Netflix has revolutionised television. But is its crown starting to slip?

Below-par subscriber numbers last week were bad news for a service that must keep growing to survive. How will it respond?

The rise of Netflix has torn up TV schedules and destabilised Hollywood, but last week it was the streaming service’s turn to be shaken. Shares in the maker of Stranger Things and The Crown suffered their biggest drop in two years on Monday after a surprising failure to hit subscriber targets.

A torrent of Netflix-produced content – 700 original TV shows and 80 films this year alone – has kept the fans rolling in and made Netflix a darling with investors. But last week’s figures revived doubts about the US company’s business model. Here are some of the challenges that Netflix must address if it is to sustain its $165bn (£127bn) valuation.

Subscriber growth

Netflix stock fell more than 14% in after-hours trading on Monday after the company missed subscriber growth forecasts for the second quarter by 1 million. The company still added 5.2 million new users globally, which, given its base of 130 million, hardly feels like a crisis. However, the Netflix investment case relies on remaining in constant high-growth mode, and that means continuing to be able to acquire new subscribers steadily, quarter after quarter. And that is getting tougher as the “easy” subscribers in the US and major western markets have mostly been converted.

“Netflix’s big challenge is maintaining growth worldwide while its customer base saturates in core western markets,” says Richard Broughton, analyst at Ampere. “Netflix is having to work ever harder to gain new subscribers.” The low-cost nature of the streaming service – a premium subscription costs £9.99 per month in the UK and $13.99 in the US – means that it needs inexorable growth to pay for its content. Must-watch shows and films beget happy customers and draw new subscribers, which helps pay for even more content. Netflix’s content budget is $8bn this year alone – it costs a lot of money to attract a Hollywood star such as Will Smith to a sci-fi film like Bright – and in recent years it has been raised by about $1bn annually. Netflix is stuck in a costly and precarious cycle.

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Disney intends to withdraw all its content, including the Star Wars films, from Netflix as a prelude to setting up its own video-on-demand service. Photograph: Jonathan Olley/AP

Debt

Netflix is running up substantial liabilities as it struggles to bridge the gap between revenue and the spiralling cost of content. Ampere puts Netflix’s total liabilities at $30bn-$33bn, with debt about a third of this, while the majority is programming commitments. Its debt mountain has grown from $300m as recently as March 2016 to almost $9bn at the end of the second quarter this year. In April, it issued its fifth bond in three years, which added $1.9bn in fresh debt.

Netflix declares a profit – expected to be about $1bn this year – because it is able to spread the costs of making shows over a number of years. Its total streaming obligations, for making and licensing TV and film content, will cost it $18bn over the next few years. It also has $3bn-$5bn in costs it expects to pay relating to “traditional film output deals or certain TV series licence agreements where the number of seasons to be aired is unknown”.

The growth machine is struggling to keep up. Netflix expects a negative free cash flow of between $3bn and $4bn this year, meaning the amount its spends on content, marketing and other costs in 2018 will exceed what it earns from subscriber revenue ($16bn) by at least $3bn.

Rivals

In the early days of building a streaming empire, Netflix was able to get hold of the rights to TV shows and films on the cheap. Rights owners and future rivals had not identified the global potential of subscription video-on-demand rights, and Netflix prospered. The value of those rights has now spiralled, which has pushed up Netflix’s content budgets and fuelled its drive to produce its own content.

This strategy is also designed to help maintain Netflix’s popularity as some partners withdraw content because they now see Netflix as a threat to their own ambitions. Last year, Disney said it would pull all its content from Netflix in the US – including the Marvel superhero films, Star Wars, Pixar films such as Toy Story and big hits such as Frozen and Beauty and the Beast – as it tries to launch its own rival service.

Disney’s $71bn bid for Rupert Murdoch’s Fox, which includes the studio behind films such as X-Men and Deadpool and TV shows such as The Simpsons, is a move to control crown-jewel content to supply its service and further starve Netflix.

In addition, although Netflix’s huge budgets – the first series of The Crown cost £100m have opened up a new golden age of television, they have also stoked inflation for top on-screen and off-screen talent, with rising costs further fuelled by competition from Amazon and Apple. “Netflix has invested big and inflated the market for scripted drama, but this is classic unsustainable bubble territory,” says Tim Mulligan, analyst at MIDiA Research.

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Youth-oriented shows such as Thirteen Reasons Why have been a hit, but teenage viewing habits are changing. Photograph: Beth Dubber/Netflix

Young viewers

Netflix is doing fine against traditional TV companies. Earlier this year, the BBC revealed that 16- to 24-year-olds spend more time with the US streaming service in a week than with all of BBC TV, including the BBC iPlayer. Youth-targeted shows such as Stranger Things and Thirteen Reasons Why have been major hits, but Netflix faces some of the same pressures caused by the rapid generational shift in viewing habits.

The BBC’s research found that more than 80% of children go to the Google-owned YouTube for on-demand content (half also go to Netflix). Last week, media regulator Ofcom revealed that 16- to 34-year-olds spend more time watching non-broadcast content – such as streaming services, catch-up and on-demand TV – than traditional scheduled TV. YouTube was again found to be the biggest winner, accounting for the highest proportion of non-broadcast viewing in the age group.

The BBC’s research found that children aged five to 15 spend more time each week online (15 hours and 18 minutes on average) than they do watching conventional or streamed TV (14 hours). All media is now in competition for attention, and online it is the Facebook-owned Instagram and Snapchat that are currently dominating the attention of younger generations.

Moving into sport and news

A key part of Netflix’s rapid growth is that it is cheap: the most popular £7.99-a-month package is seen by many as a bargain for access to such a vast range of content.

Last week, Ofcom revealed that subscribers to streaming services such as Netflix and Amazon had overtaken numbers taking traditional pay-TV services such as Sky and Virgin Media for the first time. However, Netflix’s low-cost nature has meant that subscribers mostly choose to bolt it on as an additional option. Viewers mostly keep their main pay-TV subscription, which is more expensive but provides wider content such as exclusive football and news services.

Some analysts believe that Netflix needs to develop its content offering and become more like traditional TV companies in order to become a “must-have” service. “Netflix is the TV disrupter that everyone is watching to see what they do next,” says Mulligan. “To move to the next level they need to add global news and sport to their content offer.”

Doing so would also justify the inevitable price rises that Netflix is having to introduce as it continues the race to cover its costs. The company is already experimenting in Europe with a high-definition “ultra” subscription, which costs €16.99-€19.99 a month in Germany and Italy. Traditional pay-TV companies such as Sky, which originally built its business on exclusive Premier League rights, charge up to £100 a month, though this also includes costs for landlines and broadband.

“Netflix’s long-term strategy is that it has to increase its revenue from subscribers; it needs to move into those content genres to replicate the journey of traditional pay-TV companies,” says Mulligan. “You need a full suite of content if you want to be a real substitute, not just an additive service.”

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