Debunking the Netflix "Virtuous Cycle" Myth

Netflix (NASDAQ: NFLX  ) management has often talked about pursuing a virtuous cycle that will sustain rapid streaming membership growth for years to come. By having more members than competitors such as Amazon.com (NASDAQ: AMZN  ) or Hulu, Netflix can afford to spend more on content, improving the quality of the service and attracting even more members.

The company's long-term view states, "Success relative to these competitors-for-content would be us having substantially larger revenue and therefore sustainable increasing content, tech and marketing spending, leading to further growth, and a virtuous cycle."

This expectation of a virtuous cycle is one of the primary reasons Netflix CEO Reed Hastings believes that the company will ultimately attract 60 million to 90 million U.S. streaming subscribers. As he explained during the company's recent earnings interview: "[B]y the time we get to 40 million and 50 million, we get the content better and the service better. So, it's not 60 million or 90 million for the current service, it's 60 million or 90 million for the future service that's much improved, with maybe a lot more originals and incredible streaming."

There's just one problem: The much-talked about "virtuous cycle" is a myth. As the membership base grows, Netflix does have more streaming revenue, allowing it to increase its content budget. However, that is very different from the picture of "increasing content" that Netflix describes.

In fact, inflation in the cost of content is likely to outrun Netflix's U.S. subscriber growth rate for the foreseeable future. In other words, Netflix will spend more on content but will get much less for its money. This will force Netflix to either ramp up content spending at an even faster rate than membership growth or else face the possibility of a vicious cycle a few years down the road, whereby decreasing content leads to fewer subscribers, leading to further content cuts.

New competitive landscape
Netflix's top executives seem to realize that they face a potential content cost inflation issue, but they aren't willing to admit the severity of the problem. On the company's Q1 conference call, Hastings noted that Hulu and Amazon had begun bidding more aggressively in the past 12 months, driving up content prices. By contrast, Netflix had been the only serious bidder for U.S. streaming rights until last year.

In the long-term view, Netflix tries to reassure investors that it won't get caught up in a bidding war with competitors. The company claims, "Competitive pressures in bidding for content would lead us to have slightly less content than we would otherwise, rather than overspending."

Netflix's Q2 results provide ample evidence of that strategy at work. While the domestic streaming subscriber base hit just above the midpoint of the 29.40 million-30.05 million guidance range, domestic streaming contribution profit of $151 million beat the top of Netflix's guidance range. Moreover, the domestic streaming contribution margin expanded by 190 basis points, nearly double the company's target.

This unexpected increase in profit and contribution margin may seem like a good thing. However, since revenue and subscriber growth was in line with expectations, the higher profit must have been the result of lower costs; i.e. not overspending on content. With Netflix suddenly economizing, how will it continue to drive strong subscriber growth through a "virtuous cycle"?

Losing ground
Let's take a step back and look at the competition between Netflix and Amazon from a user perspective. Earlier this year, Amazon won the exclusive streaming rights to the popular PBS show Downton Abbey. Until the new agreement went into effect a month ago, Netflix and Hulu also streamed old episodes of the popular show. Downton Abbey is the most-watched show on Prime Instant Video, which suggests that it was also heavily watched on Netflix and Hulu.

More recently, Netflix declined to renew a broad licensing deal with Viacom (NASDAQ: VIAB  ) for a variety of content, including popular kids shows such as Dora the Explorer and SpongeBob SquarePants. In Netflix's Q1 investor letter, management stated that it was interested in renewing a few popular titles from Viacom on an exclusive basis rather than having a bulk, non-exclusive deal. However, it didn't win any of that content, as Amazon happily stepped in and bought the streaming rights to Viacom's shows.

Netflix is still spending more money on streaming content each quarter. However, for every major new addition to the content library, there are big subtractions. Netflix seems happy so far with its recent move into original programming, but it remains to be seen whether the long-term value (dollar-for-dollar) of Netflix's originals will outweigh that of the programming it is losing. Downton Abbey averaged more than 10 million viewers in its most recent season on PBS (Season 3), whereas Arrested Development drew just 4 million viewers on average in its third season.

Netflix doesn't release viewing statistics, so it's impossible to know how many people are really watching its original shows. However, given the known popularity of the shows it's dropping, investors should question whether the service is really "better" today than it was six months ago in the eyes of the marginal subscriber.

Beware the coming vicious cycle
So far, Netflix hasn't suffered any ill effects from the loss of key content deals to Amazon. However, much of the lost content has departed Netflix in the past three months. We shouldn't expect to see 1 million Downton Abbey fans cancel Netflix and sign up for Amazon Prime on the day that Netflix lost that content. Instead, the loss of content at Netflix and the improvement at Amazon (and, to a lesser extent, Hulu) will gradually lead to higher churn at Netflix, as users become disillusioned upon seeing that some of their favorite programs are gone.

For example, when Downton Abbey fans want to catch up on old seasons of the show before the Season 4 premiere next January, they may decide to subscribe to Amazon Prime. Some may keep their Netflix subscriptions as well, but many others will drop Netflix to save money. This type of behavior will lead to lower subscriber growth over time.

Netflix bulls often argue that Netflix's viewing data allows it to drop the shows that aren't cost effective, and therefore investors shouldn't worry about content losses. However, bulls seem to ignore the fact that Netflix has to work within a budget. Two years ago, the lack of competition for streaming content allowed Netflix to avoid tough choices on content. Today, Netflix is dropping hugely popular content because it simply can't afford to pay for everything that's popular without crushing its streaming margins.

Over the next two years, Netflix's domestic growth is likely to peter out, as rising content costs and budget constraints prevent Netflix from improving the overall quality of its offerings. In its recent investor letter, Netflix stated it expects content costs to continue rising, but that it has many multi-year deals in place to mitigate the effect. However, the flip side is that as these cheaper deals expire over the next few years, Netflix will continually be faced with an unpleasant choice between paying vastly more to renew the deals, or losing even more content.

Time to get realistic
Netflix's growth days aren't over just yet. But with the stock still trading for almost 80 times 2014 earnings estimates, investors appear to be counting on many more years of rapid growth. This scenario seems highly unlikely. Reasonable people can disagree about the quality of one show versus another, but it's hard to make a convincing argument that Netflix has dramatically improved its content library this year. The content Netflix has lost is just as high-profile as the content it has added.

Time Warner's (NYSE: TWX  ) HBO service has been incredibly successful in maintaining a big subscriber base despite offering a limited content library. If Netflix can develop some of its originals into popular franchises, the company may realize its dream of becoming the next HBO, even if its content library shrinks on a "net" basis.

However, investors should be careful of what they wish for. If Netflix continues to dump lots of popular third-party content to free up money for originals, user defections could soon balance out new subscribers. Then Netflix really would be on the way to becoming the next HBO: a highly acclaimed, popular service that can't seem to grow. Somehow, I don't think investors will be very happy when they get there.

Netflix's foray into original programming opens up lots of big opportunities. Yet there are also plenty of risks.  Traditional networks are adapting to safeguard their market position in the TV business. If you want to know who has the upper hand in the fast-moving TV industry, check out the Motley Fool's new special report "Who Will Own the Future of Television?" Click here to read the full report; it's free!


Read/Post Comments (12) | Recommend This Article (7)

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  • Report this Comment On July 27, 2013, at 1:34 PM, gunste wrote:

    The list of streaming titles is vastly different from what is available on DVDs. When I added streaming,

    none of the 28 titles on my DVD list was available via streaming. - Contractual problems, it seems.

  • Report this Comment On July 27, 2013, at 2:02 PM, sliderw wrote:

    By setting the mile-high expectation of 60-90 million US subscribers, Hastings has given investors one more reason to bid the stock way up. Possibly it is already baked into the current stock price. Time will tell he's right or overpromising. The latter case won't be good for investors.

  • Report this Comment On July 27, 2013, at 3:11 PM, TMFVelvetHammer wrote:

    Adam,

    I think you raise some valid concerns, but you ignore Netflix's primary source of growth in the future: international expansion.

    Additionally, these increasing content costs will impact all competitors as well. Amazon seems to be satisfied to use streaming as just a part of Prime, and not a standalone offering, which will limit it from ever being as focused on content as Netflix is. Hulu isn't even worth discussion, even with the recent $750 mil infusion. That's barely more than 1/3 of Netflix spends every year on content.

    You raise valid concerns, but there's a bigger picture that investors need to look at.

  • Report this Comment On July 27, 2013, at 6:50 PM, TMFDukenewkirk wrote:

    In my mind, the 'debunking' falls short. Like so many articles I've read citing 'uncontrollable rising content costs', this article ignores retail reality. Netflix providing quality content at this ridiculously low $8/monthly price, doesn't strike me as so different than what most retailers do. Like a Costco, for instance, Netflix has a pretty reliable subscription source. Granted, being a far less mature business (streaming in particular) churn is more noticeable, but this brand is still growing strongly, and worldwide. Costco doesn't need to have nearly everything in the market available to thrive and it pays for goods what those goods are worth. Suppliers haven't priced their goods out of reach in their case or countless other retail spaces. Most importantly, Netflix has the best established system for determining the value of their goods.

    Like Costco has Kirkland, Netflix now has 'Netflix Originals'. I've looked at HBO's lineup and in one year Netflix has already surpassed 'must watch' content with House of Cards, Arrested Development and Orange is the New Black. I believe their data advantage has helped them pinpoint the content people must watch. As your own article points out, HBO has garnered much success in terms of retention despite a limited library of current content. I believe Netflix can do much better.

    In Europe, The Killing is simultaneously broadcasting with AMC, as I understand it, and locally, cable cutters only need wait 3 months after the season ends ( in a week now) to have access to this 'must watch' series. This series was kept alive as Netflix deftly straddled TV Network interests and their own to become a partner in this show's continuation. This to me suggests a more dynamic company, one with greater optionality than the successful HBO.

    There's much more to Netflix than simply an arbitrary collection of random content, and content providers ultimately will wield no more power than their brands are worth, just as manufacturers of any other goods.

  • Report this Comment On July 27, 2013, at 11:10 PM, AceInMySleeve wrote:

    Still no particularly strong argument here for wildly escalating content costs.

  • Report this Comment On July 28, 2013, at 8:48 AM, TMFGemHunter wrote:

    @elihpaudio: International expansion can produce revenue growth, but I'm more focused here on profit growth. With the partial exception of the new originals, Netflix buys content on a country-by-country basis. In other words, U.S. content costs can only be spread across U.S. customers.

    To me, the domestic streaming business is the important one to keep an eye on, because it serves as a "benchmark" of sorts for the international business. Right now, Netflix loses money internationally, and that is expected to continue for the next few quarters at a minimum. There's no reason to believe that the international business will achieve higher margins than the domestic business. So if (as I expect) domestic margin growth is going to stall out next year, that has strong implications for the profitability of the business as a whole.

    @Dukenewkirk: interesting comparison to Costco. However, as you said before, "content providers ultimately will wield no more power than their brands are worth". Most things that Costco sells are commoditized. I think it's much easier to substitute between Skippy, Jif, and Kirkland peanut butter, than between different shows and movies.

    If people REALLY don't care what they watch then Netflix could cut tons of content without having an effect on membership, as long as what was left was "good enough". But that situation wouldn't be any better for Netflix, as its own business would be commoditized.

    @AceInMySleeve: I can't give you anything stronger than the fact that originals and exclusives are much more expensive than non-exclusive deals, and any deal signed today (when there are 3 serious bidders) will be more expensive than deals signed 2-3 years ago. If that doesn't convince you, that's fine; we'll just have to see how this story plays out over the next couple of years.

    That said, I should point out that total costs are not escalating "wildly", because Netflix is cutting lots of content in order to offset the increasing cost of content in general. I don't expect a significant uptick in spending until Netflix sees growth stalling out. But by the time that happens, the company won't have any good options.

    Adam

  • Report this Comment On July 29, 2013, at 1:02 PM, TMFDukenewkirk wrote:

    @TMFGemhunter

    In my experience Costco doesn't merely sell you 'whatever' as I feel you've suggested. Costco sells many, many top quality products. And, when Costco substitutes Kirkland for something, again, it's not with simply 'whatever'. An example is honey at Costco. For years I've only liked BeeMaid Honey, which Costco used to sell. Now Kirkland Honey has been substituted and I can't tell the difference so much so that I wonder if it's actually some arrangement for the same honey they've made with the original producer. Either way, they knew what their customers liked, as Netflix does, and made it their own.

    Content 'is' a commodity that can be duplicated or recreated ad infinitum. Sure, all artists think they are special, but even if they are, there are simply so many of them, a shortage seems impossible. There's far more supply of amazing talent and technology leveling the playing field today than Netflix could ever possibly need to satisfy a fair subscription price.

    Like a Costco, Netflix has the potential to prove a better business partner for talent that 'needs' delivery than any other delivery model today. That's where Netflix is disrupting, by turning an aging business model on its ears, bringing efficiency where clearly there once was little, in valuing and then using content to its fullest potential. I'm sure there will be plenty of room for great content that Netflix won't have, but that will also be streaming on Amazon, Hulu and with whomever else gets with the program.

    Also, The Killing (now made in America) is playing simultaneously in Europe. Is it a fair assumption that we won't see far more top notch American content find its way abroad? I'm not well versed in the impediments to more of the same, to be honest.

    I'm not claiming this company will be the be all/end all of the entertainment industry. I do, however, believe Netflix will lead. However I look at it, assuming content creators will ultimately dictate price is putting the cart before the horse.

  • Report this Comment On July 31, 2013, at 11:31 AM, fiveminutemajor wrote:

    Hi Adam,

    'That said, I should point out that total costs are not escalating "wildly", because Netflix is cutting lots of content in order to offset the increasing cost of content in general. I don't expect a significant uptick in spending until Netflix sees growth stalling out. But by the time that happens, the company won't have any good options.'

    And what evidence do you have to show for this? Because they didn't renew some deals. Perhaps the economics didn't work out and they decided better use of funds was elsewhere. You call out specific times where they've subtracted. How about the times they've added? I'm a subscriber and content goes AND comes.

    The concept I believe you are missing is the power of a large network. If NFLX is able to be a dominant player in streaming content, will content costs really spiral out of control? Who will be sitting across the table bidding up content - competitors with much few subs? I don't think so. The cable companies - don't make me laugh. This spiraling cost of content is a myth in the long-run if in fact NFLX is able to scale the business and be the 500 pound gorilla. Not saying they will be the 500 pound gorilla for sure, but if they do, I'm afraid the virtual cycle will be in tact.

    Doug

  • Report this Comment On August 06, 2013, at 1:41 PM, HectorLemans wrote:

    "International expansion can produce revenue growth, but I'm more focused here on profit growth."

    I wouldn't dismiss revenue growth out-of-hand. They could pull an Amazon and dupe shareholders into thinking revenue growth is all you need with little or no profits.

  • Report this Comment On August 06, 2013, at 4:08 PM, AceInMySleeve wrote:

    "They could pull an Amazon and dupe shareholders into thinking revenue growth is all you need with little or no profits."

    If profits end up coming in 10 years, were investors duped or just smarter than you?

  • Report this Comment On August 06, 2013, at 8:31 PM, HectorLemans wrote:

    ^^ "were investors duped or just smarter than you?"

    No idea but I'm sure not going to lock up my hard-earned money that long to find out. Not trying to be snarky, just amazed that Amazon can do what it does.

  • Report this Comment On August 07, 2013, at 12:12 AM, TMFGemHunter wrote:

    To put a finer point on it: the reason why I think the domestic side is so important is that it is a "proof case" for the international business. If growth peters out on the domestic side due to saturation, people will expect the same to occur on the international side at some point later on. So the peak profitability of the domestic side would provide a good ballpark of what the int'l revenue growth is "worth".

    By contrast, Amazon has actually been growing domestic revenue faster than international revenue recently. So it's not clear where domestic revenue is going to flatten out, let alone international revenue. Plenty of analysts and investors believe that Amazon will eventually be massively profitable (after it reaps the full benefit of ongoing growth investments). I'm not in that camp, but it seems more plausible to me than the Netflix bull argument.

    Adam

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