Netflix’s moment of truth

Last week, Netflix reported that U.S. subscribers in 2Q19 declined for the first time in nearly a decade, erasing over $20 billion in market capitalisation as investors fretted over the looming “streaming wars”. The company’s dominant position in programmed video streaming will soon be tested by the launch of streaming services from Disney, NBCUniversal and Time Warner. While Netflix has handily fended off rivals such as Amazon Prime Video and Hulu, it has yet to face a serious challenge from a major studio and will now face three challengers without the benefit of some of its most popular content.

Content, especially exclusive content, is the competitive moat surrounding any streaming service. Netflix management attributed the second quarter subscriber miss to a lack of new hit content (coupled with price increases) – coincidentally the same justification for the subscriber miss in the second quarter of last year as well. On the one hand, this suggests that consumers are more partial to incremental new content than the existing back catalogue of content. If Netflix can continue to deliver new content, a shrinking back catalogue of licenced shows might not matter. On the other hand, this also suggests that Netflix needs to continue churning out the most popular hits every quarter – hard enough in a vacuum, and likely to get harder once Disney and other studios launch their own streaming services.

Does the back catalogue still matter?

Management’s comments about new content suggest that the back catalogue isn’t material to driving subscriptions, but that may not be the case. As The Wall Street Journal reported last month, Netflix will be losing its no.1 show The Office in 2021 when the sitcom returns to producer NBCUniversal’s new streaming service. The new intra-company deal is reportedly worth around $500 million compared to the $100 million that Netflix paid for its current licence agreement, a sign of how much the competitive landscape has evolved in recent years.

Another top show, Friends, which Netflix paid US$100 million to licence through 2019, will also leave the platform in 2020 as producer WarnerMedia launches its own streaming service. This all comes on top of Disney’s earlier decision to pull its content from Netflix in preparation for the launch of its Disney+ streaming service in November 2019.

If the lack of new content drove the subscriber miss, does a shrinking licenced content library matter? According to Nielsen data, Netflix U.S. subscribers spent 72% of their time streaming Netflix’s licenced back catalogue and the three rival studios made up nearly 40% of total viewing minutes (Netflix does not comment on third party research). If international subscribers follow a similar pattern, then a shrinking back catalogue of most-viewed licenced content could certainly pose a problem – if not for gross new additions, then at least for subscriber churn.

Can Netflix continue to churn out hits?

The skew of viewing minutes towards the licenced content library suggests that for all of Netflix’s billions in content budget and famed story-telling prowess, it seems to be lacking one thing – replay value. Netflix’s most acclaimed shows, including Stranger Things, The Crown, House of Cards and Black Mirror, are dramas or thrillers that have intricate story arcs which unfold across a season (or more) and usually need to be watched chronologically, with limited suspense or shock value upon a second viewing. Sitcoms such as The Office or Friends can be picked up at any point and rewatched out of order as the comedic and entertainment value of each episode is largely self-contained, with perhaps a loose plot line within and across seasons. Thus, we hypothesise that while Strange Things-style shows predominantly drive new subscribers, they are less effective at retaining existing subscribers.

The power of a subscription model lies in being able to amortise costs (content costs in this case) over as large a subscriber base as possible. This is why Netflix can afford to outbid rival streaming services for licenced content – it has 154 million subscribers globally, each paying an average of $11 per month to fund Netflix’s content budget. But this model only works if subscribers stay subscribed long enough for Netflix to earn a return on its content investment, and as explained above, we have our doubts about the longevity of the company’s hit shows.

Perhaps unsurprisingly then, a recent exclusive report by The Information revealed that Netflix content executives and producers have been ordered to be more careful with money, and that big budget TV shows and movies especially needed to be more cost effective. Consider the latest Adam Sandler Netflix exclusive, Murder Mystery, which reportedly cost nearly $100 million to film. This 97-minute movie would have to bring in 1 million new subscribers who remain subscribed for a year or delay 9 million subscribers from cancelling their subscriptions for a month to pay for itself. Triple Frontier, which cost $115 million to film, was also cited as too expensive for how many viewers it attracted. This directive supports our hypothesis that big original shows and movies might not be as effective at reducing churn as some of the historically cheaper licenced content.

Fortunately for Netflix, it still has 154 million paying subscribers across which to amortise its content costs. And while the imminent rival streaming services are unlikely to put a dent in Netflix’s existing business, they could depress the trajectory of future subscriber growth and price increases – a precarious situation for a stock with lofty market implied expectations. Netflix executives often talk of “winning moments of truth with our members”; the company and its shareholders may soon face their own moment of truth.

DH5_2155Daniel Wu is a Research Analyst with Montaka Global Investments.
To learn more about Montaka, please call +612 7202 0100.

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