Michael P. Lamb, Consultant and Tyler J. Chaia, Consultant also contributed to this article.
Less than a decade ago, the movie rental industry was booming and Netflix dominated with its revolutionary DVD-by-mail subscription service. However, as on-demand video services took off, consumers began looking for options that could meet their expectations for instantaneous content delivery. Just as with the VHS to DVD transition 10 years earlier, these consumers were poised to abandon companies that ignored changing consumption trends and reward those who were ahead of the curve.
As Netflix transformed from a subscription DVD rental delivery to direct content streaming service, it established itself as a leader in this new avenue of media delivery, and was very successful in the process. Since 2011, the company has seen its sales grow by roughly 10 times.
Developing Original Content
Switching content delivery methods has not been the sole reason for Netflix’s success and its 33,668% return since its IPO in 2002. A large contributor to Netflix’s rise is its original content production and adoption of a “studio cash flow model,” which has had a strong correlation to subscription growth. This model mirrors the strategy of media company HBO, often referred to as the “King of Original Content.” In 2013, Netflix CEO Reed Hastings said in an interview with GQ, “the goal is to become HBO faster than they can become us.”
Investments in series such as House of Cards, Orange is the New Black, and Stranger Things, as well as deals with celebrities, including David Letterman and others, have paid off. Analysts estimate Netflix will continue to generate strong subscription growth over the next few years.
Servicing 125 million households worldwide, there is no argument that Netflix has successfully captured the attention of viewers and investors. However, an increase in subscribers comes with an increase in expenses, and the company has certainly seen the effects on its cash and debt positions.
The Street and investors have been relatively pleased with Netflix’s growth, but looking forward, profits will be the main concern. In its most recent earnings release, it was no surprise that Netflix saw its 16th consecutive quarter of negative free cash flow (FCF). According to FactSet Estimates, FCF is projected to decline 56% on a year-over-year basis in FY 2018. Netflix’s management is even less optimistic, guiding for a possible 104% decline given the lower band from guidance of -$4 billion. The negative growth in free cash flow can be explained by massive increases in original content as discussed above, and analysts estimate that Netflix may not generate a positive FCF until FY 2021.
With the costs tied to original content continuing to grow, Netflix has taken on more debt to address its shortage in capital. This fiscal year alone, the company has taken on an additional $1.8 billion in debt, increasing its overall long-term debt to $8.5 billion. For its original shows, Netflix amortizes 90% or more of a production's cost within the first four years, and the final 10% is distributed over the remainder of the TV show or movie’s useful life. When you pair this aggressive amortization schedule with the significant addition of debt to fund content acquisitions (see chart below), you can see why the company is so cash poor. This raises a very important question when analyzing Netflix: at what point do these significant increases in expenses begin to seep into the company’s margins and consequently decrease earnings?
It is important to note that Netflix has not bought back stock since 2011, which means that EPS growth has not been artificially boosted by share repurchases. The growth in EPS is primarily due to the rise in sales from increasing subscriptions, but Netflix has also raised the price of its subscription plans multiple times to combat analyst worries about a decline in sales growth. Does Netflix have wiggle room to raise prices higher? When do subscribers become frustrated, leading them to drop their subscriptions and look elsewhere? Does Netflix’s original content keep viewers loyal? There is no doubt that Netflix has some internal worries ahead, but external factors like competition will also pay a role in its future.
Disney Plans to Enter the Content Streaming Business
During its most recent quarterly earnings call, Disney CEO Bob Iger revealed plans for a content streaming service similar to Netflix, slated for a late 2019 release. Iger said in an August 2017 earnings call, "this is an extremely important, very, very significant strategic shift” for the company, as Disney attempts to develop new revenue streams with the advent of “cord cutting” in the cable industry.
Disney’s efforts in content streaming have already begun, with the company offering a monthly subscription to ESPN, which recently scored an exclusive streaming deal with the UFC (Ultimate Fighting Championship). In April 2009, Disney took a minority stake in Hulu, another streaming service that has gained traction while developing its own original content and later that year, a $4.2 billion deal with Marvel Entertainment was announced. Disney appears to be building an artillery of assets in preparation for its streaming service, including its recent $71.3 billion purchase of 21st Century Fox after a bidding war with Comcast. With this acquisition, Disney gets its hands on a majority of Fox’s notable assets, including an additional 30% stake in Hulu, 20th Century Fox Studios, FX Networks, National Geographic, and more. Let’s not forget Disney’s endless library of original content and future content.
Is Disney preparing to offer a live TV and content streaming service? If priced correctly, Disney could make serious waves in the industry while taking subscribers away from Netflix and other competitors. Recent comments from Bob Iger hints at their possible strategy:
“If a consumer wants all three, ultimately, we see an opportunity to package them from a pricing perspective…But it could be that a consumer just wants sports or just wants family or just wants the Hulu offering, and we want to be able to offer that kind of flexibility to consumers”
Disney is not the only player looking to take business away from Netflix. Tech giant Amazon has invested heavily in original content, while others, such as Youtube, Apple, and even Wal-Mart, have shown interest in original content and a streaming service.
While Netflix has had tremendous success over the past 10 years, it faces significant headwinds. Whether Netflix will be able to continue its historic success will depend on its ability to manage costs while also staving off new competitors like Disney and Amazon.