NETFLIX: Can this Great Tech company continue to stay Great?

• Published on February 27, 2019

• Netflix, the smallest of the proverbial FANG companies, which has redefined the way home entertainment has shaped up in the new millennium is again at the crossroads. The company is today staring at the increased competition which potentially threatens to disrupt its growth model.
• Netflix is also burning a significant amount of cash in content creation and this has led to a continued negative free cash flow situation. Whether these investments are sustainable remains a key question.
• On the positive side, that company has been a growth engine, adding around 21 million new subscribers in 2017 and growing revenues at 30%+ over the last few years. It operates in 160+ countries and is expanding the non-US markets at a rapid pace. The company is investing in massive growth markets like India, where it sees its next 100 million customers coming from.

A veteran of many battles.

Early Days: Netflix has been written off many times during its tumultuous history. The company to some extent inculcates the DNA of its Co-Founder and CEO Reed Hastings, who is gentle and yet battle-hardened. Like a typical start-up artist, Reed started Netflix to solve a major issue that he had been facing with the giant video rental company Blockbuster. Reed like other customers ended up paying a hefty sum as a late fee for not returning the Videotape on time and that’s when he decided to use the US postal service in delivering and picking up CDs and save the customer the hassle of visiting the store. While this reduced the customer pain, the trouble was that in the nineties less than 1% of the US household owned a DVD player. Reed continued to persist and the inflection point came in the early 2000s when DVD players became cheaper and the market took off. This woke up the sleeping giants like Blockbuster and Walmart and they kicked off a price war in response to the innovative subscription-based pricing that Netflix had rolled out in the market. But unlike Netflix, companies like Blockbuster, had huge operating costs as they were running thousands of stores across America. Competing with Netflix on the pricing front was hardly a wise idea which besides other things led to the demise of this behemoth.

Internet Company:

The real growth phase for the company started in the second decade of the new millennium with the maturing of online video streaming. Netflix was quick to catch up and reinvented itself as a technology company. The market initially was nascent. After all who wanted to watch a movie on a personal computer. Netflix persisted and even gave services free to drive adoptions initially. The strategy of driving online paid off and helped the company grow revenue 12-fold between 2007 and 2017.

Content Creator:

The third battle came up as content providers and big entertainment companies began to grow uneasy with the phenomenal growth generated by Netflix. They wanted to extract their pound of flesh and made content licensing difficult and expensive. Netflix again decided to fight this out and took up the new avatar of being a content creator. The “House of Cards” which was a 100 million USD bet in terms of investment was a calculated gamble which the company took in 2009 and never looked back.

The markets have in the meanwhile rewarded the stock of the company for fighting like a pit bull and slaying the Goliaths in the process. 100 dollars invested in 2007 would have currently yielded 10000 dollars, even after the stock has seen a sharp correction. However, it is precisely the market and expensive valuations that are haunting the company now. The concern is that Netflix might not be able to win the battles which test its very survival going forward.

The War is ahead !!

It is clear that internet entertainment will replace linear TV going forward. Internet entertainment unlike linear TV is on-demand, personalized, and available on multiple screens. Whether Netflix will therefore continue to thrive in the environment is the big question. There are many hurdles that the company will need to cross so as to maintain its dominance:

The onset of big-ticket competition: Competitors like Disney, AT&T, Apple, and Google have taken notice of the massive potential that the online streaming market holds. Disney has been working extensively on its own online streaming service which will be possibly launched next year and with this, the massive Disney and Fox entertainment content may get knocked off from Netflix. Other powerhouses like Google, Apple, and Amazon Prime have big plans backed by sizeable war chests. It will be interesting to note how these battles will shape the texture of the industry. I believe that while Disney may have the advantage so far as the content is concerned, Netflix, is well entrenched and with its algorithms, has a comprehensive understanding of the consumers and may prove to be more than a match. It may however face stiff resistance from Amazon, given the muscle that the company is building in its Prime Video service. In markets like India, it is ISPs like Reliance Jio, which are working on their own platforms, as also acquisitions, can pose problems for the company.

The market, however, is big and has room for multiple players. The non-US markets will power the growth leading to shrinkage or maybe the eventual demise of linear TV and replacement with internet entertainment.

Content Creation burning a hole in the pocket: Content Creation is what has made Netflix a force to reckon with. Today the platform is identified with shows like House of Cards, Black Mirror, Stranger Things, Sacred Games, Bodyguard, and the list goes on and on. The content, however, is a double-edged sword and it takes loads of cash to create content. The company is free cash flow negative in spite of generating an 8%+ net margin. It has burned USD 8 billion last year in creating this content. While the company treats content creation costs as investments, it remains to be seen whether the company will be in a position to continue with these levels of investments across the markets. It would all depend on the growth of subscribers and revenues. Netflix may eventually have to explore advertising as an alternate revenue stream to sustain this kind of content program.

The Future Expectations

Growth will remain a critical determinant of the company’s success. Net subscriber additions which increased to a record 6 million in the third quarter of 2018, have become part of the template to drive shareholder value. Markets are expecting Netflix to consistently grow the subscriber numbers and Netflix is spending more money on creating content, so as to get more customers on board. This is a vicious cycle and the key question, therefore, is, whether Netflix, will be able to maintain the growth when content creation slows down. The market is big enough and countries like India, Japan, and regions like the EU may drive growth going forward. The company is still working on its China strategy.

The other trouble remains the expensive valuations. At roughly 10x Price to Sales and 136x Price to Earnings, Netflix remains one of the most expensive tech stocks and a lot of expectations have been factored into the stock price.

Whether the company will meet the expectations remains the big question. That the company will exist ten years down the line may not be such a difficult proposition. After all, a platform on which customers spend hours or sometimes days binging and gobbling up season after season of some new show must be doing things right.

Sandeep Ganju is a senior business executive, with about 20 years of experience in the consumer, telecom and the information space with companies like Pepsico, Whirlpool, Airtel and Reed Elsevier. His interests include technology, marketing, business strategy and the stock markets.