Ensemble Fund – Netflix: Best Days Are Still Ahead

Summary:

• From peak to trough, Netflix went from a market capitalization of $300 billion to just $75 billion.
• Netflix continued investment in its nascent games business has the potential to expand the TAM even more.
• Our belief that Netflix had the right strategic approach to building this business persists.

The following segment was excerpted from this fund letter.

Netflix (NASDAQ:NFLX)

We last discussed Netflix three years ago. At that time, five months into the COVID pandemic shutdowns in 2020, Netflix had added 26 million new subscribers to its service and went on to add 10 million more for a total of 36 million, ending the year with 204 million subscribers. Then in 2021, the company added 18 million subscribers culminating with 8 million new subscribers added in 4Q 2021, aided by the global success of the Korean-produced show Squid Game.

The share price hit a record high of $687 in November 2021 before commencing a steep decline in December and January, presaging a significant reversal in its fortunes. Subscriber losses of 200,000 and 1 million in Q1 and Q2 of 2022, the first such net subscriber loss in Netflix’s history, caused shares to fall 75% from the November 2021 peak to its bottom six months later. As it turned out, through all of 2022, Netflix grew subscribers by 9 million or 4%, a big drop compared to the 20% average growth over the previous five years, but less than the worst fears.

Inflation had taken off in 2021 causing central banks around the world to pivot their view of it being a transitory phenomenon into a more ingrained process. Russia invaded Ukraine in February 2022 further pressuring energy and food prices globally. The ensuing aggressive increase in interest rates led to a recalibration in liquidity and market multiples, with those companies that missed expectations punished even harder. From peak to trough, Netflix went from a market capitalization of $300 billion to just $75 billion.

Netflix’s gross subscriber adds, i.e., the number of new subscribers signing up for the service, stalled in all geographies in a manner that even the management team seemed at a loss to explain. The market narrative shifted, and with it future financial expectations, from a company with a seemingly unstoppable business model accelerated by the COVID pandemic to one that had saturated its market and succumbed to burgeoning streaming competition from legacy media companies.

From our perspective having a major war break out in Europe’s borders and another major global economic shock so soon after the COVID shock seemed the most likely explanation for why people abruptly paused in signing up for a new Netflix subscription en masse. We had seen regional changes in new sign-ups historically when people’s attention had been drawn to certain events like the World Cup or the Olympics, only to see additions rebound in subsequent quarters, but we had not seen a globally synchronized pause before.

This was the second time in Netflix’s history as a public company that it had faced a crisis of confidence among investors, where management’s ability to adapt was tested. It had faced a similar test when it pivoted its business model from a very profitable DVD by mail service into a money losing streaming service back in 2011, resulting in a similar fall in its share price before regaining investor trust over the next 2 years and increasing its value over 10x thereafter.

This time it was the inexplicable stall in subscriber growth that led the company to pivot its business model from a pure subscription video service into one that incorporated both advertising as a new revenue source and monetizing the 100 million engaged viewers that were borrowing someone else’s password by implementing tighter password security. This complimentary approach of tightening user password sharing and offering a new lower priced, economically accretive ad-supported plan (or additional add-on subscriber fee) opened up a large pool of already engaged users to reenergize revenue and profit growth rather than solely depending on new to Netflix sign-ups.

This effectively multiplies the total available market (‘TAM’) for Netflix over a subscription-only model, while also raising the ultimate pricing umbrella for the service over time. For context, US TV advertising revenue was about $67 billion in 2022 compared to Pay TV subscription revenue of $86 billion. This amounts to advertising increasing the total revenue from TV content by 80% over subscription rates alone.

Furthermore, Netflix continued investment in its nascent games business, which has the potential to expand the TAM even more. Globally, gaming is a $213 billion market. The net result of all of these service extensions multiplies Netflix’s monetization value for each subscriber dramatically, especially as the adjacent services revolve around the same end user and complement one another.

One other pivot by management was on capital allocation in relation to content. Netflix’s strategy on content spending had been to “overinvest” in content in order to grow the scale of its catalog ahead of subscribers along two vectors – category expansion and geographic expansion. This in turn drove new subscriber additions in existing and new geographic markets. With subscriber growth slowing drastically under indefinite macro-geopolitical circumstances, management rationally adapted and reprioritized the scale of that investment. The result is faster growth in free cash flow generation, now on track to surpass $6 billion this year.

With Netflix letting its foot off the content pedal for the first time in a decade, we fully expected competing streaming services to see blood in the water and get more aggressive. While we did not believe that competition was a factor in the subscriber growth slowdown as the common narrative believed, we did assume that scaling competitors like Disney (DIS) (whose courage and humility in copying the Netflix growth strategy we were impressed by) or Warner Bros. Discovery (WBD) could get more aggressive and use the content growth strategy to win a greater share of new streaming subscribers, eventually eroding some of Netflix’s scale dependent competitive advantage.

To our surprise, both companies announced their own cutbacks in content spending and increased prices aggressively for their own streaming services, finally finding the breathing room Netflix’s reduced aggressiveness allowed to improve the profitability of their own money-losing streaming services rather than trying to take share from Netflix.

This was great news to us as investors as it allowed Netflix to become less aggressive on its content growth strategy, drive higher positive free cash flow, while retaining its relative moat advantage as it adapted its business model. The company has been clear that as revenue reaccelerates to its goal of double-digit growth, it will become more aggressive again in content investment to drive further subscriber gains, to the extent it’s justified.

In retrospect, Disney and Warner Brothers Discovery’s reactions made sense given their financial circumstances of high debt loads and weakening linear TV revenue, traditional media’s cash cow. US Cable TV subscribers, the main source of their linear TV subscription and advertising revenue, has seen its subscriber defections accelerating to a record pace of -7% as of 3Q 2023.

Despite Netflix’s nickname from only a couple of years ago being “Debtflix” as it took advantage of low-cost debt to “overinvest” in scaling its own content catalog, it never put itself in a position where the debt load became a precarious noose around its strategic hands.

As a result of their business and financial issues, Warner Brothers Discovery stock price has declined approximately -70% (setting aside the WBD pre-merger DISCA stock spike above $30 during the Archegos scandal) while Disney declined -60% from its peak. Benchmarking their prices back to 2019, Netflix has outperformed its notable US-based media competitors getting back near its pre-Squid Game highs because it is the only one with a significantly profitable, cash generating streaming video business.

So where does this leave Netflix’s position today and prospects for its future as investors today?

We have a number of positive data points indicating a reinvigorated business with a reacceleration in subscriber growth as consumers have adjusted to economic and geopolitical conditions globally albeit nudged along with the end of free password sharing. The company is on track to have added about 25 million new subscribers in 2023, a similar number to its pre-Covid pace, and has outpaced Disney’s and Warner Brothers Discovery’s streaming service subscriber growth over the past year.

Netflix’s advertising business has reportedly seen strong interest from advertisers looking to move more of their brand advertising spend from linear television, with its declining share of engagement, to streaming. Roughly 200 billion hours being spent on Netflix by its 250 million subscribers is premium advertising real estate that brand advertisers want access to and are willing to pay a premium to do so. While Netflix has seen huge success in content engagement, it still has work to do to build out and extend the advertising capabilities addressable by its platform and scale the number of subscribers accepting its ad-plan (most subscribers signing up still prefer to pay more for the ad-free experience).

We estimate ARM (average revenue per month) for this service near or above the $15.49 standard ad-free plan in the US (comprising of a $6.99 subscription coupled with a $8-10 per month per subscriber in advertising revenue) despite only four minutes of advertising served per hour of viewing. In our view, this has a lot of headroom to grow from these levels as ad targeting and customization improves. In the other 11 countries where it has launched the ad plan, advertising economics aren’t quite as good but there is a clear path to improvement for the business in the dual goals of eliminating password sharing while offering a more economical service for those sharing out of necessity, creating a win-win solution for both customers and the company.

As legacy media companies have begun to focus on reducing their losses from their streaming services, they’ve returned to licensing some of their premier content to Netflix after previously suspending deals in favor of their own buildouts. This is true for even the bigger ones like Disney/ABC and Warner Brothers Discovery/HBO, who have inked deals with Netflix for some of their most popular content. This is great news for Netflix subscribers – valuable and unique content is non-fungible, which is why we never subscribed to the competition argument, and we’ve seen how unique new content has driven subscriber additions for all the major services.

Consumers have increased the number of streaming services they subscribe to because they want access to all this great content. However, “subscription fatigue” has more recently led them to stay more loyal to core streaming services with content scale and velocity (represented by lower churn) while shuffling through secondary services where they may want to binge on a certain more limited set of content. By having access to license unique sought-after content from other media companies, Netflix gets to satisfy members of its own service while reducing the content cash demands required of only relying on original content.

We’ve argued since our initiation in 2016 that there are likely to be a handful of key global subscription services and most other media companies are going to find superior economics in licensing to them rather than building their own platforms – and this thesis appears to be coming to fruition. Beyond the legacy media players are the large tech giants also playing in the space with different economic business models like Apple, Amazon, and YouTube, who are also building successful global platforms. Our belief that Netflix had the right strategic approach to building this business persists and as the leader in the space it continues to be well-positioned to win more than its fair share of the very large global entertainment pie.