present.
The more important question that many are wondering is, has the management lost track of what it really means to put the customers’ interests first? Can they win back the hearts and trust of their customers? These short-term headwinds are currently a test of their ability to execute, and whether they can navigate them remains to be seen.
What are your thoughts on the quarter? Let us know in the comment section below.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.