UPDATE: Tom Staudt continued his analysis of Netflix following the results of the January 20th, 2015 earnings call. The updated post can be found here.
Over the past week, investors’ faith in Netflix NFLX has been shaken. Following its earnings announcement on Wednesday, and amidst a tumultuous week on Wall Street, its share price fell almost 25% to its lowest level in five months. While critics are focusing on lower than expected subscriber numbers and revenues, as well as new streaming competition, this short-term thinking misses Netflix’s massive opportunity. With the cable television bundle beginning to unravel and a superior algorithmic based approach to content development, Netflix is in position to take significant share of a much bigger pie.
CABLE UNBUNDLING OFFERS GREAT OPPORTUNITY
Netflix subscriber growth appears to be following the standard saddle life cycle curve for an innovative technology service. After the exuberance of early adopters who only pay for over the top (OTT) streaming services, subscriber growth slowed as the narrowly defined streaming video market approached saturation. Crossing the chasm to further adoption in the mass market requires disrupting an existing dominant platform, in this case the 100 million traditional pay television homes in the United States.1 With 36.3 million domestic subscribers, Netflix is now shifting its focus towards current pay TV customers who will switch from cable or satellite to Netflix as a use-case. Because US business represents 65% of Netflix’s value, each subscriber adds new revenues at low marginal cost. Until recently, the only evidence of a market shift was a slight decrease in the number of subscribers as “cord-cutters” cancelled their service. Now, however, the unwinding of the cable bundle is gaining traction.
Netflix detractors noted recent announcements by Time Warner TWX, Starz STRZA, and CBS CBS that they would be launching stand-alone streaming services for the popular HBO Go, Starz on Demand, and CBS (with CBS-owned Showtime strongly rumored to be next). Each service is viewed as well-established additional competition for subscribers in the streaming video market, to go along with the incumbent competition from Hulu and Amazon AMZN Prime.
These companies are not battling for the $10.5 billion streaming video market in the US: they are aiming for a market that is ten times that size today. The average pay television bill in 100 million US households is $90 per month,2 bringing the total pay TV bill to $108 billion annually. Adding the streaming video and pay television markets creates a far more attractive $120 billion opportunity today.
The announcement of the additional premium streaming services will accelerate the rate of cord-cutting. If the availability of HBO or Starz without a cable subscription is enough to drive current pay TV subscribers to streaming options instead, then the additional competition will benefit Netflix rather than hurt. HBO could be a complement to Netflix, rather than a substitute.
No single streaming service is likely to replace pay TV. Instead two or three services will win. Customers are likely to make decisions based on content, both in terms of the availability of the library of older shows, and new high-quality original content.
ALGORITHMS AND DATA GIVE NETFLIX CONTENT DECISION MAKING ADVANTAGE
While some Netflix content selections may seem like odd choices to some, they have not been selected randomly. Netflix uses carefully culled algorithmic viewership data to determine content opportunities. It can identify viewing habits, preferences, unmet needs, and characteristics of programming most likely to drive eyeballs and subscriptions. While other media companies continue to use traditional methods, studio heads and show runner’s gut instincts, Netflix can use science and mathematics to lower risks associated with the large upfront capital cost of its robust new programming pipeline. It also allows for strategic purchases of immediate streaming rights, such as the notable new program Gotham, produced by Warner Bros. and airing on FOX.
Interesting to note, Netflix already offers better value per viewing hour than cable. Cable offers roughly 300 choices (channels) at any one moment in time, while Netflix offers ten thousand. The variety of options is a large part of the reason Netflix viewing hours per customer have increased 350% since 2011. By our calculations, cable subscribers pay roughly 25 cents on average per viewing hour, while Netflix subscribers pay 18 cents. The company continues to look down the long-tail of content to ensure this remains true for all of its customers, including those in foreign markets.
INTERNATIONAL EXPANSION IS JUST BEGINNING
Netflix management is outspoken about the opportunity for foreign expansion. Its first international foray was Canada, which now sports a contribution margin equal to that of the United States. Countries across Europe, most notably France and Germany, launched last quarter, and offer significant growth opportunities.
While Netflix continues to push penetration by creating local original content, it also will be a first-run distributor for American television abroad. Better Call Saul (the Breaking Bad prequel), which will air in the US on AMC AMC, not Netflix, is a good case in point. While it may not be able to secure rights in the United States, Netflix will gauge the success of the programming airing domestically before deciding what to purchase and export. Netflix offers “new” highly acclaimed American shows to foreign markets, turbocharging customer acquisition at lowered costs.
While some see Netflix as a “cult stock”, we believe otherwise. The recent price drop of over 20% presents investors with an opportunity to buy low. The aforementioned opportunities have not diminished. On the contrary, cable unbundling points to massive potential. While disappointing in the short-run, subscriber acquisition slowdowns in the interim are merely speed bumps while market reorganization takes place. As the cable industry unbundles, the $108 billion per year domestic market will be up for grabs in addition to current streamers, with Netflix in the best position to be the market leader. Algorithmic data and new world DNA will allow the company to thrive in the new marketplace, providing a leg up against new competitors Starz, Showtime, and even HBO. Future possibilities such as tiers or other monetization strategies could offer better margins down the road. With recent announcements, Netflix’s opportunities have not dropped 25%, as its recent price behavior would suggest; instead they have increased substantially, perhaps tenfold.
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