Netflix, Part 1 - "Riding the Wave"
Updated: Jul 19, 2020
With 172 million subscribers globally and a presence in 190 countries, Netflix (NASDAQ: NFLX) is the world’s largest streaming company. The company has benefitted from a first-mover advantage, having transformed from humble beginnings as a DVD delivery-by-mail company in the late 1990s. Today, Netflix is the world’s largest and best-known streaming company, as well as a leading producer of award-winning content (both series and films). During this rather amazing 22 year period, Netflix has been a disruptor on at least three separate occasions:
Netflix began its life in 1998 by offering DVD’s for rent and sale via the post, moving a year later into an “all you can watch” DVD subscription plan based on a monthly fee (and dropping DVD sales). As Netflix gained traction, it was the “bricks & mortar” DVD rental chains like Blockbuster that began to suffer. (Blockbuster filed for Chapter 11 bankruptcy in 2010, and its last store closed in 2019.)
In its next phase, Netflix started streaming content in 2007. Netflix was an early pioneer in streaming, a market leader that – along with other future streaming entrants – capitalised on the growth of fast internet. This creeping penetration of streaming companies like Netflix gradually eroded the dominant market share position of traditional linear media providers like the networks (ABC, NBC, CBS, Fox), cable TV companies (Comcast, Charter Communications, COX Communications), and satellite TV companies (DirectTV, DISH).
When it started its streaming business, Netflix almost exclusively offered series and films that had already been shown on other linear media services. An example is “Breaking Bad, which was developed by and originally aired on AMC (cable TV) before Netflix bought the rights and began streaming the programme itself. Next, Netflix moved to licensing – and in some cases commissioning – content exclusive to Netflix, meaning it aired first and only on Netflix. This content was original to Netflix and advertised accordingly, but it was generally developed by third-parties. An example is “Orange is the New Black”, which was developed and produced by Lionsgate. The company’s last stage of evolution was to begin developing some of its own content “in-house”, hiring writers and producers. “Stranger Things” is an example of in-house developed original content. By gradually increasing their presence in the market for original content, the company started competing more directly with other media content companies like HBO, Time Warner (now WarnerMedia), and Walt Disney.
Netflix had revenues in 2019 of $20.2 bln and net income of just under $1.9 bln. The company has seen its revenue, operating profit and net income grow on average 48.1%, 70.8% and 97.5% per annum over the last five years (i.e. 2015-2019), truly remarkable and supportive of an above-market P/E ratio. The company’s subscribers increased from 73 million at the end of 2015 to 173 million at the end of 2019. The company offers films, series and documentaries through its monthly-pay subscription service. Netflix does not offer sports or Video on Demand (“VoD”). As of the close yesterday (February 13th, 2020), the company’s market value (equity) was 167.4 bln, representing a P/E of 92 (and a P/E using forward-looking income of 45). Just over 5% of the company’s float is held short, which is a relatively large amount. Netflix does not pay a dividend. The company’s high yield debt is rated Ba3/BB-. The company is part of the infamous “FAANG” group, which also includes Facebook, Apple, Amazon and Google (Alphabet). (I wrote on the FAANG stocks on February 5th in this post.)
Since there is a lot to cover, I have divided my work on Netflix into two parts. The first post (this one) will cover Netflix from a consumer perspective. In this post, I will
Examine the dynamics that have driven the transformation of the market for the delivery of media (i.e. the “macro case” for streaming),
Explain the competitive landscape and the position of the existing and pending streaming companies,
Present pricing from the consumer / retail perspective in the U.S., the most competitive, dynamic and transparent market.
In the second post to come within the next week or two, I will look at the operating performance and valuation metrics of Netflix. Let’s start with the industry dynamics.
The Macro Case in Favour of Streaming Companies: “Cutting the Cord”
There are two prerequisites which are necessary for consumers to switch from legacy linear TV providers (cable TV or satellite TV companies) to streaming. Firstly, a household must have access to broadband, either fixed line or increasingly fast mobile. Secondly, consumers that have traditionally used cable or satellite to access television programming must be convinced that there is a better value proposition in subscribing to a streaming service (or two or three) compared to traditional linear delivery services.
Broadband penetration globally has increased as companies (and countries) have invested in the requisite infrastructure, or “backbone”. However, developed / richer countries have seen their growth in broadband penetration slow as they have reached near-saturation levels. The graph below illustrates the growth in broadband penetration in U.S. homes for the period 2000-2018 (source: Pew Research Center), illustrating that around 75%-80% of U.S. adults are broadband users, a level that has been reasonably consistent for several years.
There is little doubt that broadband usage as a percent of the worldwide population will continue to grow, but the growth is likely to be skewed towards developing markets which today have lower broadband penetration. The graph below, from The World Bank, shows broadband penetration for various countries and regions over time. (Note that unlike the first graph, this one shows broadband access (fixed or mobile) per 100 people rather than percent of families with broadband.) The opportunity for continued growth of broadband in developing markets is clear, as you can see from the relatively low penetration rates in certain emerging regions (Latin America), as well as in developing countries like China and India.
The more people that have access to broadband, the larger the addressable market becomes for streaming companies like Netflix. Consumers that have gained access to competitive programming from streaming companies have a viable – and often less expensive - alternative to access premium content vis-à-vis the traditional avenues like cable / satellite TV providers. This has led to more and more people with access to fast internet dropping traditional linear TV services and switching to a combination of fast internet plus one or more streaming services. The growth of mobile broadband andthe fact that more and more TV’s are now “internet ready” (if that’s the right jargon) have further increased the appeal of streaming services by making these services available on a broader number of devices (usually app-supported) and making the services easier to use. As you might have guessed, the loss of linear pay-TV subscribers has been more than made up by the growth of broadband-only subscribers, and many of the same companies offering linear TV via cable or satellite also offer stand-alone broadband. The best data I came across depicting these trends in the U.S. is from Leichtman Research Group, a research firm specialising in media. See their 3Q2019 report here – it’s worth a read. Leichtman reports the following in its most recent report (3Q2019), regarding the U.S.:
The top pay-TV providers (i.e. cable TV and satellite TV companies) have seen their subscriber base steadily decrease over the last decade, from 94.1 million users in 2010 to 84.8 million at the end of 3Q2019 (down 10%).
At the same time, broadband usage in the U.S. (families) increased from 72.8 million users in 2010 to 100.6 million users at the end of 3Q2019 (top 16 providers, 96% of market) (up 38%).
These trends help to explain the incredible growth of Netflix during the last decade. The rise of broadband / fast internet has provided the foundation for the company’s future growth, albeit in an increasingly competitive streaming marketplace. These trends also explain why many traditional media and production companies that have successfully produced content for many years are eager now to “hop on the bandwagon” and exploit the streaming opportunity that has fuelled the rise of Netflix, using their own legacy content and production skills as a drawing card.
Let me return to one point I mentioned earlier. Streaming has been a “rising tide that has lifted all ships”, but one underlying yet key component of this growth – availability of broadband - is levelling off in developed, mature markets as penetration rates of fast internet grows approaches saturation levels. As a result, the opportunity for rapid growth going forward might be more in developing markets, although these markets have their own complications. For example, consumers in these markets have less discretionary income (by definition) to spend on things like subscription-based TV services. Also, customers in developing markets will almost certainly be more sensitive to pricing, generating heated competition amongst steaming companies in these markets to acquire customers. I suspect that similar to mobile telephony in developing market countries, subscribers will be super-sensitive to increases in monthly subscription costs, making customers less “sticky” and churn rates higher. Concurrently, competition will increase amongst the streaming companies focused on developed markets like the U.S., the U.K. and continental Europe, as we can see now from the velocity of new entrants. To justify a given subscription cost/month and retain customers, streaming companies will need to consistently offer high quality and appealing content, increasingly original and/or unique to that company.
This is the mainly favourable background facing companies today that are or intend to stream their content via subscription-based services. Let’s look now at the companies that are in the mix in the U.S.
The Players and the Playing Field
The streaming wars have been bubbling along through the latter half of the last decade, but really began to grab headlines in 2019 as Apple, Disney, HBO, NBC and CBS all announced that they were going to offer streaming services, joining Netflix, Amazon Prime Video, Hulu and YouTube in the U.S. (along with others in other countries, like NowTV in the U.K.). The table in this link is quite detailed and provides a look at the streaming competitors, including those on the horizon which have not formally launched their services. The table only includes those streaming companies active in the U.S.
As you can see from reviewing the competitor table, several traditional broadcasters, cable TV and satellite TV companies - like Comcast and AT&T - as well as media / content companies like Disney, TimeWarner, HBO, NBC and CBS – have introduced new streaming services or are in the process of doing so, very much blurring the lines amongst traditional legacy linear companies, media/content companies and streaming companies. Since the pure-play streaming companies like Netflix, Amazon Prime Video, HBO Plus and Apple+ are not in the business of connectivity, their “holy grail” is increasingly content. This means they need to have a large and interesting library of past programmes (films, TV series, documentaries, etc.), as well as original and/or unique content. The traditional content companies - including the network broadcasters and Hollywood studios – will naturally want to reclaim the licenses for their own original content, and go after other shows up for grabs, when they start their own streaming services. For example, last summer HBO announced it had signed a five-year licensing contract for “Friends” - currently streamed by Netflix - when it starts to offer its streaming service via HBO Max this year. And Peacock, NBC’s streaming service slated to launch this summer, will take back “The Office” from Netflix in 2021 when the current license expires. This means that Netflix will lose its two most-watched series in the U.S. To offset this, Netflix will be forced to spend more and more on original content, and it will need to be spent on programming that interests its subscriber base. To be fair to Netflix, they were ahead of the curve on this and have been licensing or developing in-house original content since at least 2012 or so, much of which has been popular and critically-acclaimed. These competitive pressures and industry dynamics could cut either way for Netflix. One on hand, an increasing reliance on original, exclusive content raises the company’s execution risk, because the company has to spend considerably more on exclusive content development to keep their product offering interesting to subscribers. On the other hand, Netflix has clearly demonstrated that it is very good at developing original content, at least so far. A number of Netflix-produced films and series have been nominated for film, TV and music awards across a variety of categories, including Oscars, Emmys, Grammys, Golden Glove and BAFTA awards – see this Wikipedia link. The challenge for Netflix will be to continue this amazing run.
There are two more things worth mentioning regarding Netflix, setting it apart from its peers. First, Netflix is clearly focused. The company creates or licenses - and streams through subscription - only films, series and documentaries. It has avoided sports and seems committed to doing so, and does not offer Video on Demand (“VoD”). This is different than Amazon Prime Video, which carried a series of English Premier League football games in the U.K. over Christmas, as well as the Australian Open. Obtaining sports rights is expensive and raises the risk considerably for a streaming company. Secondly, Netflix has the broadest international reach and following of any of the streaming companies. Netflix has been a trailblazer in terms of developing foreign language content specific to certain markets, widening its appeal well beyond the U.S. This certainly provides a foundation for further international growth for Netflix, where its subscriber base is growing much more rapidly now than in the U.S.
Pricing of Streaming Services
The final area I want to cover in Part 1 of the Netflix story is pricing for users. In this respect the partially-completed chart below outlines the subscription prices of active and soon-to-be-active players in the U.S. streaming market.
As the table illustrates, Netflix certainly has fair pricing, but some of the new entrants have the financial muscle to buy subscribers up-front at low monthly rates, or in some cases, for free. Apple for example offers Apple TV+ free for one year for people that have recently bought certain Apple products. And Disney Plus is apparently being offered free for one year to select Verizon customers, possibly explaining the huge number of subscribers they added in a mere three months of existence. Others provide pricing differentials based on the presence of adverts (free to low monthly cost). Still others offer VoD alongside their free or low cost programming, to allow users to access content that might not yet be offered on any subscription-based streaming service. These include the likes of Amazon Prime Video and Apple TV. The monthly subscription costs of the various streaming services make it more likely that consumers will have multiple streaming services, which – even collectively - are substantially less expensive than the monthly cost of a cable / satellite TV subscription. Forbes wrote an article last year, using data from U.S. company Vindicia, which reported that approximately 70% of U.S. households have at least one streaming subscription service, and approximately 40% of U.K. households have at least one. They go on to report that the average U.S. subscriber to streaming services has on average 3.4 such services, for which he pays around $29/month (in aggregate). This is less than one-third the cost of the average cable bill, which is $107/month. (Of course, you do have to factor in the cost of broadband, either fixed or mobile, to access streaming services.)
In conclusion to Part 1, the sands are shifting in the world of streaming as the market grows increasingly competitive. However, Netflix’s large (172 million) customer base and geographic diversity is a huge asset for the company, as its award-winning exclusive content. Valuation is an entirely matter, and I’ll discuss this in Part 2.