- Netflix reported mixed results highlighting that the increased churn trend will continue.
- Competition has intensified domestically, and local content requirements abroad require further investments.
- I am bearish about the growth prospects for Netflix in the short term amid the multiple headwinds it faces.
So far, video-streaming giant Netflix (NSDQ:NFLX) has been one of the biggest stories of this earnings season as the company reported better than expected results that were followed by a sharp 13% decline in stock price. In an earlier article published before the earnings, I highlighted future growth concerns as the key factor that could drive the stock price after the earnings. For a while, investors have been concerned with Netflix’s future growth amid the company's difficulties in China, the increasing competition in the US, and the fear of a massive churn in the UK as a fallout effect of the Brexit.
Investors’ concerns became a reality when Netflix reported lower subscription numbers for both the US and the international markets, missing the company’s guidance for Q2. Netflix added only 160k subscribers in the US and 1.52 million subscribers abroad, which is significantly below the company’s expectations of a 500k increase in the US and 2 million internationally. The big miss triggered a sharp decline in the stock price, which dropped 15% outside of regular trading hours, immediately after the announcement, continuing the stock’s year-to-date decline as shown in the chart below.
The alarming issue with Netflix’s earnings is not the fact that the company missed its subscriber growth guidance, which has happened a few times before; the alarming issue is that CEO Hastings pointed to the price hike as the driver behind the churn increase, while saying that the company will increase investments to create more original content. These two vectors cannot exist side by side – if subscribers leave due to a price increase and the company needs more and more cash to produce more content, it will put tremendous pressure on the top-line and bottom-line performance in the following years. Moreover, the management plans to raise capital through the high-yield debt market to fund content investment in 2016 and 2017 and will need the cash to pay interest on these bonds, which only increases the pressure on the bottom line.
To keep the cash coming, Netflix will need not only to increase its growth pace but also to hike prices worldwide to compensate for the lost growth, and Netflix could find itself in a loop in which higher prices drive higher churn, which drives higher prices, and so on. In the background, competition in the US and worldwide is intensifying as Amazon (NSDQ:AMZN), Apple (NSDQ:AAPL), Hulu, HBO, and more eye Netflix's market share and will do anything to grab a piece of it and impact future growth. Anthony DiClemente of Nomura best described the Netflix growth problem, by stating that “most Netflix investors pay a multiple premium for its outsized growth. While most companies trade on revenue growth, for Netflix, there is a seismic difference between the growth rate of net subs additions (slowing), and the growth rate in revenue (accelerating, in part, owing to the increase of ASP).”
Netflix's domestic problems are different from those that it experiences worldwide. Netflix has recently been launched in most countries, and each country expects to have local content, with subtitles or dubbing alongside, for high profile US shows. Great complexity is associated with the significant investments that are needed, to localize a large amount of content and to develop original local content in each (or most/some) country, while keeping a competitive price. I am sure that the company’s management took these challenges into account when it expanded globally, but I just wonder if it underestimated the difficulties that would be encountered.
Netflix provided a disappointing report for the current quarter and mentioned that it still faces serious regulatory headwinds in China, which is a big setback for the company’s global expansion. As a result, most sell-side shops cut the price targets for Netflix, citing their concerns about its future growth. After this earnings call, I am also concerned about Netflix's ability to generate sustainable topline growth, while delivering more original content in the US and abroad, and still maintaining its strong position. The expected raising of debt will add another significant hurdle in the company’s attempt to improve the bottom line. In the short-term, I am sceptical about Netflix, as I expect the company to lose market shares in the US and face further headwinds worldwide (including China), which will burden its growth.