Netflix (NFLX 1.41%) shares are reeling after last week's big flop in its earnings report.
The stock is down about 40% in just a few days, and is off about 70% from its peak last November. A surprise drop in subscribers torched the leading streamer, and the narrative that it could grow consistently as the streaming market expanded now looks broken.
It's not a surprise that Netflix plunged, but it's a mistake to write off the one-time market darling. Here are three reasons why Netflix stock could recover.
Image source: Netflix.
1. There's a lot of content fat to trim
Netflix plans to spend $18 billion on programming this year. To put that in perspective, that's roughly equal to the budgets for the 60 most expensive movies ever made.
Netflix makes more than movies, of course, but $18 billion seems excessive, especially for content that lives almost entirely on Netflix itself, rather than in movie theaters or cable networks. The company ramped up content spending for years, arguing that more content drove subscription growth, but that strategy now appears to have reached its endpoint.
Netflix recognizes it needs to spend more efficiently on content, something that never seemed to be a priority before, and the company is already taking steps to do that. According to The Wall Street Journal, it's now prioritizing return on investment instead of reach, and plans to focus on quality rather than quantity.
As the success of other streaming platforms has shown, you only need one or two hits to attract subscribers, and much of the content on Netflix gets lost as there's no easy way to view the full catalog. While management hasn't said it will slash content spending, it did indicate on the earnings call that it would hold it back, at least until it reaccelerates revenue growth.
Improving ROI in content should be low-hanging fruit for the company, as there appear to be plenty of flops on the service -- like "He's Expecting," a Japanese show about a man who gets pregnant, which gets just a 1.1 out of 10 on IMDB.
2. Advertising is coming
Netflix has long resisted advertising, as co-CEO Reed Hastings has said he prefers the simplicity of the company's subscriber model. But with subscriber growth stagnating, the company looks ready to change course. On the earnings call, Hastings said, "Allowing consumers who would like to have a lower price and are advertising-tolerant [to] get what they want makes a lot of sense. So that's something we're looking at now. We're trying to figure out over the next year or two. But think of us as quite open to offering even lower prices with advertising as a consumer choice."
A lower-tier advertising plan makes sense for Netflix. It would help the company combat the challenge it's facing with password sharing, and the ad-tier model has been proven to work elsewhere. Hulu, for example, makes about the same in revenue from its ad subscriptions that it does from ad-free subscriptions. Diversifying revenue streams also seems like a smart move, especially as subscriber growth no longer seems reliable. Advertisers are likely eager to get on Netflix, which has a unique reach with more than 200 million global subscribers and in-depth knowledge of their viewing habits.
Offering an ad tier will likely give Netflix another high-margin revenue stream.
3. Fixing recommendations
One longtime challenge for Netflix has been its recommendation engine. Every user gets a different set of movies and TV shows displayed to them when they log in, but Netflix isn't always so good at finding something you want to watch. Users regularly complain that there's nothing good on the service, and its massive library tends to get lost in a menu that shows comparatively few choices.
In the letter to shareholders, management said it was focused in particular on improving the "quality of programming and recommendations." The company also said it was introducing a feature called "double thumbs up" to help users tell them what their favorite shows and movies are.
It's been years since Netflix introduced a major product change, and it seems long overdue. Improving recommendations may not be easy, but it's a problem well worth tackling. In order for Netflix to provide value, the only two things it really needs to do is create content users want to watch and make it easy for them to find it.
Management seemed to think that it would take a year or two to get these changes in place to reaccelerate subscriber growth -- so a turnaround won't be sudden, but Netflix clearly isn't standing still.
The good news is that the streaming stock trades for less than 20 times trailing earnings. If management executes, the stock could reclaim its previous heights in a few years.
