Wednesday 23 January 2019

Is Netflix screwed?

Netflix has become a darling stock over the past decade (despite a moderation in the euphoria of late), and is an honourary member of the FANG club. It is seen as one of the new breed of incumbent online monopolies, and trades at more than 100x current earnings. However, to my mind, many investors seem to be ignoring some fairly important realities/risks, and believe it can be argued that Netflix is more akin to a Tesla than an Amazon - i.e. a company that is set to become 'just another media (auto) company' that will soon have to compete with many seasoned competitors in possession of far greater financial resources. It's going to be interesting to see what happens.

To date, Netflix has been a huge success, and hugely popular with customers, for a very obvious reason: they were the first to offer a service with a customer value proposition akin to: you can watch virtually any scripted TV show or movie you want, anytime, for about $10 a month. Who wouldn't like that? Not surprisingly, the company's subscriber base grew very rapidly.

They provided this value proposition to customers by signing up online distribution rights from traditional content companies, who made (and continue to make) most of their money through the traditional pay TV bundle. The content companies saw Netflix as an additional monetisation opportunity for content they had already made/were making, and were already getting paid for, so those extra revenues would flow straight to their bottom lines. Furthermore, Netflix would not break the traditional pay TV bundle, they reasoned, because the latter also had sports and live news, and so would remain in demand. Often traditional pay TV services were bundled with high speed broadband access as well.

However, while customers loved the product, Netflix made very little money doing it, because they were doing little more than aggregating this content onto a simple online interface available for streaming. The margins were very thin, and the traditional content owners captured virtually all of the value. Consumers loved Netflix, but it wasn't a great business. This made sense, because most of the value being provided to customers derived from the content itself. Putting it all together onto an online interface that made it convenient to access added value, but this was a simple business that wasn't all that hard to replicate. And it had no value without a large content library.

Then, much to the surprise of many of its content suppliers, Netflix strategically pivoted, and in a manner that unveiled grave long term strategic risks to content suppliers that they had previously overlooked: Netflix started producing its own content, and started giving primacy to marketing its own content on its platform ahead of those from external studios (e.g. through their 'recommendation engines').

Traditional content producers, who had previously considered Netflix merely a content distribution partner/customer, suddenly realised they had made a huge strategic blunder. By providing Netflix with access to much of their content, they had allowed Netflix to aggregate a large audience of subscribers. And by aggregating those subscribers, Netflix was able to dictate what they watched, and was now attempting to use that large audience against them. They had forgotten to insist on Netflix not self-producing its own content as a condition of carrying their content. As Netflix's control of eyeballs continued to increase, and it's own library of content also grew, they would have more and more power to cut traditional supplies out of the picture entirely, or at the very least significantly weaken their bargaining position. Netflix would have the power to say 'cut prices 50% or we drop all your content', as we already have enough of our own, and they would have no choice.

Traditional content producers were slow to realise what was happening, but they eventually woke up (a couple of years ago). They realised that Netflix was not a distribution partner at all, but a competitor, and one that wanted to put them out of business long term and monopolise the entire global media profit pool (on both content production and distribution). And by supplying Netflix with content that was helping them to drive growth in subscriber numbers, they were 'feeding the dragon'. The bigger Netflix got, the more content they would be able to produce, and at a lower cost per subscriber, the more customers they would be able to attract. This would then allow them to produce even more content, in a flywheel that could result in Netflix dominating the entire global scripted media industry. They had set in motion events that were resulting in them digging their own graves.

Unfortunately, in many cases these suppliers had locked themselves into 3-5 year content deals with Netflix, and so there was not much they could immediately do about it. However, the problem Netflix will face over the next several years is that these content deals are going to start to expire. Several content companies (notably Disney) have stopped signing new deals with Netflix, and have also said they intend to pull most of their content off the platform this year, as legacy deals expire.

In the not too distant future, the only content you will be able to access on Netflix will be Netflix's own content, plus perhaps a bunch of indi films, etc, that don't have mainstream distribution access (unless Netflix is prepared to pay uneconomically high prices for traditional studio content). What this means is that their value proposition to customers of 'watch any show you want, anytime, for $10', is going to become 'watch any show Netflix has produced, any time, for $12' (they just raised prices). In coming years, more and more customers are going to have the disappointing experience of trying to look up some of their favourite shows to watch, and realising they are no longer available on Netflix. It's going to happen a lot, and customers are going to be surprised and disappointed.

Meanwhile, all of the non-Netflix content produced by the traditional studios, as well as their massive content libraries, will soon be available (if not already) on a wide variety of competing streaming platforms owned by the traditional media companies themselves. It seems to me that the platform that is most likely to win with customers is going to be the one that offers the widest array of shows from the widest array of studios, because that's what customers want. They want to be able to access any show they want to watch from a single platform, just like customers do with Spotify when they listen to music. In other words, customers want the platform that represented Netflix's value proposition 3-5 years ago, rather than the Netflix that will likely exist in the next few years.

The frontrunner in this regard would seem to be Hulu, in my view (which, incidentally, has recently started to add new US subscribers at a faster pace than Netflix). Hulu is 60% owned by Disney (formerly 30% Disney and 30% 21st Century Fox, but the former just acquired most of the scripted content assets of the latter, as well as its stake in Hulu), Comcast's NBC Universal (30%), and AT&T's WarnerMedia (10%). This platform can draw on the combined content production budgets of all of these shareholders (as well as other traditional media companies), as well as their deep libraries which reflect the fact they have been producing content for 50 years, vs. less than 10 for Netflix. They could also re-jig shareholdings to match their respective content contributions, and bring new traditional media shareholders into the fold. It is also possible a new Netflix-like platform emerges that promises to not self-produce content, that all the traditional media companies get behind.

This is why we have been seeing so much M&A in the media space, as traditional content producers rush to get bigger. Disney, for instance, recently bought out most of 21st Century Fox's scripted content assets, in one of the biggest media deals of all time; Discovery merged with Scripps last year; and Comcast bought Sky TV in the UK (which self-produces 50% of its content), after a bidding war with Fox. Telcos such as AT&T have also been pushing into content (acquiring Time Warner) in an effort to differentiate their increasingly-commoditised services (they want consumers to have a reason to stick with them other than just price). Traditional content companies have realised that the online platforms with the widest availability of content are going to win, and so they need to get bigger. Big enough that they have larger libraries and content production budgets than Netflix. That's why they are merging. They are not stupid, and they now know what they need to do to win.

What this means is that Netflix is soon going to have to compete with platforms and media giants that have access to much bigger content libraries, and much bigger combined annual scripted content production budgets, than Netflix does. It's going to be interesting to see how consumers react, but in my opinion, consumers are likely to migrate to the platform that is more likely to have all the shows they want to watch available. And they could also potentially do so quite quickly.

That being said, it is true that scripted TV is not a winner takes all business. Individual shows and movies are genuinely differentiated. A lot of customers may well continue to see $12 a month as good value for Netflix, given its growing library and content budget. Customer inertia will also work in their favour. However, ultimately, these new industry/competitive dynamics are going to turn Netflix into 'just another media company', like say HBO. Would you pay $12 just to subscribe to HBO? They have a lot of great content. You might. But it's not the same as subscribing to all content, everywhere, and the target market is likely to be much smaller.

In addition, very importantly, Netflix does not have the cost of its content creation subsidised by affiliate fees and advertising revenues from the bloated costs of the traditional pay TV bundle, where although subscribers are declining, they are still large. Netflix has only one content monetisation channel - low cost monthly subscriptions. But this begs the question, just how profitable is this going to be for Netflix? We don't know. And if an online price war for consumer eyeballs were to emerge, it seems likely that Netflix will lose, because they are already barely profitable and are FCF negative, while the media giants are monstrously profitable and generate tonnes of FCF. That means the latter have significantly greater capacity to cut prices than Netflix does.

Furthermore, investors have forgotten that Netflix's customers can cancel anytime without notice, or strategically sign up and cancel multiple times, in order to 'game the system'. You can sign up for one month for $12, for instance, binge watch entire seasons of all your favourite shows, and then cancel your subscription. You can then come back for a month next year and watch the new seasons. Customers haven't gamed it like this in the past because Netflix was their go-to for all content. But if Netflix is merely a place they go to watch one or two shows they like, it becomes a real risk. And Netflix's business model won't work if a lot of customers do this. It's also a particularly pronounced risk because Netflix has massive content-production financial commitments. If their customer count drops, the fixed costs of producing shows will increase on a per-subscriber basis, squeezing margins.

It's going to be interesting to see what happens. I've been a happy Netflix customer in the past, but am waiting for the day Hulu extends its services globally (it is still constrained by legacy rights deals with traditional pay TV operators in many markets), and makes its services available in places like Singapore, where I currently reside. If and when they do, I'm probably going to switch to Hulu. Netflix only has a couple of shows they produce that I want to watch every year (although to be fair, I do not watch a lot of TV), and they no longer carry most of my favourite shows. It remains to be seen if other customers behave similarly.

Time will tell. I wouldn't short Netflix, because there is still a plausible bull case that they come to entirely dominate the global scripted media industry long term, if they pull off their strategic ambitions. This is a huge economies-of-scale business, and they have been an early mover. The flywheel effect is significant. As their subscriber count grows, their cost of content production per subscriber falls, which allows them to produce more content to attract more subscribers, etc. This is the same flywheel that worked so well for the traditional pay TV ecosystem in prior decades. If they succeed, there is still significant upside. However, this flywheel cuts both ways, and if subscriber growth undershoots expectations and goes into reverse, Netflix could well blow up.

So I wouldn't short it. Buying deep out of the money long term puts might be worth considering. However, I don't hold any of the above views with a great deal of conviction. Indeed, they somewhat defy my intuitions. I just like to probe consensus views to see how they might be wrong, because that's how you find opportunities in markets. I'm mostly just interested to watch from the sidelines to see what happens.