Should Netflix Investors Be Worried?

In this segment from MarketFoolery, host Mac Greer and Motley Fool senior analysts Andy Cross and Jason Moser tune in for the surprise twist of the week: a Netflix (NFLX -0.51%) quarterly report in which it did not meet or beat expectations on subscriber growth. But does this really signal a change in the long-term story arc for the streaming media giant, or was it just a hiccup?

The analysts are more interested in other aspects of the Netflix tale, and they explain the metrics they're watching, as well as their views on the company's strategies, content, and rivals.

A full transcript follows the video.

This video was recorded on July 17, 2018.

Mac Greer: Guys, let's kick things off with Netflix earnings. We have some concerns over slowing subscriber growth. Jason, shares down around 8% at the time of our taping. That wasn't nearly as bad as they had been at the open of the market. Now, I have to ask you, Netflix the stock has been on an incredible roll. Their earnings were actually better than expected. Is this a case of unrealistic or unsustainable expectations? Or is there a storm on the horizon?

Jason Moser: That's a very good question.

Greer: Thank you!

Moser: I would just say maybe. [laughs] Maybe to all of it! I think, probably, the reaction mostly is attributable to the fact that it's not all that often that management misses their own subscriber targets. They're really good about hitting the targets that they set, and often exceeding them. So, when they miss their targets, I think the market takes a little bit of a step back and hits reset.

The stock has obviously had a great year. The stock in comparison to the business and its obligations is a little out of whack. So, a little bit of a pullback probably makes some sense here. But, as an investor, for me, the question is less about the number of subscribers -- that's important, but I think Netflix is big enough now where that question is becoming a little less relevant. To me, the more relevant question is the pricing power that they're going to be able to exercise with their subscriber base over time.

Netflix is not going anywhere. They have a pretty good product for the price that you're paying. I think it's top of mind for anyone who's looking to get their first streaming service. For me, I wonder how high they're going to actually be able to take the price of that subscription before people start to get a little turned off of it. I know, personally, I'm close. I don't feel like their content is all that good, to be honest. I don't know if you saw Josh Brown earlier today, he was talking about the fact that they have so much content and not a lot of it is very good. That may be a bit of a controversial opinion. I don't know. For me personally, I'm not impressed with all that much of their content, and I find that the platform is becoming more and more difficult to navigate because they have so much of it.

Andy Cross: That's a good point, Jason. I disagree with Josh a little bit.

Greer: Who's Josh Brown?

Cross: He works at Ritholtz Capital. He's wonderful, he's prolific on Twitter and he writes a lot, a very smart thinker. To his point, there are 130 million numbers now on Netflix globally. Worldwide, on average, we watch two hours a day. We consume a fifth of the bandwidth on Netflix. A fifth of the total bandwidth that's used goes to Netflix.

So, clearly there are a lot of people who continue to use the service in vast ways around the world as they continue to expand more and more globally. Now they have more international subscribers than they do in the U.S. Their net additions -- which was the concern with the stock price today, Mac -- came in a little bit lighter. As Jason said, they missed their own expectations.

First of all, they're very transparent about those expectations. It's fantastic from an analyst's perspective. They're open and honest when they hit that. Now, they didn't give much of a reason on why that was. They didn't really blame the price increase they put in over the last few months. Their average price was up about 14% year over year.

When you just think about the pricing power, to Jason's point, how much you will pay and what you have to pay for that, vis-a-vis what Netflix has to pay for that content, Jason, they're going to spend somewhere between $10-12 billion this year on content acquisition, both their own plus licensing deals. Goldman Sachs estimates that by 2022, they could be spending more than $20 billion on content acquisition and developing content.

Netflix is really developing into this studio-plus-distribution model. As an investor in Netflix, people are wondering, is that the model that's going to be the future? Will they have pricing power for that? Will they be able to generate not just the profits but also the cash flow to be able to sustain that? They borrowed almost $2 billion recently in the last quarter of this year to be able to fund that.

Mac, you're talking about a business that has been humming along The stock price has been fantastic this year, and one of the drivers of the market in general. Certainly, when the subscriber additions come in light like this, investors start to wonder, are we starting to see a little bit of the challenge that Netflix will have for the future when it comes to their growth prospects?

Greer: For me, it's all about Stranger Things. If Netflix didn't have Stranger Things, I don't know if I'd subscribe. But, you know what? That's incredibly powerful. It reminds me of HBO back in the day. At the end of the day, I don't think people have a relationship with Netflix, per say. They have a relationship with certain shows that they love. As long as you have a Stranger Things, or your equivalent of a Stranger Things, then all the other stuff on Netflix can be overwhelming, it can be junk, it can be stuff that I never watch, and I don't care, because I'm getting value from that one show. Now, the problem is, you have to keep cranking out that one show.

Moser: You have to keep cranking it out. To Andy's point, they are closing in on $20 billion in content obligations already. I'm glad that you brought up the HBO point, because that's what I was thinking about this morning. It's these two different strategies, Netflix vs. HBO. We remember how Reed Hastings said they were trying to become HBO faster than HBO could become them. But really, they are two different strategies to this point.

I think that Netflix has benefited from this strategy of producing a lot of stuff. You're right, most of it, I don't really care about. But they're producing a little bit of something for a lot of people out there. They have this tremendous cross-section of content. Maybe you don't like most of the stuff that's on there, but there are a couple of shows that you really do like. They're really trying to do that to be able to grow this huge audience, to cast the widest net possible.

HBO traditionally has been a more concentrated content portfolio. That's why they've not been able to grow that subscriber base in quite the same way, not to mention the fact that they were late to the over the top game, as well. But, it does seem like they're two very different strategies in the way that they're spending to develop that content.

I think that's what ultimately brought that question in pricing power up to me. If it's not the place where I'm getting most of the stuff that I like, how willing am I going to be to pay $X for it? I don't know. That's going to be different for everybody. But, I think we're getting closer to really having to examine that question as far as the investment.

Cross: Here's one of the keys that I see for Netflix. We've talked about this over the years. You guys may disagree with this. As consumption of media becomes more and more fragmented -- and it is. We have longer tails, we have more and more titles that we can watch. Jason is absolutely right, there are more and more titles that fewer and fewer people are watching. Most of the hours consumed, whether it's on Netflix or YouTube or at a movie theater, continue to be concentrated in fewer titles. So, the overall volume is more, but the number of titles is more fragmented than it was before.

Here's the key with Netflix, it's in their technology and their recommendation engine. They've been developing this over the years. I think they have a years-ahead advantage of other competitors in this space. It allows them to be able to buy or develop those titles, and develop the algorithm that tells them, "Mac likes this, Andy likes this, Jason likes this." The titles can be fragmented.

It's much different than when you go into a grocery store. This is what I'm starting to see with Whole Foods, guys, by the way. You go into Whole Foods, and now, all the aisles are jammed with stuff that they're trying to sell you. Netflix has the algorithm and the technology behind it to help me find the stuff that I want to find -- not just me, but also help my two daughters and my wife, be able to find what might be right for them. It allows them to justify, potentially, the massive amount of dollars they're going to spend on titles.

Moser: That's funny. I find that that recommendation engine is lacking. I find that whether it's Netflix or Amazon (NASDAQ: AMZN) or Hulu or whatever, I will more watch a show based on word of mouth from friends as opposed to what Netflix is recommending me. It's not just Netflix. I go to Amazon and the same thing will happen. But, you could sit there and surf around for 30 minutes and find nothing that's all that compelling, and then you just wasted a bunch of time.

I think, to me, that's where it's lacking. Part of that is probably because there's so much content out there now. It is more difficult to find what you want to watch, so you rely more and more on that word of mouth from your friends. There are some shows that I've caught thanks to word of mouth vs. relying on a recommendation engine.

That's where I wonder if, maybe, they're not getting flooded with too much stuff that makes it a bit more difficult to isolate and identify the stuff that you're going to enjoy or that Mac is going to enjoy. That's their goal, right? Personalize it as well as they can. It just seems like they may have a bit too much stuff out there to make it as effective as possible.

Cross: It's high-class problems for developed countries. The big story for Netflix is international growth, as it continues to put more and more effort and dollars into growing internationally and entering all the new markets, especially India. They're spending a lot of effort joining in India, where they're very new to the market. Of course, they're not even in China, really.

When you think about going into markets where the markets are still forming and the profitability on the international side is so much less than what it is on the U.S. side for Netflix, the ability to drive hopefully both growth and profits internationally is a real opportunity for Netflix.

You want to continue to see both the sub growth, as well as the profitability in international. But, I think the technology and the offerings that they're bringing specifically for international markets really does give them an advantage that no other player has globally. Now, there are very niche offerings in those markets, but globally, no one else does that like Netflix does.

Moser: It's going to be fascinating, the Indian market. I think India was mentioned 21 times in Netflix's call. We know that Amazon Prime is already making big inroads into India. I think both companies right there see India as a great opportunity. It's a little bit more price-sensitive, so I think they're trying to figure out the offerings there, and how they can cater to customers' price expectations. But no question, a tremendous opportunity.

Greer: Guys, as we wrap this up, I want to talk a little about the external competition. Jason, you just mentioned Amazon, we mentioned HBO earlier. HBO, by the way, recently announced a strategy shift. They suggested they're going to be focusing, I found the quote, on getting "bigger and broader." That'll be interesting to watch.

If you're Reed Hastings and you're looking at your external competitors, who are you worried most about? Let's reel off a few -- HBO, Amazon and their streaming service, or Disney (NYSE: DIS)? We haven't even talked about Disney's streaming service, which comes out next year.

Moser: I think, bigger and broader, like you said, for HBO, that's interesting, because that's becoming a bit more like Netflix, isn't it? For me, I think Amazon is really gaining a lot of steam in this space.

But, the thing that really interests me is how Disney is going to deal with Hulu going forward. I ask that because Hulu has a very compelling skinny bundle package now. It's around $40-45 that you can pay for commercial- free streaming along with live TV. So, you get your sports, your news, your live TV offerings from channels, if you're going to be watching some linear TV series.

I think that Disney has big plans with Hulu in some capacity with their offerings, plus ESPN. Hulu has a lot of potential. I think that's one where you have to start looking at it and thinking, "Hmm, maybe that's going to be a player that comes up pretty quickly in this space and starts to compete a little bit more."

Cross: My worry with Hulu is all ownership structures they have and all the voices they have contributing to that story. With something like Netflix, even Disney, to a certain extent, but with Netflix, you have Reed Hastings and his team continuing to focus. I know, Mac, you mentioned the competitive landscape. Certainly, I imagine they pay attention to what's happening in that space. But as I said, in the conference call, and I've talked about it in the past, the focus on driving their business and the focus on their engine and their competitive opportunity and what they have in their assets. So, when I look across the competitive landscape, I just think Netflix has advantages and has that first-movers advantages that other global players can't quite match.