A surge in Netflix Inc.'s (NFLX, Financial) subscriptions during the Covid-19 pandemic hides Netflix's biggest problem, the running out of profitable opportunities.
Netflix reported earnings for the fourth quarter of 2020 last week, announcing it is "very close" to being free cash flow positive and is considering buying its shares. Global paid net subscriber additions were up at 8.5 million, beating the 6.47 million analysts have expected.
Subscriber additions have been closely monitored by investors seeking clues to determine whether the streaming giant's relentless growth remains intact.
Still, investors should interpret the recent subscriber surge with caution due to the Covid-19 pandemic, which resulted in theater closings and lockdowns that boosted demand for streaming services.
For the first quarter of 2021, the company expects paid net adds of 6 million versus last year's 15.8 million, which included the impact from the initial Covid-19 lockdowns.
Meanwhile, the strong subscription growth during the pandemic hides Netflix's biggest problem: running out of profitable opportunities to deploy capital and the erosion of its competitive advantage, as evidenced by a prolonged decline in economic profit before the Covid-19 crisis.
Economic profit is the difference between the return on invested capital and the weighted average cost of capital or the number of investment dollars it takes to generate the return on invested capital. It's a measure of a firm's effectiveness in allocating capital to profitable business opportunities. It's also an indication of whether the firm creates or destroys value as it grows.
Netflix's economic profit has dropped from 33% back in 2010 to -11% in 2013 and -3% in 2019. That means the company destroyed rather than created value as it grew over that period.
There are a couple of good explanations for this trend. One of them is the shift of the company's growth from the domestic to the overseas markets, where revenue per subscriber is lower than in the U.S. In the third quarter of 2020, Netflix revealed that its average monthly revenue per paying streaming customer in North America amounted to $13.40. By comparison, Latin America's streaming memberships brought in just $7.27 per month on average, with Brazil's subscription rates as low as $3.99.
| Country/region | Basic price per month |
| U.S. | $9 |
| EU | $8 |
| India | $6.97 |
| Mexico | $6.30 |
| South Africa | $5.76 |
| Brazil | $3.99 |
Source: https://www.comparitech.com/blog/vpn-privacy/countries-netflix-cost/
Lower international subscription rates could explain the disconnect between membership growth and revenue per membership reported by the company last week. While average paid streaming memberships increased 23% year over year in the fourth quarter, the average revenue per membership was flat year over year both on a reported and foreign exchange neutral basis.
Then there's the rising cost of producing original content both for the domestic and overseas markets. And the growing competition from Disney (DIS, Financial) and other original content producers makes it difficult for Netflix to raise subscription prices and pass the higher costs on to consumers.
In the U.S., there's a problem bigger than the competition, which is market saturation, the drying up of the pool for new subscribers.
That's when younger companies reach maturity and their growth slows. In turn, slow growth creates a zero-sum business environment, whereby there's a fight for market share, which leads to price wars.
Meanwhile, local government regulations, language barriers and lack of internet infrastructure could constrain the company from exploiting profitable opportunities abroad.
And that could make it difficult for Netflix to grow and earn an economic profit and create value for its capital holders.
Disclosure: I own shares of Disney.
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