Netflix (NFLX -3.92%) gave a number of reasons for its subscriber losses in the first quarter and expectations for even further losses this quarter; not enough connected TVs, password sharing, competition, and the economy all made the list. But the reality of the situation is that Netflix's management was caught flat-footed.
While management and investors saw slow growth in 2021 as a hangover from the pull-forward of subscriptions in 2020 during the height of the COVID-19 pandemic, that wasn't the whole story. "COVID created a lot of noise on how to read the situation," CEO Reed Hastings said during Netflix's first-quarter earnings call. "In 2021, I think we thoughtfully said it was mostly pull-forward, which was the logical conclusion. But now, coming into 2022, that doesn't really hold," he admitted.
For Netflix investors, it means growth will be hard to come by over the next couple of years.
Image source: Netflix.
Where Netflix is challenged
Management said the biggest factor impacting its subscriber growth is "soft acquisition across all regions." In other words, Netflix is bringing in fewer new subscribers than it has in the past.
That's a bit surprising, considering Netflix is releasing more content than ever before as it comes out of COVID production shutdowns. The first quarter included several big-name releases, including the first part of the Ozark finale, Inventing Anna, the second season of Bridgerton, and the film The Adam Project. The biggest reason consumers sign up for a streaming service is to watch a specific title.
That said, consumers are still looking for good value. After it enacted a price hike in several regions during the first quarter, some potential sign-ups could've been put off.
The company also noted a slight uptick in churn rates. CFO Spencer Neumann noted that the difference was between 0.2 and 0.3 percentage points, which would equate to about 1.7 million more subscribers lost than expected over the course of the quarter. That's certainly significant, but it doesn't fully account for the difference between Netflix's outlook and its results.
Netflix isn't ready to roll out a solution
What was most surprising in management's discussion of the quarterly earnings was that it sees the problems -- soft subscriber acquisitions and account sharing -- but it's not ready to roll out the solution.
During the earnings call, Hastings announced that he's open to the idea of an ad-supported tier for Netflix, something he's long resisted. He noted the competition is all doing ad-supported tiers, and there's clear consumer demand for the option to pay less and sit through ads. The company doesn't really need to test its viability.
However, the implementation of an ad-supported tier is still years away. It's as if it didn't become a serious consideration until it was clear the premium subscription option had hit an extremely high level of saturation.
Meanwhile, Netflix only started taking password sharing seriously a few months ago. While it's looked at the issue in the past, it never amounted to anything. With a current test in Latin America to charge users a little extra for sharing accounts across households, it may be a while before the solution rolls out globally, if it ever does.
What it means for investors
Since Netflix isn't prepared to improve subscriber sign-ups with an ad-supported tier or monetize password sharing in the near term, it means an extended period of slow revenue growth for Netflix. Management plans to keep its operating margin around 20% over the next two years as it works through this period of slow revenue growth.
If these efforts can reaccelerate revenue growth, investors should expect a return to operating margin expansion and more days of very strong earnings growth as a result. But there's no sure bet that either will successfully push Netflix back toward its target of double-digit revenue growth, enabling 300 basis points of operating margin expansion.
Netflix's management has run into trouble like this before, though. Specifically, it stumbled over 10 years ago when it separated the DVD-by-mail service from the streaming service, and it lost subscribers. Management has delivered in the past, and it's capable of delivering again. But it will take some time.
As Netflix enters a period of low earnings growth and uncertainty around its future, its stock definitely deserves a price cut. But with the stock down nearly 70% from its all-time high, it's worth picking up some shares if you believe in management's ability to eventually reaccelerate revenue and expand margins. While the growth outlook is definitely dimmer, there's still room for long-term earnings expansion as Netflix takes a greater share of overall video entertainment consumption around the world.
