Netflix: New Strategy Fundamentally Changes Dynamics

Summary:

• I have ended my Netflix long recommendation after almost 300% profit, as the stock now presents a balanced risk-reward profile.
• Despite the success of paid sharing and advertising, these initiatives may hurt user engagement and Netflix’s long-term platform power.
• Competition from Amazon’s ad-supported Prime Video and potential creator backlash pose additional risks to Netflix’s growth strategy.
• While I see future potential in Netflix Houses, licensing opportunities, and sports, the stock is no longer the bargain it once was.

I am writing today to update my call on one of my best stocks, as I am now completely out of my Netflix (NASDAQ:NFLX) long position.

Author History

I have to admit, it feels a little weird to be writing that. I have been a Netflix bull for longer than I have been a Seeking Alpha writer. Pretty much from the moment they became the first-mover in the then-nascent streaming sector, I called them a buy. There’s a long history of articles here on Seeking Alpha you can go back to and see just how far back my Netflix bullishness stretches.

I have sold out my Netflix once before, in 2018. Those articles stop around that same time. I felt pretty clever in timing the top of the stock until COVID-19 hit and the ticker reached all-new heights as lockdowns put Netflix right up there with basic utilities like heating and electricity. I figured it was too late to buy in at that point, but in 2022 the Great Netflix Correction saw the stock plunge 75% and offered the opportunity to get back in. I reinstated my long around $200 and have enjoyed watching the ride up ever since.

Now, I’m done again. A few days ago, Netflix briefly touched $720 and that was my cue. It’s not that I am suddenly a Netflix bear, and I have no plans to short the ticker. It’s just that what once was a screaming buy now seems a much more balanced set of upsides and downsides. There is an opportunity to close out the Netflix position for almost 4x what it went for barely more than two years ago. While I still feel a little nervous that I may be closing out a little too soon, on the whole I am comfortable taking some extremely large winnings off the table at this point.

A Different Take

Like so much of my investing analysis, I find myself reaching similar conclusions as some other analysts but for different reasons. The talk of the town for the past few years when it comes to Netflix has been on their two big new initiative: Paid Sharing, and advertising. Most of the bullish analysis over the past few years has emphasized the potential and, in Sharing’s case, the already-apparent success of these two initiatives.

I’ve been very bullish on Netflix the past few years as well. To be honest, though, neither of these initiatives impresses me as much.

Advertising

Advertising is pretty much the sine qua non of a bullish Netflix argument these days. With pretty much all of its competitors already offering ad-based service for several years, it was sort of the go-to change to make when Netflix stock collapsed. And the rebound since then would seem to suggest the market thinks advertising will be a big boon for Netflix.

Does the data really back that up, though? According to reports Netflix will net some $760 million this year in advertising revenue. Not bad for an early performer, to be sure, but hardly evidence of runaway success, either. In fact, it’s probably not even enough to add anything to Netflix’s operating income. When Netflix added downloads to its service a few years ago, it had to pay about a 20% premium on most of its existing rights for which it had not previously negotiated that option. Its fee to add advertising to content where AVOD rights had not been purchased was variously put somewhere between 15 and 30%.

I recognize that management has indicated that the vast majority of Netflix content spending is now on original content, with which it can presumably do what it likes in terms of format. But if Netflix is spending even $3.5 billion of its $17 billion a year content budget on licensing, those numbers would suggest that the rights fees on ads are going to swallow all of the ad money this year.

Creator Backlash

Nor are all of advertising’s costs financial. I just said Netflix can do what it wants with its own originals, and it can, but that doesn’t mean its free of consequences. When Netflix broke a 15-year taboo against ad interruptions it wasn’t just customers who lost out; Netflix’s content creators weren’t happy, either.

More than one of them had selected Netflix as the home for their shows specifically because it would not be ad-interrupted. While their contracts did not specifically ban ads, obviously, they have the power to express their alienation by taking their next project somewhere else.

It would probably be difficult to tease this out from general data noise, exactly how many of the massive number of projects that Netflix doesn’t secure every year can be attributed to creator alienation, but its a point I do not think should be completely dismissed.

This isn’t necessarily a reason to go back on advertising at this point; most of the damage here is probably already done. But it is possible that the damage isn’t yet fully reflected in the results. Projects have a multiyear path from deal signing to broadcast; Netflix’s new Chronicles of Narnia movies were first signed in 2018, finally got a director last year, and still aren’t going to be released until 2025 at the earliest. So if there was some sort of hit to Netflix’s cache among creatives, that hit is probably still ahead of us rather than behind.

Advantage Amazon

Perhaps the biggest cautionary indicator, however, is that behemoth of advertising, Amazon (AMZN) launching its own ads. In January Amazon began shifting all Prime Video members to a default ad-supported option. The effect on the advertising market for streaming video was almost immediate. Prices began to fall as a sharply increased supply met a stagnant to falling demand.

Consider the change in Netflix’s ad pricing. When Netflix with Ads first was announced, the pre-launch stories were that Netflix was seeking some truly astronomical prices, as high as $80 CPM in some cases. They wound up launching around $65. That had already fallen to $45. Now, with Amazon offering far more reasonable rates than anticipated for its own, far better targeted ad slots, Netflix has cut ad prices down to below $30. And management reports that even with all this price-cutting, they still have more supply of ads than demand for them from marketers.

Under the circumstances maybe it’s not so surprising media reports are Netflix is already revamping its ads strategy, barely a year after launching.

Paid Sharing

Paid Sharing has arguable worked out better. After reporting 5.9 million net additions in Q2 2023, net adds were just over 8 million this year. Even more impressively, in between Netflix added a total of 30.2 million subscribers in nine months. Roughly one in seven paid Netflix subscribers has joined the company in the past year.

There are a few qualifiers here we should be aware of. First, not all of this growth is attributable to Paid Sharing. Management has indicated that there is substantial organic growth in there, too. In fact, given the opportunity the CFO has still declined to say that Paid Sharing is even the majority of these net adds. Remember that Netflix also got the chance to take advantage of Warner Brothers Discovery’s (WBD) absolute desperation for cash right around this same time, when it licensed large portions of the HBO library for the first time.

And it wasn’t exactly standing still even before paid sharing launched. That same nine month stretch going into 2023 yielded 11.8 million net adds – less, but still significant.

All the same, it seems indisputable that Paid Sharing has put a considerable boost into Netflix’s subscriber count, even if we can’t tell exactly how much. I make no bones about that, but again, it wasn’t free.

Engagement Cost

What both of these initiatives have in common is that they represent ways to boost revenue that hurt engagement. Sitting through ad interruptions or being told to either sign up for their own account or get lost are both things which, while they clearly extract more money from users, tend to also reduce the amount of time people spend on the platform, either because they’ve been literally blocked from it, or just because ads are annoying and while someone might sit through them to watch a piece of must-see content, they’re not going to watch their next show on Netflix, but rather switch over to another service that is still ad-free.

That lost engagement may hurt Netflix more than the new revenue helps it. I’ve written before about the fact that while good content is important, the “content is king” mantra has become rather overstated today; owning the platform is at least as lucrative as owning the content in 2024. This is why Amazon, Apple (AAPL) and Alphabet (GOOG) (GOOGL) are all pouring resources into set-top box hardware.

Netflix, of course, does not create streaming hardware, but it has achieved such broad prominence and ubiquity in streaming that it is almost a “virtual” platform of its own. As the Suits viewership explosion demonstrated being the platform that decides which of a dozen or a hundred shows rockets to the top of the cultural zeitgeist is worth more than just bragging rights; it’s worth money. Especially if, unlike Suits, Netflix does it while the show is still running.

The Value Of Engagement

This effect has gotten progressively harder to measure as more and more content has moved onto mobile devices and laptop computers where Nielsen and other measurement firms find it harder to measure them. But back in 2017, when Netflix was far less ubiquitous than it is now, it was already starting to show considerable potential to steer customers towards whichever shows were on its platform.

That year, Riverdale and Shameless back seasons were added to the platform for the first time. They both saw major boosts in their current-season viewership on their own channels, with Shameless reporting a 25% boost in viewership from season seven to season eight despite being on a premium network, which customers must pay extra to access.

In other words, 20% of the total viewership of those shows came down to it being discovered on Netflix first.

That 20% is almost certainly an understatement of Netflix’s platform power, by the way. It also presumably has a similar effect on those who knew the later seasons of the shows would eventually come to Netflix as well and decided to simply await its arrival rather than following it to another platform with an additional cost.

But even if 20% was the final number, Netflix has massive profit potential simply from its ability to essentially make a hit, simply by virtue of a show’s presence on its service. If Netflix is considering purchasing the rights to one of four different crime procedurals, for example, it doesn’t necessarily need to pay the full cost of those shows that another service would.

If Netflix can generate a 20% viewership boost, and another service can only provide a 1% viewership boost (if that, even) then Netflix can logically seek to negotiate the value of the other 19% as a discount to the price it pays to get the show. Odd as it sounds, higher viewership can in Netflix’s case make content cheaper instead of more expensive. It can essentially pocket some of the value those shows “create” on its platform for itself, knowing that the viewership itself has value to the owner. And if the price isn’t reduced, they can simply call one of the other three shows vying to get on Netflix.

More importantly the creatives Netflix is bargaining with know that as well. But this is all contingent on keeping engagement high, and obstacles to viewership, even so far as basically kicking viewers off the platform, weaken this effect.

My concern is that it isn’t clear how the Paid Sharing and advertising initiatives trade off with this weakened ‘Netflix Effect’ as it’s come to be known, are going to work. I don’t deny that perhaps the former can outweigh the latter, but I am a little puzzled by the assumption that “of course it will.” And given how well Netflix was already doing with its time-tested ad-free, sharing-is-love approach, I wonder if this hard swerve towards more penny-pinching methods that retard consumer experience was really the way to go.

The Ongoing Bull Case

None of this is to say that I am bearish on Netflix. I am not. I wasn’t wild about its new direction two years ago, but that didn’t stop me from buying in. I bought it because a 75% plunge following a bad quarter or two seemed to me like a ridiculous overreaction. I believe subsequent events have proven that it was, Paid Sharing subscriber boost aside.

I also think that there are still a lot of positives on the horizon, even if Paid Sharing levels off and advertising doesn’t work out. This article is already quite long, but just in brief:

Netflix Houses: The company is launching a small (so far) series of consumer experience outposts where some of the company’s leading brands such as Bridgerton, Stranger Things, etc., can be immersed in. It’s not quite Disney World level, yet, but the company seems optimistic about their ability to leverage Houses to drive consumer interest, boost viewership, and harness fandom. And who’s to say this can’t lead to something more…grand, in the years to come?

Licensing Opportunities: As already discussed, most competitors are once again opening the spigots to license their best content to streaming competitors after briefly trying to hog everything for their own services. This is another opportunity for Netflix’s famed recommendation algorithms to go to work. Management has already indicated that the new Sony (SONY) and Universal (CMCSA) Pay-1 output deals may be more efficient at drawing in and keeping customers than their Netflix Original movies and there are presumably similar efficiencies to be found on the TV side.

Production Dominance: Aside from licensing, most competitors are also pulling back on future productions. This is leaving more room for Netflix to play the field of ongoing projects, although it doesn’t have the game entirely to itself in this regard. Netflix was one of two big spenders to report increased production commissions when most competitors were chopping back productions; Amazon, powered perhaps in part by its outperformance on the advertising side, was the other. Even so, with many so many others retrenching, there may be room for both to thrive here.

Sports: I have a little more trepidation about this one, because like ads and sharing it is going to impose costs that aren’t obvious at first glance, making profit harder. But clearly Netflix is all in on live ads at this point, and the WWE deal it just signed is a reflection of how Netflix might be able to bargain shop for underutilized sports properties while avoiding the massive overpays on things like the NBA. Color me cautiously optimistic here, so far management appears to be bringing their usual hyper focus on efficiency in content spending to the new content vertical.

Investment Summary

Netflix is far from a bad investment at these prices, but it is no longer the ridiculous bargain it was two years ago. I am ending my long recommendation because it seems to me that the upsides are now fairly balanced by the downsides. I know it’s possible I got out a little too early, and I do see significant potential even from here.

But I wonder why, with a stock that had annualized 40% returns for over a decade, anything at all really had to change.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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