The Path Forward for Netflix

I was out last week... Did I miss anything? I could have been vacationing on Mars and still heard the news of streaming giant Netflix (NFLX) losing 35% of its value in a day last week when it reported its first subscriber losses in years and guided to lose more next quarter. The company has […] Not rendering correctly? View this e-mail as a web page [here](. [Empire Financial Daily] The Path Forward for Netflix By Berna Barshay --------------------------------------------------------------- [Buy?... Sell?... Hold?]( My unique stock market "early warning system" called the 2020 crash weeks early. And it spotted the coming bull market at the bottom. My system has called the rise of AMD when the stock was $2. And it called the demise of fad stocks like Peloton and DoorDash. Now, it's flashing green on five specific stocks... While at the same time, it says to sell 14 of the most popular stocks on the market. [Click here to find out more](. --------------------------------------------------------------- I was out last week... Did I miss anything? I could have been vacationing on Mars and still heard the news of streaming giant Netflix (NFLX) losing 35% of its value in a day last week when it reported its first subscriber losses in years and guided to lose more next quarter. The company has hit a wall in subscriber growth. Some of that is because of more existing subscribers churning off the service, and the rest is attributable to headwinds in getting totally new consumers to sign up. As for the tick up in churn, the price increase – which hit the U.S. in the first quarter and had been trickling into other regions over the last several months – probably didn't help. There's also likely some COVID hangover... Netflix always acknowledged that it had pulled forward a lot of future demand in 2020 when the world shut down. With the world fully reopened, some of those lockdown subscribers may have decided they don't really need the service now that the world has reopened. Churn after price increases is normal and the possible COVID hangover is a more of a transitory issue. The more worrisome causes of churn and new subscribers stalling would be competition and macroeconomic headwinds... As for competition, the bears have been predicting for almost five years that the launch of new services would take a bite out of Netflix... Could it finally be happening? Sure, although growth is slowing down for even the more recently launched services that are earlier in the adoption curve. Turning to the macro picture, Netflix faces the same problem as every consumer company in the world: inflation and its impact on consumer discretionary spending. With the price of gas and food up so much, everything in the budget can be on the chopping block – including Netflix, because it's a want, not a need. It will be interesting to see how other global subscription services do in this environment. When music streaming leader Spotify (SPOT) and Netflix competitor Disney (DIS) report earnings, what they say should help us decipher how much of the Netflix headwinds are due to global macroeconomic conditions and how much might be more company-specific. Even though I got prematurely bullish on the stock in January after its first big earnings drop, none of this slowdown really shocks me... I thought the business was at peak growth and peak margin improvement the last couple of years, and that the law of large numbers plus the recent outperformance would make further gains more difficult in the short term. So, the slowdown doesn't shock me as much as the violent reaction to it. It's one of the most dramatic sentiment shifts I've ever seen in the stock market. When I didn't like NFLX shares in 2020 and 2021, I felt very alone. As one Wall Street analyst after another pumped up their price targets to the $600s and beyond, I was perplexed how people couldn't see the company was growing at an unsustainable rate. Now the same big bank analyst who had a $400 target before the pandemic started and had raised that target to $700 by the end of 2021 is back at a $450 target. I'm not calling out which one because this analyst is emblematic of the whole pack... I'm not trying to critique any one individual, just the herd mentality. Suddenly, people are questioning the entire business model of streaming, pointing out how it has inferior economics to the traditional cable network business... and they're right. This fall from grace for Netflix is leading to gloating from the perma-bears and schadenfreude from legacy media execs who have had to compete with Netflix, which essentially had free reign to spend to grow and not make money for years, while the rest of Hollywood had to play by the old rules. The crash in NFLX shares and the endless battle of all these streamers to outspend each other is a problem created by Wall Street, not Hollywood. As Puck's Matthew Belloni perfectly summed it up over the weekend... But here's the truth: none of that stuff is Netflix's fault. The $17 billion in annual content spend, the firehose creative strategy, the soul-crushing culture, the entire philosophy of business – Wall Street made that happen. Wall Street identified Netflix as the key disruptor, the first major mover in subscription streaming. And Wall Street lavished on Netflix a rocketing share price that enabled it to load up on debt and spend without consequence. That allowed [co-CEOs] Hastings and Sarandos not just to shoot for total domination, but also to dictate strategy to the entire industry, to change decades-old business practices... But you can't put the toothpaste back in the tube... Now that consumers know what it is like to stream entertainment anywhere, anytime, on their schedule – they aren't going back to the old linear model. Legacy media made a tremendous mistake aiding and abetting Netflix to build the streaming industry according to its vision... Years ago, legacy media companies like CBS, now part of Paramount (PARA), and Disney had an opportunity to quickly act on the streaming opportunity. The industry tried and failed to get together to create a "TV Anywhere" initiative. Instead of building streaming as an add-on that would have preserved the very profitable cable TV ecosystem, they took the quick, high-margin gains of selling library content to Netflix. In retrospect, these content deals were like picking up pennies in front of a bulldozer. They allowed companies to beat earnings, build up cash coffers, and do aggressive stock buybacks... but they also allowed Netflix to define what streaming meant to the consumer. And Netflix defined streaming as cheaper than cable, despite added features and benefits, like portability, bingeing, and being on demand. But all that's in the past... As I said, we can't go back to the past – streaming is the future. And the industry is what it is... and right now it's collectively unprofitable and highly competitive. The way to fix that is consolidation... I may sound like a broken record, but I don't see how this industry gets profitable with this many players. There were a couple of things that I liked on the Netflix call... I applaud that it opened the door to an ad-supported tier. While some people have said this move increases uncertainty – and they are right – I have long thought Netflix should offer an ad-supported option, especially in international markets. Having ad-supported content enables a lower-priced tier without Netflix taking a margin hit. This option will be crucial to Netflix's growth in the emerging economies where so much of the future growth is. It's even more important if macroeconomic conditions prove to be a formidable headwind. Even in higher income markets like the U.S., consumers want this option. Research firm Morning Consult recently published a survey showing that consumers all across the globe want a cheaper, ad-supported tier... Source: Morning Consult While I personally have zero interest in saving a few bucks per month if it means watching ads, I acknowledge that the answer to this trade-off will vary widely depending on who you ask. Netflix had historically resisted offering an ad-supported tier because management was very focused on the customer experience... Some view this radical shift in corporate philosophy as a sign of a management team adrift or panicking. I see it as the opposite. While it is indeed a radical strategic shift and the plans to launch an ad-supported tier are far from cemented, I think management is showing great flexibility by recognizing that serving the customer best in 2022 may require a different playbook than it did in 2012. I'm glad that Hastings and Sarandos and the rest of the management team are open-minded to change. I'm also relieved that they didn't say the answer to this growth stall is just spending more on content. Had they said that I might have soured on the stock. --------------------------------------------------------------- Recommended Link: [Elon Musk's secret fuel?]( In addition to leading the charge for batteries, electric vehicles, and solar-powered homes, the Tesla founder is quietly working on a new type of fuel to power his SpaceX rockets. McKinsey, a leading consultancy, claims this technology will change our lives forever and create a $4 trillion industry. And one little-known company at the forefront of this industry has the potential to become "America's Next Big Monopoly." If you missed out investing in Tesla, Apple, Amazon, Google, or Netflix early on... this could be your second chance. [Get the details here](. --------------------------------------------------------------- I guess I am just by nature a Netflix contrarian – whether that means being a bear or a bull... Whichever way the crowd is going on this company, I am the opposite. Back when Netflix was just getting into streaming in 2011, I was a big bear on the stock. I made a little money during the Qwikster debacle – the ill-fated announcement that the company would split off its DVD-by-mail business from the streaming one. It was actually a pretty good short – it went from the high $30s to around $10 that year. But I didn't make that much money because I stuck with the short for too long. I was super bearish for two reasons. First, I thought the economics of streaming would never be as good as cable TV. And I was right! But it didn't matter, because the legacy media companies were hooked on the quick gains of selling content to Netflix and allowed the upstart to create the rules for this new industry of streaming. My other big bear point proved totally wrong – I thought the company would hit a wall at around 30 million subs, which was around where the HBO premium cable channel topped out at the time. I was so wrong – and that's why the stock has been a 20-bagger over the last decade – even at today's depressed price... I ended up covering my NFLX shares with a small gain because of two men... First, legendary investor Carl Icahn went long – and I figured that would put a bid under the stock. Second, my business school friend Jason Kilar - who was running Hulu at the time and until a couple of weeks ago had been running Warner Media – told me that Netflix was not to be underestimated, would do great things, and would blow through that 30 million sub count. These were two guys I didn't want to bet against, so I covered – but I never went long, mostly because I didn't believe Netflix would ever generate free cash flow. It was one of the bigger mistakes of my career. So here I am, and everyone is bearish on NFLX shares – as I was for so long – only to flip positive at the beginning of the year for the first time ever. Clearly, I was early and wrong, with the shares down around 50% since then. I could write a lot about how this company used to trade at a price-to-earnings (P/E) ratio of 100 times or more, and now it's at a 19 times P/E ratio – in line with the S&P 500 for pretty much the first time ever. I could give you 2027 subscriber estimates and translate that into revenue and make some assumptions about margin expansion and give you a 2027 earnings estimate and slap a multiple on that. But it would all be guesses. The future of Netflix is an exercise in looking into the future. What is the real total addressable market ("TAM") for streaming? In the past, Hastings has said it's 500 million people. Kilar has said it's 1 billion. I'm not sure what it is – but it is a lot more than the 222 million subscribers that Netflix has now. But TAM for subs who can afford to pay $15 per month may be a lot lower – so I'm encouraged that Netflix is opening the door on an ad-supported tier. Stepping back, it's clear that streaming is at low penetration globally. It will grow. While competition has increased, Netflix is still the global leader in terms of subscribers, content production, brand awareness, and margins. It still has the management team that created the industry. I'm willing to bet on this team finding the path forward. Along the way, I'd like to see them hire a great leader for the ad-supported business. Filling this job with the right person may be as important for the next 10 years as hiring Sarandos to expertly run the content ops was for the last 10 years. There are a lot of candidates for this job outlined [in this Business Insider article]( where I am quoted and offered some suggestions. NFLX shares last traded around $200 at the end of 2017... Back then, it had 111 million subscribers and was burning $500 million per quarter. Now it has twice as many subscribers and should generate cash this year. Yet five years of stock gains have evaporated. Yes, there is more competition, but there is also less risk around global streaming adoption. The fixes here aren't quick – but there is a clear path forward. And if they don't execute on that path, consolidation is still coming. I do fault management for not being more aggressive in using their stock when it was over $500 for more than a year to make acquisitions. But with NFLX shares in the dumps, management has a finite amount of time to get the ship righted. At a $300 billion market cap, it was a tough acquisition for even the largest possible buyers. With its current market cap of $91 billion – well, that's less than half the cash that tech giant with a tiny content library Apple (AAPL) has on its balance sheet. Netflix is the epitome of growth interrupted... and investors hate that. So NFLX shares are in the doghouse. But I think patience will be rewarded in the coming years – so I remain bullish on NFLX shares. Skipping the mailbag because this was long... I wanted to offer a thorough analysis since I unfortunately did lead my readers astray with this one by flipping my view too early. Who thinks Netflix is broken and is bearish at these levels? And who is with me that this is still the market leader in a growth industry... and with time, it will find its way back to profitable growth, or else get taken out by another player? And what should Netflix do next to reinvigorate growth? I want to hear from both the bulls and the bears. Let me know by [clicking here](mailto:feedback@empirefinancialresearch.com?subject=Feedback%20for%20Berna). Regards, Berna Barshay April 25, 2022 If someone forwarded you this e-mail and you would like to be added to my e-mail list to receive e-mails like this every weekday, simply [sign up here](. © 2022 Empire Financial Research. All rights reserved. Any reproduction, copying, or redistribution, in whole or in part, is prohibited without written permission from Empire Financial Research, 601 Lexington Ave., 20th Floor, New York, NY 10022 [www.empirefinancialresearch.com.]( You received this e-mail because you are subscribed to Empire Financial Daily. [Unsubscribe from all future e-mails](