Hello there.
If you are a regular reader of this blog, you know that I am a huge fan of Mike Maboussin. I discovered his writing at Credit Suisse and have been hooked ever since.
Here is a preamble to what we will look at today:
Earlier this month, Netflix reported its numbers. The stock promptly dropped 22%. This made a great buying opportunity for me.
Then, I got thinking. Why? It’s not like there is a really credible competitor to Netflix. If anything, they had a great Q3 with Squid Game. What gave?
Here are the headline numbers:
This post will try and break down the likely triggers and present a contrary point of view. This is an intellectual exercise, not really taking a position on whether the market is correct or not. Most importantly, I think it wasn’t the performance itself that caused a crisis of confidence but the communication. The IR efforts, the signalling and the positioning were quite a bit off.
Lets try and analyze. Shareholder letter here and IR call video here.
1. Guidance
This chart is from the Netflix shareholder letter. They have, very helpfully, charted the guidance (gray blips) and actual reported subscribers (red or green blips) for each quarter for last 5 years. Covid gave a huge jump as people got bored - out-delivering the guidance by >2x. Now, if you look at the most recent quarter, the 8.3mn subscribers added are among the company’s best results. and even though there is a very clearly visible seasonality (Q2 of each year), this company averages ~28mn new subscribers each year. Not shabby by any stretch of imagination.
The company guided Q1-22 to be ~2.5mn new subscribers. It is weaker, but not unprecedented. Their reasoning is that a lot of the new content slate will be coming around March 22, and that acquisition growth is slowing due to Covid in LATAM. So likely, Q1-22 may be a bit weaker. I would say under-commit and overdeliver. The market clearly disagreed.
2. Competition
One of the other items done badly dealt with competition:
Most people referred to this line:
“While this added competition may be affecting our marginal growth some, we continue to grow in every country and region in which these new streaming alternatives have launched”
Here is the full para for context:
“Consumers have always had many choices when it comes to their entertainment time - competition that has only intensified over the last 24 months as entertainment companies all around the world develop their own streaming offering. While this added competition may be affecting our marginal growth some, we continue to grow in every country and region in which these new streaming alternatives have launched. This reinforces our view that the greatest opportunity in entertainment is the transition from linear to streaming and that with under 10% of total TV screen time in the US, our biggest market, Netflix has tremendous room for growth if we can continue to improve our service”
Apparently this is a cause for concern. Probably, but nothing new.
See, Netflix already faces a lot of competition. There are traditional TV services, there is Hulu, Youtube, Prime Video, HBO, Disneyplus and a whole bunch of smaller services like Curiosity Stream and Nebula. Globally, only Disney and Amazon are credible players. So, a 3 player market for most part. Once again - the 27mn users seem to point to a market that does not really have competitive intensity. If anything, one can safely assume that there is a significant overlap - as an example, I subscribe to all 3 services. I am sure most of you reading this too as well. that doesn’t really indicate a very strong competitive landscape - or at least - not a zero sum game dynamic.
To the extent there is a lot of credible competition, it seems to be limited to the US because of the historical evolution of the sector in that country.
Here are some more excerpts from the Earnings Call.
“We think slower new subscriber additions may be due to several factors including the ongoing Covid overhang and macro-economic hardship in several parts of the world like LATAM.”
“No structural change in the business that we see.”
“Healthy retention with churn down, healthy engagement with viewing up. Acquisition of new subscribers just growing but a bit slower than pre-COVID levels, just hasn’t fully recovered.”
“It’s tough to say exactly why our acquisition hasn’t kind of recovered to pre-COVID levels. It’s probably a bit of just overall COVID overhang that’s still happening after two years of a global pandemic that we’re still unfortunately not fully out of, some macro-economic strain in some parts of the world like Latin America in particular.”
“We can’t pinpoint it or point a straight line [but] when we look at the data on a competitive impact there may be some kind of – more on the marginal kind of side of our growth – some impact from competition. But which again, we just don’t see it specifically.”
“There’s more competition than there’s ever been. But, we have had Hulu and Amazon for 14 years. So it doesn’t feel like any qualitative change there.”
Conclusion: Netflix isn’t sure why the growth is slowing down. Hardly a confidence builder for jittery investors at peak valuations.
But, hold on, there is another bugbear the smart ones are going to be thinking of at this point. Saturation.
3. Saturation
Ok, Let’s get this one out of the way. Netflix has 222mn subscribers globally. It is a fair concern that at some point, anyone who can be a potential subscriber would have already signed up and the business would have become an annuity. Let’s look at their most mature market - US and Canada. Fair to assume that if they haven’t saturated US/Canada yet, other markets still have a way to go before we can come to the point of global saturation.
Lets see:
75mn subscribers there in US/Canada.
Netflix subscriber count is ~65% of peak PayTV subscriptions (before cord cutting was a thing).
Now, given this context, of course growth will slow down. 60-65% penetration is nothing to scoff at. In fact, low single digit growth rates are what can reasonably be expected of a highly scaled media business.
In 2021, Netflix grew their US/Canada subscriber base by 2%, despite having grown by 9% in 2020 when the initial Covid lockdowns pulled forward new demand. In the just released fourth quarter of 2021, the company added 1.2 million new subscribers in this market. Other than the surge of new subscribers seen during the initial wave of Covid, this was the highest number of new US/Canada subscriber additions since the first quarter of 2019. To grow at 2%-3% a year in the US/Canada region, Netflix only needs to add about 1.9 million subscribers at today’s run-rate and the fourth quarter result represents nearly 2/3rds of that amount.
How is that a shabby run?
4. What Netflix should have highlighted:
As one reads the investor letter and the transcript, I cant help but say that there were easy, cogent and more relevantexplanations that were lost in being too conservative. Here are a few:
A realization and communication that Netflix is a discretionary spend. A great example is LATAM where the growth rate has been weak ever since Covid hit. Food and shelter are higher priorities for folks in ravaged economies.
Squid games was launched a a probably bad time. It pulled forward sign-ups from the next quarter into the current one. People who might otherwise have signed up in December or January (the period that Netflix uses to forecast first quarter guidance) likely did so earlier in the fourth quarter. Highest watched TV show in history y ‘all!!
That they were able to raise prices in the US/Canada market. It shows a cognizance of the dominating market position and relative price inflexibility of the subscriber base. Also, they should have pointed out that anyone who hasn’t subscribed by now is likely uninterested or unwilling to - either way, a price hike raises the entry barrier and does likely manifest as a slowdown in new subscriber additions for 1-2 quarters.
That the content slate will be likely weaker in 1Q22. to be fair, they pointed this out but they should have spend more time focusing on this aspect, given how much it is a driver of new additions. New series of hit shows like Bridgerton1 will only come towards March.
This chart should not have been there. Pictures are worth a thousand words. Sometimes they give the wong thousand words:
One would assume that they would spend a lot of time and column inches discussing the cash flows and economics. This one para is almost everything and a solid facepalming WTF moment:
“We anticipate being free cash flow positive for the full year 2022 and beyond. As a reminder, we prioritize our cash to reinvest in our core business and to fund new growth opportunities like gaming, followed by selective acquisitions. We’re also targeting $10-$15 billion of gross debt. We finished Q4 with gross debt of $15.5 billion and we’ll pay down $700 million of our senior notes due in Q1’22. After satisfying those uses of cash, excess cash above our minimum cash levels will be returned to shareholders via stock repurchases.”
5. Conclusion
Being too smart and trying to head off an anticipated weak quarter can turn into a self fulfilling prophecy.
As always, I look forward to hearing from you. If you liked this post, pls feel free to share this or subscribe to this newsletter using the links below. While I have been tardy of late, I try to write a 1000-2000 word essay once a week.
I still don’t know why this show is a thing. I don’t want to know why either.