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Wells Fargo Is Right -- and Wrong -- About Netflix

By James Brumley – Dec 3, 2019 at 3:25AM

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The recent downgrade may overlook the streaming giant's changing per-user trajectories.

Wells Fargo analyst Steven Cahall recently made a valid enough point about streaming video leader Netflix (NFLX -3.89%). That is, in the wake of a well-received launch of a rival service from Walt Disney (DIS -1.70%) and another one being planned by WarnerMedia parent AT&T, something has to give. Cahall is concerned that Netflix will decide to spend more in an effort to sustain impressive subscriber growth rates (and to keep investors happy).

Cahall's explanation of the downgrade, though, looks past an important detail -- Netflix was making measurable progress on its per-user costs beginning earlier this year. The advent of Disney+ and a stand-alone video service from Apple certainly give shareholders something to keep tabs on, but it's arguable Netflix has already achieved fiscal escape velocity, so to speak.

A woman laying on a couch watching streaming TV on a tablet

Image source: Getty Images

What he said

"We think Netflix can achieve the Street's subscriber growth expectations," writes Cahall, adding, "but those subs will be more expensive than investors realize." It's an acknowledgment that Netflix can't realistically expect to not beef things up on the marketing front now that powerful new rivals are appearing on the streaming video landscape.

The Wells Fargo analyst is particularly concerned that the necessary spending on marketing and promotion will eat into Netflix's already wobbly cash flow. Cahall explained, "Thus far, [subscriber acquisition costs] including content costs have not demonstrated meaningful cash operating leverage with Netflix still losing around $2/sub/month (cash) despite [fewer than] 158 million subs."

His rough math changes depending on the quarter in question. For example, Netflix earned roughly $6.19 worth of operating income per paid subscriber last quarter. Regardless, operating cash outflow of $501.7 million translates to an effective per-subscriber loss of $3.17 for the three-month stretch.

The trajectory of the company's spending trend, though, suggests Netflix is nearing a critical mass of self-sustainability.

Shaky but measurable progress

It's long been a criticism of the streaming pioneer's operation. It may be one of the top-performing growth stocks, but its spending and finances have always appeared unsustainable.

Except, it is moving in the right direction. Since early 2018, the company's quarterly cost of revenue -- mostly content costs -- per user has peeled back from a peak of $20.11 to last quarter's $19.57. Total spending on content has soared from less than $1 billion per quarter as of the beginning of 2014 to a little over $3 billion last quarter. That's been more than matched by an increase in the raw number of subscribers and how much they're paying every quarter, though. That figure was an average of $33.13 for the three-month span ending in September.

Image of historical Netflix revenue and cost of revenue per subsriber

Data source: Netflix. Chart by author.

The cost of acquiring a paying customer is a little trickier to pin down for Netflix, as the platform may need several quarters' worth of advertising to bring a new subscriber into the fold. Best guesses on what Netflix has to spend to enroll a new subscriber can range from Timothy Green's figure of $204 needed to add a new paying customer in the United States to David Trainer's figure of $581, calculated after the company's second quarter report. The variance lies in what you count as acquisition-based spending, and how long you believe it takes to convince a would-be subscriber to sign up.

Regardless, when stripping out the second quarter's lethargic (and likely anomalous) subscriber growth, the cost of adding new paying customers appears to be at least starting to level off. It's still rising, to be sure, but when dividing the trailing-12-month marketing spend by the trailing-12-month subscriber growth -- arguably a fairer figure in that it can take many months to sign a newcomer up -- the acquisition cost cools to somewhere between $80 and $90.

Graphic of Netflix per-user marketing spending trend

Data source: Netflix. Chart by author.

Take it with a grain of salt

Again, the point is well taken. Competition is here, and Netflix will have to address it. Somehow, that's likely to mean more spending, if not on content, then on marketing -- or perhaps both.

Take the downgrade of Netflix with a grain of salt, though. It's arguable that the streaming leader was simply caught in transit, reaching a critical mass of sorts right as its most serious rivals yet were launching their alternative offerings.

Also bear in mind that Cahall was the same analyst who in September -- within sight of the Disney+ launch -- wrote of Netflix: "FCF (free cash flow) could do far better than we fear." He went on to say:

The short version of our concern is FCF. Management could guide to two to three year FCF generation, and it could be well in excess of our and Street estimates if either content costs are falling as a percentage of revenue, or there is operating leverage elsewhere in the business model.

That's less likely just two months later? Things change quickly, but they don't change that quickly. One can't help but wonder if the tune will change again two months from now.

James Brumley owns shares of AT&T. The Motley Fool owns shares of and recommends Apple, Netflix, and Walt Disney and recommends the following options: long January 2021 $60 calls on Walt Disney and short January 2020 $130 calls on Walt Disney. The Motley Fool has a disclosure policy.

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