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Netflix Stock: The Market’s Sell-Off Is Overdone (NASDAQ:NFLX)

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Netflix (NASDAQ:NFLX) The share price fell almost 72% and the total market cap is $77 billion. During the pandemic, Netflix’s subscriber growth has accelerated, driving growth. Now, subscriber growth has stalled or even declined, leading the market Reassess Netflix and downgrade heavily on future growth.

Many of Netflix’s valuation metrics are at all-time lows, and Netflix is ​​being valued as if its growth will be in the 10% – 15% range over the next few years. The market likely overdid itself with its predictions about Netflix’s growth.

Netflix stock rating
Data from YCharts

Industry experts estimate the growth rate of SVOD (Subscription Video-on-Demand) at 8-20% in the next 5 years (Source1, Source2, Source3). The range is wide, as estimates vary widely based on geographic and industry scope.

Netflix stock fundamentals

Netflix Price Correlates With Fundamentals (Fastgraphs)

SVOD – Size Matters…A Lot

The streaming industry has significant barriers to entry that keep new competitors at bay. Shooting a movie or an entire series costs millions, sometimes even billions, depending on the actors involved. These are costs that other participants cannot simply bear.

Netflix’s advantage was that it didn’t start out as a content creation company, but instead sold existing movies and series to its customers. In the very beginning it was a video rental company that shipped DVDs, games and the like to its customers across the United States. As bandwidth increased in the US, DVD rentals transitioned to online streaming, and Netflix was excellently positioned to take over the entire market early on.

The availability of online streaming ensured Netflix would grow and studios used Netflix services to deliver their content through their platform. The platform itself is not a competitive advantage, so we see studios offering their streaming platforms. Disney+ (DIS), Prime Video (AMZN), Hulu, Apple TV (AAPL) and YouTube (GOOG) (GOOGL) are just a few in the industry.

However, since Netflix has grown significantly in size, it can afford to create its own content and make it available to its customers.

Netflix context and history matter. The size of the streaming market will likely be limited to a few big players who can afford to generate and aggregate content.

Content is king until it’s not

Content is a very complicated thing. Sometimes poorly made videos, movies and series go viral while well made movies, videos or series are never profitable. “Going viral” or “Why Things Go Popular” is a phenomenon that has taken many years to describe, but there doesn’t seem to be a secret recipe for how it works. If there was a secret, studios and content creators would probably have used it to create content like this.

In their decades of tenure, major film studios such as Universal, 20th Century Fox, Metro Goldwyn Mayer and many others have never found the special recipe for cinematic success.

The book The Curse of the Mogul describes this phenomenon in more detail and explains why studios have never been able to produce better results than with their eyes closed and a dart.

The content creation industry has always been a tough industry characterized by meager results. Customer retention and supply-side scaling are required for a business to be successful. Content creators cannot fall under this category.

But content aggregators can have both – customer loyalty in the form of good movies and series from many different sources – supply-side scaling because their infrastructure requires high initial fixed costs to collect, manage, market and redistribute the content.

The platform mania

Platform mania is a term coined by investment banker and professor Jonathan A. Knee to describe how investors misidentify a company’s core value proposition as enabling and enhancing connections between individuals and organizations because they are online and users are on collect on a platform.

The problem lies in the perception that network effects and a platform provide sufficient competitive advantages and structural barriers to entry for new competitors into the market and that these effects alone create superior returns for shareholders.

Knee argues that this is rarely the case. Network effects without additional competitive advantages are not sufficient barriers for new competitors.

At Netflix, we’re currently seeing investors becoming disillusioned with said platform and network effects. In the absence of additional competitive advantages beyond size, large companies with sufficient capitalization or companies that already have a lot of content can enter this market.

Here is one of many charts intended to represent market share distribution in the SVOD (Subscription Video-on-Demand) industry.

HBO Max, Apple TV+ Register Market Share Gains In Streaming Wars

Streaming Chart – Market Share (cleveland.com)

Many more of these charts have different distributions depending on time, measurement criteria, and more.

In general, Netflix currently holds ~25% of the market, followed by Amazon Prime Video – ~18%, Disney+ – 14%, HBO Max – 14%, Hulu – 14%, and Apple TV – 6%.

Netflix started out as a content aggregator, improving people’s access to content such as movies, games, and series. It got rid of the pesky late fee that made Blockbuster most of its money. Then, as internet bandwidth increased, a streaming platform was created that further lowered the barriers to content viewing.

The platform isn’t a competitive advantage, though, and Netflix recognized that early, starting funding original films in 2015. It had the size and capitalization for it, but there’s no scale effect or other competitive advantages in making movies.

To stop. You’d say, “But Netflix has all this user data that it uses to find the best content.” True, but how does that data give Netflix a competitive advantage? In 2015, Columbia Law School professor Tim Wu asked Netflix CEO and chief content officer Ted Sarandos if data represented a distinct competitive advantage in content creation. Sarandos said: “It is important to know which dates to ignore. In practice it’s probably a 70-30 mix. Then Sarandos added: “But the thirty must be up if that makes sense.”

While there’s a valid notion that user data gives Netflix some edge, it’s more likely that human judgment plays a big part. Other providers of sufficient size can follow suit and become viable competitors.

Netflix will maintain its high market share

We found that creating quality content (movies, series) is difficult and expensive. To pull all this information together, we need to look at the SVOD industry.

The SVOD industry is growing and cable cutting is increasing. The pandemic has accelerated this trend, pulling subscribers forward, which is now impacting Netflix’s subscriber growth.

Households with cord cutters in the US, 2019-2024

US cord cutting trend is accelerating (emarketer.com)

If we look at Netflix QoQ additions over the past 2 years, we can see that the pandemic-driven surge in subscribers has pulled many subscribers ahead, which has impacted the current subscriber growth.

This is consistent with the dramatic increase in cable cutting from 2019 to 2020.

Netflix Membership Extensions

New Netflix Membership (Keyanoush Razavi – Netflix Annual Report)

Many new SVOD companies entered the market during the pandemic. The platform in and of itself is not a barrier to entry and is easily duplicated. Therefore, content creators have decided to offer their own services instead of using a content aggregator like Netflix.

Total US SVOD Subscribers - US

Total US SVOD Subscribers (HarrisX, MoffettNathanson)

Consumers benefited greatly from this. The competitive landscape has increased and there are no switching costs for consumers. Customer churn is a big issue in the SVOD industry. Netflix doesn’t publish its churn rate, but experts estimate that churn rates are among the highest in the SVOD industry.

Average churn rate by industry.

Customer churn rate by industry (profitwell)

Netflix is ​​no exception. Jamie Powell, a Financial Times writer, estimates that Netflix’s churn rate is ~34%.

SVOD companies need good content to engage their customers.

Netflix is ​​a well run company

Netflix does a lot of things right. It focused on customer acquisition and until now has users share their account passwords to bring more people to its platform. It’s focused on cash flow and has been positive rather than negative for the past two years.

It entered the gaming segment to increase Netflix’s appeal and made some strategic acquisitions. Boss Fight Entertainment and Next Games are two of its gaming-related acquisitions to capture more of consumers’ screen time.

Netflix’s share price decline has wiped out all gains over the past 5-6 years, and it has underperformed the S&P 500 over the same period.

Netflix finances and returns
Data from YCharts

I find it highly unlikely that Netflix’s current valuation justifies underperforming the market for such a long period of time. Netflix grew its revenue by 154% and its EBITDA by 215% over the same period.

The recent macroeconomic backdrop, interest rate hikes and global tensions may have contributed to the market’s overreaction to Netflix’s disappointing but expected subscription growth rate.

Conclusion

The market may have overdone it in Netflix’s re-evaluation. Netflix has pulled a lot of growth from the future during the pandemic, leading to hype and high expectations.

Netflix still has plenty of powder left to improve its margins, capture more screen time from consumers, and create exciting content. The SVOD market is limited in size and only a few broad-based global players are likely to survive.

During Netflix’s most recent earnings call, many opportunities to improve margins and increase sales were highlighted. Netflix is ​​now actively tracking password sharing. This is one area where Netflix can improve margins and revenue by making a few small adjustments to its operations. Ads could soon become a thing, too. This would be a new pricing tier that is cheaper but includes third-party ads.

Over the past 10 years, Netflix has demonstrated operational excellence while expanding globally — while keeping its margins in a tight range.

I am always happy to receive constructive criticism and open discussions. Please do not hesitate to send me a comment or message regarding my calculations and/or sources I use in my articles.

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