After delivering >109% growth between 2020 and 2021, Netflix’s pandemic driven growth has dried up. To make things worse, its share price tanked by 36% in its biggest one-day loss, after its earnings report on 20 April 2022. It is now trading at a 4-year low.
Here, I’ll discuss the reasons for Netflix’s crash, its (possible) future and hopefully give you an idea of what you should do as an investor.
Why did Netflix’s stock crash?
i) Macro Environment
Overall, this year has been bad for growth and tech stocks in general as the rising interest rate environment is causing a valuation reset. No one knows when this environment would stabilise, my gut feel is that we are still early and that there’s still room for these stocks to slide.
However, macroeconomics alone doesn’t explain Netflix’s crash.
ii) First loss of subscribers since 2011
In its 1Q22 earnings report on 19 April 22, Netflix reported a loss of 200,000 subscribers, the first loss since 2011. This was a far cry from analysts’ expectation of 2.5m new subscribers.
iii) Worrying guidance from Netflix’s management
There is no good news on the horizon as Netflix expects to lose another 2m subscribers in the second quarter of 2022.
Netflix’s latest guidance has made investors anxious about its future, the stock tanked 25% following the earnings release.
iv) Cooling of the pandemic ‘high’
It should be obvious by now that the positive effect of the pandemic – putting people at home and they have nothing to do so they subscribe and watch Netflix – is wearing off. Majority of the countries have decided to live with Covid even though Omicron is a more contagious variant. As such, people are getting out rather than staying home with Netflix.
Hastings has also cited the growth in Latin America is slowing as the economy is struggling to recover from the pandemic and it has affected the demand for the streaming service.
v) Slowing revenue growth rate since 2018
Every company will become a victim of its own success at some point. Hence, it is normal that new customers are increasingly difficult to get once you have a large customer base. The easier customers have been captured and now more persuasion is needed to attract yet-to-be customers.
And this was strikingly obvious in Netflix’s case as their revenue growth slowed annually since 2018:
- 2017 +32.4%
- 2018 +35.1%
- 2019 +27.6%
- 2020 +24.0%
- 2021 +18.8%
Netflix has grown too big for its own good?
Netflix is available in every country except for China, North Korea, Syria, and the disputed region of Crimea. Netflix is far and away the world leader in distribution.
The company is now investing in original programming in 40 countries and has produced original scripted shows in 20 foreign languages. It’s spent more than $1 billion on Korean content alone. In each country, Netflix hires content executives to commission work from the local creative community.
Netflix’s video subscription TAM
Personally, I watch Netflix but I don’t pay for it. I leech my wife’s subscription. How is Netflix going to persuade me to pay for a separate subscription? The unit economics for Netflix is by the household and not the individual.
Using an average of 4.9 pax per household (do note that average may be misleading at times), my super rough estimate is that there are about 1.58b households in the world. This includes poorer countries that may not be able to afford Netflix.
However, let’s just make a blue sky scenario here. Netflix has 222m subscribers currently (14% of total households) which means Netflix still has another 1.36b households to sell to. It is a huge TAM.
TAM may be over-inflated
Not every household may want a Netflix subscription. Some would leech onto existing subscriptions, others gain access through password sharing.
According to Statista, password sharing contributed to an estimated loss of US$791m for Netflix in 2022.
Netflix’s Response
One way is to up the subscription fee which Netflix has done previously. But that alone is not sufficient to allow Netflix to continue growing. They might explore the following:
1) Crackdown on Password sharing
Netflix has hinted that it would crackdown on password sharing, and have been reported to be testing password sharing prompts in certain markets.
2) Launch a cheaper ad-supported subscription tier
This solution isn’t new, Hulu has launched it successfully. 88% of Hulu subscribers opted for a lower subscription fee. 66% of their total revenue came from subs while 34% came from ads.
Given that
- Roku: 60m users
- Hulu: 43m users
- Netflix: 221.64m users
If Netflix launches the ad-supported lower subscription, Netflix may see a dip in total revenue in the short term – from $29.7b to $23.5b. Sub revenue could drop to $19.6b while ad revenue jumps to $3.9b initially.
That said, reality may not be that bearish given that I am assuming zero growth and merely cannibalising the current subscriber base. The above estimates are conservative as the lower priced ad-supported Netflix should see a one time big jump in subscription.
Another positive sign is that Netflix could charge higher ad fees given that the scale of the subscribers is much larger.
Lastly, the most important thing is that the ad revenue is likely to rejuvenate the revenue growth that Netflix has lost in recent quarters.
The Video Advertising segment is projected to reach US$183b in 2022 and a 10% market share is about $18.3b, which is equivalent to 62% of Netflix’s 2021 revenue.
Of course it will take time for Netflix to capture the market. Hence it might be too early to make a call now. That said, this could be a major inflection point for Netflix if done right. Investors should take a closer look in future quarter/s.
Netflix’s competition
That said, Netflix isn’t the only video stream service.
Over the years more streaming competitors have come online – Disney+, Amazon Prime Video, Apple TV+, HBO Max, just to name a few. Hence, Netflix’s market share has shrunk although it is still able to command almost half of the market.
Does Netflix have the economic moat to further protect its market share?
I would say yes because it benefits from economies of scale. Netflix has commissioned many exclusive content on its platform and many have gone on to win awards, as well as breaking viewership records.
The more subscribers Netflix has, the more capital they can get to do more great exclusive content, and in turn retaining current customers and attracting new ones – a virtuous cycle.
Streaming non-original content is no longer viable nor attractive. And you need decent budgets to create blockbuster shows. Not half-hearted efforts as seen in Amazon and Apple. This is a personal view though – their selections suck. The only alternative that is attractive to me is Disney+ because of the exclusive Marvel shows.
So Netflix has some moat flywheel in this – they have the biggest subscriber base to provide the capital and they have the experience to create great exclusive content. Unless Amazon and Apple are willing to splash capital to fight the streaming war, Netflix is enjoying the advantageous position.
Why Netflix is moving into games
That said, Netflix’s competition isn’t limited to other streamers. Netflix is competing for leisure time. And a big space would be games.
If someone is playing games, he wouldn’t be watching Netflix and its value proposition declines. Hastings held this view and has been deliberate in Netflix’s expansion into games.
However, it will be a tough transition as there is no compelling reason for people to be playing games on Netflix’s platform.
That said, I think a possible strategy is to create games off their Netflix originals, restricting access to these games within the Netflix ecosystem. Squid Game comes to mind – Netflix could make ancillary products to reap maximum benefits out of a hit show. This is what Disney has done very well – merchandise, amusement parks and royalties. Netflix could squeeze more profits out of the same customers instead of just attracting new ones.
Netflix is unlikely to become a big tech company
Despite the loss of customers compared to the last quarter, Netflix actually grew its revenue by 10% and its subscribers by 7% when compared to a year ago. So it isn’t that bad. Growth is definitely slower. The significance to me is that the video streaming model cannot propel Netflix to the big tech league.
In the past, Netflix has been put together with Facebook, Apple, Amazon and Google to form the acronym FAANG. But it has never been in the same league and unlikely it will be. Netflix’s market cap is about $115b after the drop. While the big tech companies are in the trillion dollar club – Apple at $2.7T, Alphabet at $1.7b, Amazon at $1.6T and even Meta is 5x larger than Netflix at $590b and was once in the trillion dollar club.
FAANG has been replaced by MAMAA, and Netflix has been dropped. Hence, don’t expect Netflix to be a big tech or will grow into one.
Netflix is becoming value stock instead
Netflix is a mature stock now and no longer a fast growing one.
It is not a growth stock anymore and that means investors should treat it more like a value stock.
Valuation is crucial for value stocks because the value of the company is no longer increasing at a rapid pace and might even stay stagnant. The way to make money is to buy only when there is a big discount to its value. Like a rubber band, when the price is overextended on one side, it snaps back to the value, providing a good capital gain to the investor. This also means that a value stock has to be sold at some point in time and not to be held forever.
Using revenue-based metrics are no longer good enough as value stocks are supposed to be profitable and generate good cash flow. PE or EV multiples may become more relevant for Netflix.
Netflix’s valuation
Compared against its 5y average price metrics, Netflix is trading below most of them currently:
- Price / Sales (PS): now: 3.14, 5yr average 9.03
- Price / Earnings (PE): now: 19, 5yr average 120
- Price / Earnings-to-Growth (PEG): now: 0.56, 5yr average 2.4
Netflix stock price doesn’t look expensive but note its declining growth rate and that the 5y averages may not be a good indication as its valuation should be higher in the past when its growth was higher.
Its Free Cash Flow yield is still negative, which is terrible. It needs to generate more cash even after spending on content production.
Netflix is no longer a growth stock but becoming a value stock
Unfortunately, at the point of writing, Netflix is in no man’s land – it is neither a growth nor a value stock. It is in transition.
Netflix will take some time to be more profitable, (hopefully) turn free cash flow positive, and for the market to adjust to this new expectation. I don’t see any opportunity right now with Netflix.
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