Netflix (NFLX, Financial)’s latest results appear to point to its days as a disrupter in the media landscape being numbered and its place in the value chain slowly descending. As such its eventual path to profitability appears to be severely hampered.
The old Netflix was able to significantly disrupt the media landscape by exploiting a unique spot in the value chain. The diagram below shows how Netflix fit into the media universe.
Netflix aggregated third party media content and then delivered it to consumers using third party broadband infrastructure. The key for Netflix was that it was able to purchase large amounts of content at below market prices and then pass those savings onto consumers in the form of a subscription that was substantially lower than a traditional cable or satellite service. The large content library and cheap price made Netflix a popular alternative to cable.
With content prices rising towards fair market rates, investors are beginning to wonder what Netflix's role is in the value chain of delivering content to consumers. When Netflix streaming service was in its infancy, media companies would happily license content to it on the cheap. Now that they realize the competitive threat Netflix poses, they are negotiating higher prices for content. Content prices are also being pushed up by competition from other streaming services like Amazon and Hulu.
As of the latest quarter Netflix carried a net balance of $8.35 billion in licensed content on its balance sheet compared with just $6.83 billion at the start of this year. As content costs grow, Netflix will have to pass on those price increases to consumers. Indeed, over the past six months Netflix has lost $456 million on a cash basis and increase of $146 million over the same time period last year, as shown below.
It goes without saying that Netflix will eventually need to turn a profit. It can either sharply reduce content spend and sharply reduce its overall content library size, or raise prices, or both.
This past quarter Netflix raised prices. It can call it an “un-grandfathering of low cost plans” if it wants, but the bottom line is consumers are paying more for the service and that’s a price increase.
According to Netflix’s management, the price increase was a major factor in the company coming well short on net subscriber additions. Analysts had predicted net subscriber additions of 2.5 million, but it only added 1.7 million. In the same quarter just last year, Netflix added 3.2 million.Â
If Netflix goes the route of reducing content spend, it is likely going to run into the problem of higher subscriber churn. A large part of the value of a media subscription is the constant delivery of new content. Traditional broadband cable packages are regularly giving viewers new episodes of many shows as well as news and live sports. Netflix implements a pseudo version of this dynamic by regularly rotating in and out new batches of content.
The ability of users to binge watch entire seasons or multi-season runs of their favorite shows makes new content an imperative for Netflix. A shrinking content library means users could conceivably buy a subscription, binge watch everything they like over a few months, and upon finding nothing else they like cancel their subscription. Once Netflix updates its content offerings that user could come back after several months.
A deep content library is essential to Netflix’s current business model as an alternative to a traditional cable subscription. If the library is not deep enough, Netflix may see churn rates go much higher. Indeed, with the volume of movie titles dropping 33% and TV titles 26%, the threat of increased churn is very real.
Netflix is starting to find itself squeezed from both sides. Consumers are resisting price increases while the content that it needs to stay relevant as an alternative to a traditional cable subscription is increasing in price. Neither of these trends seems likely to reverse anytime soon. Subscriber growth at Netflix is likely to remain weak for the foreseeable future as long as it attempts to become profitable.
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