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Why You Should Buy the Netflix Dip

By Andrew Tseng – Oct 30, 2020 at 12:45PM

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Ignore the short-term noise and focus on the company's scale and global opportunity.

Netflix (NFLX 2.50%) shares have been under pressure since it reported third-quarter earnings last week. The stock was immediately down 7% the day after earnings and remains at that level as of this writing.

But in a recession caused by a global pandemic that's still getting worse, there aren't many businesses with more certain long-term revenue and profit growth than Netflix. Here's why you should consider buying the Netflix dip. 

Running away with the market

Netflix is truly dominating the subscription video-on-demand (SVOD) market. Last week, the company reported that it ended the third quarter with over 195 million paid subscribers around the world, which represented 23% growth compared to one year earlier.

And Netflix is truly a global business. The 73 million paid subscribers in the company's UCAN segment -- representing the U.S. and Canada -- is now only about 37% of the total subscriber base. The other 63% is made up of the 32% in the Europe, Middle East, and Africa (EMEA) segment, the 19% in the Latin America (LATAM) segment, and the 12% in the Asia-Pacific (APAC) segment. 

And when we consider where the company's recent growth is coming from, it's even more clear that Netflix is increasingly becoming a global business. Of the roughly 37 million paid subscribers the company added over the last 12 months, about 31 million -- 84% -- of them came from outside the UCAN segment. 

The cast of Netflix's Stranger Things.

Image source: Netflix.

No other SVOD service comes close to achieving that level of global scale. Disney's Disney+ is the closest direct challenger with 60.5 million paying subscribers as of early August. And one could argue Amazon's "over 150 million" global Prime members should be considered a close challenger as well, but surveys indicate the vast majority of Prime members subscribe primarily for the fast, free shipping benefit, not for Prime Video.

With over 195 million paid subscribers and, importantly, near $25 billion of streaming revenue this year, Netflix can justify spending around $11 billion on content this year and more next year as production continues to ramp up after the COVID-related pause. It will be extremely difficult for a competitor to surpass Netflix in global subscribers and streaming revenue without matching or exceeding Netflix's content budget.

Content and pricing virtuous cycle

Therein lies Netflix's virtuous cycle. The more subscribers it attracts and the more subscriber revenue it brings in, the more it can afford and justify reinvesting in even more content. And that content is targeted at new demographic and interest groups, and new geographies to ensure that eventually almost everyone will find something that interests them on Netflix. 

That attracts even more subscribers, which increases subscriber revenue further. And the improved service with that much more content provides a greater value to subscribers, which allows Netflix to occasionally raise prices. After all, the Netflix of five or seven years ago had far less content than the Netflix of today and should cost more now than it did then. Subscribers recognize the attractive value proposition of Netflix and generally accept the occasional price increase without much noticeable resistance.

Just consider the value proposition of the Standard Netflix subscription that costs $12.99 in the U.S. The average subscriber watches about two hours of Netflix per day, according to the company's former vice president of original content. That's about 60 hours of entertainment per month, on average, for $12.99, which is a paltry cost per hour of just $0.22.

At the same time, households are used to paying $80 or $100 per month for cable TV -- and many of them now watch Netflix as much or more than cable TV. That creates a wide pricing umbrella under which Netflix should be able to raise prices for a very long time, especially as it keeps improving the service with more and more content.  

Large profits at scale

The real beauty of Netflix's business model is the idea of monetizing the same content to millions more people around the world. When one more subscriber signs up for Netflix, it costs the company next to nothing. The incremental costs include credit card processing fees and maybe some streaming delivery costs, but the content cost -- by far Netflix's largest expense item -- doesn't increase at all just because one more household is paying for access to it.

Netflix has a huge opportunity ahead given there are 2 billion households globally. And as it expands into that market, its content costs are unlikely to grow nearly as fast as its subscriber base and subscriber revenue. That dynamic explains why Netflix has such consistent margin expansion despite growing its content spending so much over the years.

These virtuous cycles should continue to spiral Netflix's business higher over the next decade. And the business should also hold up extremely well during a worsening COVID-19 pandemic. Investors should consider buying the post-earnings dip in the meantime.   

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Andrew Tseng owns shares of Amazon and Netflix. The Motley Fool owns shares of and recommends Amazon, Netflix, and Walt Disney and recommends the following options: long January 2021 $60 calls on Walt Disney, short January 2022 $1940 calls on Amazon, and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.

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