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.
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.
The total shortfall of more than a million may not appear to be a big deal for a streaming service whose subscriber numbers have now past than 130 million globally and whose share price has soared 150% year-on-year to value the business at $172bn.
Even after four consecutive quarters of subscriber growth that comfortably beat forecasts, a single quarter miss for a company that needs to remain in constant high-growth mode has investors worrying about whether the Netflix peak has arrived.
“This was always going to cause jitters among investors from a company that’s spent so heavily on content in order to boost its subscriber numbers,” said Joshua Owen, a senior trader at Ayondo Markets. “The question for investors is whether this is a blip or something more structural within the video streaming landscape.”
The Netflix juggernaut relies on maintaining rapid global growth to continue paying for the content that is its lifeblood – $8bn on 700 original TV shows and 80 movies this year alone. If the slowdown in subscribers persists, the company’s already pressurised business model could break.
Netflix is on track to make $1bn in profits this year. But the company continues to spend much more than it makes and competition against rivals such as Amazon and Apple is intensifying, forcing budgets ever higher for the best content and talent to win new subscribers.
Netflix expects a negative free cash flow of between $3bn to $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.
In April, the company issued its fifth bond in three years to help finance its activities, adding $1.9bn in fresh debt.
Its debt mountain has surged from $300m in March 2016 to $6.5bn. And it has committed to spending $17bn to making and licensing TV and film content over the next few years.
The California-based business that started out as a DVD rental outfit two decades ago has in recent years been viewed as a digital startup, making it hot stock with investors, which has, for the most part, kept it insulated from negative market sentiment and scrutiny.
“The company is still burning cash and piling up debt as it funds the development of its content library and thus customer acquisition,” said Russ Mould, investment director at AJ Bell. “Even some 21 years after its creation, Netflix [still] cannot generate the cash that ultimately pays the bills.
“The question is whether Netflix is generating enough profit and cashflow to support its monster valuation.”