How we spend our time has changed in dramatic ways since the internet was introduced. Many of the streaming services we now enjoy only became possible after high-speed connections were widely available.
Netflix (NFLX 2.51%) was a pioneer with its internet-connected movie and television offering. It revamped its business model and doubled down on streaming. It was a great move. Even though shares are down 70% from their high, they are up 1,350% in the last decade.
But its latest earnings report, released Tuesday after market close, showed a decline in subscribers for the first time since 2011. That spooked investors. And it isn't the only thing they should be worried about.
Image source: Getty images.
Slowing growth isn't a surprise
The big news out of the company's first-quarter earnings release was a drop in subscribers from the previous quarter: a loss of 200,000 paying members. Even year over year, paid memberships in the first quarter were only 6% higher. That shouldn't have been a shock. Annual growth has been trending down for years and took a nosedive last year.
Data source: Netflix. Chart by author.
Management had told investors to expect 2.5 million additions to its subscriber base this quarter. To explain the miss, it pointed to competition, inflation, and the invasion of Ukraine as culprits. To be fair, about 700,000 subscriptions were lost as the company suspended operations in Russia. But the company expects things to get worse, estimating 2 million members fewer in the current quarter.
Revenue is still climbing
Despite the subscriber decline, revenue continued to climb, albeit slowly. The top line expanded 9.8% year over year. Since 2014, the first-quarter growth rate had never been below 22%.
Data source: Netflix. Chart by author.
The year-over-year growth was mostly driven by subscribers. There was a modest improvement in average revenue per member. With subscriptions declining, that last metric will be crucial for the company to keep the financial outlook from darkening further.
Another metric to watch
As you can imagine, what customers are willing to pay for Netflix's service is different depending on geography. It has been able to increase the average amount customers paid each year by about 5%, from $8.06 in 2013 to $11.53 at the end of 2021. The increase hasn't been in a straight line. And global trends suggest that pace will be difficult to maintain. In Asia, the metric is actually declining.
Data source: Netflix. Chart by author. UCAN = U.S. and Canada; EMEA = Europe, Middle East, Africa; LATAM = Latin America; APAC = Asia/Pacific.
A broken flywheel
For years, Netflix was cited as a great example of a business model that acted like a flywheel. The company spent on content to attract subscribers, and as those subscribers watched, it gathered data on who liked to watch what. It used that information to purchase and create new shows designed to both engage existing customers and attract new ones.
The beauty of the model is that the wheel spins itself to fuel growth and doesn't require as much investment as time goes on. That's how shareholders end up with profits. At some point, a new subscriber costs almost nothing and is essentially 100% profit.
That theory is coming undone. Even before this quarter (with the exception of the initial COVID lockdown), it has been clear that Netflix is having to spend more money to acquire each new subscriber. Below are the numbers from the last eight years' first quarters.
Data source: Netflix. Chart by author.
It's not all bad news
Despite those numbers, Netflix has been getting more profitable. Its operating margin had increased to a respectable 21% by the end of 2021. Even in the recent disaster of a quarter, it delivered 25% of revenue as operating profit. Management committed to keeping that number around 20% as it revamps the business.
NFLX operating margin (TTM). Data by YCharts. TTM = trailing 12 months.
Management has a plan
Another point of optimism is management's assurance that it has a plan to reaccelerate growth. But it isn't simple. First, it's doubling down on content creation and the ability of members to identify shows they are most passionate about. That's unlikely to move the needle much.
More importantly, the company says it will begin cracking down on account sharing. It estimates more than 100 million households are using another household's account. With 220 million memberships, monetizing those could provide enormous growth in the short term. Lastly, it might also experiment with a cheaper ad-supported offering.
On one hand, the innovation and experimentation is exactly what you would expect an accountable management team to do. On the other, the most meaningful changes undermine what has differentiated the service for years. Paying for content feels different than paying to avoid ads. And account sharing helps it gather data to feed the recommendation and content-development flywheel.
Wall Street has long wondered if Netflix is a "must have" streaming service that customers would rarely cancel. The proposed changes suggest that question is about to be asked. Shareholders might not like the answer.
