Streaming wars and the Netflix business model

Key points:

• Netflix disrupted the television and film industries by creating an on-demand, video streaming service at a relatively low price point.
• While Netflix is still growing its subscriber base, it is spending far more money on producing original content than the profit it’s earning and funding the cash flow deficit with debt.
• This probably won’t change any time soon, as more competitors join the streaming entertainment space, spending billions on new content and withdrawing their titles from the Netflix library.
• Digital advertising could be an interesting secondary income stream for Netflix if it chooses to go down that path.

Netflix was a US$300 million-dollar company that ran an online DVD rental service when it became a public company more than 17 years ago.

Today, the company is one of the largest technology companies in the world and its market cap is worth US$127 billion. Not only is Netflix the leading video streaming platform in the world by revenue, it is a major Hollywood studio in its own right.

Netflix is undoubtedly one of the most interesting business case studies in the internet age, having successfully evolved its business model to get ahead of competitors and growing exponentially because of it.

But its business model is also being challenged by traditional media companies and cashed up tech companies who all want to get a piece of the pie and are prepared to spend billions on content.

Let’s take a closer look at the investment case for Netflix and whether its business model can hold up.

Understanding the Netflix business model

Netflix makes money by charging its subscribers a relatively low, flat monthly fee to access thousands of shows and movies.

Netflix’s direct costs consist of licensing fees and the cost of producing its original content assets (through amortisation). Licensing fees, which are paid to the owners of the content, are typically a large fixed amount and region specific. For instance, Netflix reportedly paid US$100 million to continue licensing “Friends” from WarnerMedia for US subscribers through 2019 (for a period of one year).

Amortisation costs of its original content assets has been increasing in recent years as Netflix has ramped up its spending on original content.

Netflix benefits from economies of scale, which means as its subscriber base grows, it benefits from lower unit costs, due to its large fixed cost base. The more paying subscribers Netflix can attract, the more profitable the company can be.

With a stellar product at a great price, Netflix’s subscriber base has grown rapidly, more than doubling between 2015 and 2019.

In Q2 2019, Netflix has 160 million subscribers and earned US$4.29 billion of revenue. Source: Bloomberg

Netflix vs theatrical release vs cable television

While Netflix’s business model is simple to understand, it was considered quite radical at first.

Netflix’s business model is similar to cable television in that members pay a monthly fee for access to a bundle of exclusive channels such as HBO or Food Network. However, Netflix has a significantly lower price point and does not play advertisements, which is a source of revenue for cable television providers. Importantly, Netflix is a digitally native, on-demand platform, compared to the linear television experience.

Film is different. Traditional film studios release their films exclusively in theatres first before making money on DVD sales and licensing the film to video streaming platforms like Netflix and Amazon Prime.

On a standalone basis, theatrical release can be the most profitable model since individual films can make billions from box office sales alone. For instance, Marvel made more than US$4 billion in worldwide box office in 2018 from just three films (“Avengers Infinity War,” “Black Panther” and “Ant Man and the Wasp”) proving that consumers are willing to pay to see films at the theatre on release. Meanwhile, Netflix released 345 original titles in 2018, including hit films such as “Bird Box,” “Roma” and “To All the Boys I’ve Loved Before,” earning revenue of US$15.74 billion.

Compared to its peers, Netflix looks like its forgoing some revenue opportunities in order to provide the best product to consumers at a bargain basement price. But it worked for Netflix with cable providers Charter Communications and Comcast losing 122,000 and 96,000 subscribers in the first quarter of 2018 respectively and Netflix onboarding a net 1.96 million subscribers in the same quarter..

Is the Netflix business model sustainable?

It’s hard to say.

Netflix recorded a bottom-line accounting profit of US$270.7 million in Q2 2019.

However, Netflix is not even close to being cash flow positive. That’s because the money it spends on its original content is capitalised as an asset on the balance sheet. This allows Netflix to spread the cost (amortisation) over many years, rather than write it off immediately.

Data source: Bloomberg

And Netflix is spending far more on producing content than the profit it’s earning. In 2018, it spent more than US$13 billion on producing new content compared to bottom line accounting profit of US$1.2 billion. In fact, the amount of money it spent on producing new content is closer to its full year revenue of US$15.8 billion.

Data source: Bloomberg

Netflix is funding the company’s negative cash flows by issuing debt. Netflix’s debt is rated Ba3 by the ratings agency Moody’s, which means it’s considered junk debt.

Can advertising change the Netflix business model?

Financially speaking, the current Netflix business model sounds precarious. The company knows it needs to make more money. Netflix hiked its monthly subscription fees in April this year, which was followed by the loss of 130,000 US subscribers over the quarter. While it’s small in the scale of things, what if there’s another way to grow the top line?

It’s interesting to compare Netflix to digital advertising models. Google (through YouTube) and Facebook revolutionized the advertising market through hyper-targeted ads embedded in their video content. It’s incredibly profitable too.  Facebook achieved an average revenue per user of US$125.86 in the US and Canada over the last 12 months from advertising alone.

We think Netflix has the potential to do the same. Firstly, Netflix’s engagement is very high. The company says its subscribers watch an average of two hours of content a day, compared to an estimated 37 minutes for Facebook and 29 minutes for Facebook-owned Instagram.  Secondly, with the data Netflix collects on its users, it could create hyper-targeted video ads just like YouTube and Facebook.

Netflix’s competitor Hulu sells an advertising supported plan that costs US$5.99 a month alongside an ad-free version that costs US$11.99 a month. The move hasn’t alienated customers, with 70% of its viewers on the cheaper, ad-supported plan. Advertising has become a significant business for Hulu, generating US$1.5 billion in ad revenue in 2018.

Even though management has stated it won’t introduce advertising, it’s hard to deny how powerful it could be if executed well. Advertising could be a very lucrative secondary revenue stream for Netflix, allowing it to leverage its powerful engagement metrics and enable it to continue to offer its subscriptions at a low price point.

Streaming wars

The popularity of Netflix’s streaming platform and Netflix’s original content hasn’t gone unnoticed by its peers.

While Netflix remains the top streaming service, its competitors, Amazon Prime Video, Hulu, and HBO Now, are starting to cut into its market share. Regional competitors like iQiyi in China and Nine-owned Stan in Australia, have also emerged. It hasn’t been an issue for Netflix so far, as the pie has been growing too.

But even more competitors are set to join the ring, one after another. Disney’s upcoming streaming platform, Disney+, will launch in November this year for US$6.99 a month or as a bundle (with ad-supported Hulu and pay television sports channel ESPN+) for US$12.99 a month.

Apple’s new service, Apple TV Plus, is rumoured to launch in November this year for US$9.99 a month. Unlike Netflix and Prime Video, Apple TV Plus will not offer any licensed content at all and only feature new original shows and films.

WarnerMedia’s streaming service is also expected to debut this year, bundling HBO, Cinemax and its vast Warner Bros. television and film library, for between US$16 and US$17 a month.

And that’s not all. Comcast/NBC Universal’s as yet unnamed service is expected to launch in April 2020 and is noteworthy for being the new home of “The Office,” currently Netflix’s most-watched show.

And they’re all set to open the purse strings and follow the Netflix handbook of producing original shows and television for their streaming services.

Netflix is still poised to dominate original content spend (for streaming) but others are ramping up spend.

The main risk is that these other companies who have extensive back catalogues (especially Disney, Fox, Warner Bros., NBC Universal) will pull their content from Netflix to host it exclusively on their own streaming services. For instance, “The Office” will be pulled from Netflix in 2020 and join NBC’s streaming service. “Friends” will be pulled in 2020 and join HBO Max. Marvel and Star Wars titles were also pulled from Netflix in 2017 by Disney and will join Disney+.

While we think Netflix’s original content is strong and while it continues to invest in building up its catalogue, hosting popular titles exclusively could help these new streaming services gain traction and potentially take market share from Netflix.

Valuing Netflix

Netflix trades on ~34x enterprise value/forward EBITDA and ~6x enterprise value/ forward revenue, quite lofty multiples for a large cap media company that’s burning through cash. However, its valuation is off its all-time high reached in June 2018 when it traded on nearly 11x enterprise value/ forward revenue.

Netflix’s market valuation is more in line with software as a service (SAAS) companies rather than media companies; Netflix’s subscriber-based revenue were thought to be recurring, just like software subscriptions. For instance, Salesforce trades on ~7x enterprise value/forward revenue.

Media companies on the other hand trade on much lower multiples and most of them are profitable and cash flow positive. Disney trades on ~16x enterprise value/forward EBITDA  and ~4x enterprise value/forward revenue.

Films are typically considered by investors to be one off products with unpredictable revenues, rather than recurring sources of income.

Are subscriptions really recurring revenue?

Unlike the cable television of old, Netflix makes it super easy for you to cancel your subscription without penalty — with just a click of a button. While it’s customer friendly, does it really count as recurring revenue?

Netflix hasn’t disclosed its churn numbers since 2010 but other providers have tried to estimate it. The Financial Times analyses the mid-point of estimates to be around 9% per quarter or 36% a year. While that’s not sky high, it wouldn’t be considered low churn either.

Bottom line

The war for eyeballs is on. We see challenges near on the horizon for Netflix as well-funded competitors muscle in on the streaming space and begin withdrawing their key titles from the Netflix library. Netflix is also vulnerable from a business model perspective, and is unlikely to be able to stem the bleed of their negative cash flows anytime soon. On the other hand, Netflix has a first mover advantage, having built up its own library of original content and being the dominant player in a growing market.

The Spaceship Universe Portfolio currently invests in Netflix

Important! We’re sharing with you our thoughts on the companies in which Spaceship Voyager invests for your informational purposes only. We think it’s important (and interesting!) to let you know what’s happening with Spaceship Voyager’s investments. However, we are not making recommendations to buy or sell holdings in a specific company. Past performance isn’t a reliable indicator or guarantee of future performance.