Does anyone else have fond memories of walking into a Blockbuster on a Friday night, grabbing a handful of movies, and going back home to watch them? While there wasn't anything novel, per se, about the idea of a video rental store, there was something magical about the experience of frequenting one. Maybe it was the anticipation of finding out whether or not the movie you desired was in stock, or maybe it was the excitement of showing off your membership card like a badge of honor.
Whatever the case, it's hard to believe that it's been about two decades since video stores peppered every town across the nation. While streaming videos on your television seemed like a futuristic fantasy, it has become one of the fastest ways people create and consume content.
Netflix (NFLX 2.51%) pioneered this concept in the late 1990s and quickly became the market leader in streaming. However, the function of providing viewers with the option to watch their favorite premium cable shows without subscribing to cable is no longer a differentiating factor. Over the last few years, media and entertainment companies such as Disney, Amazon, Warner Bros. Discovery, and Comcast have all come out with unique streaming services in an effort to capitalize on this trend. Netflix's results year to date have proven that competition is fierce, and the company must do something to regain its position as a market leader.
Netflix makes a sacrifice
During the second-quarter 2022 earnings call, the metric that arguably concerned investors the most was Netflix's total subscribers. As of Q2 2022, the company boasted roughly 220.7 million subscribers, which represented a decline of about 1 million customers from Q1. While Netflix's decision to shutter usage of the platform in some geographic regions due to lingering political tensions may have played a role in the churn, the majority of subscriber decreases can be attributed to the company's periodic price increases.
Douglas Anmuth, an analyst at JPMorgan, asked management about the efficacy of these price increases and received an interesting rebuttal. Netflix's COO, Gregory Peters, said, "We've seen pretty much the standard response that we've seen historically over the last five years or so, which is we typically have this adjustment period where there's slightly higher churn post the price change." He followed this up by saying, "But then if we do a good job basically at taking those price changes, which are significantly net revenue positive and investing those into more great content and the product experiences."
This is a really interesting paradigm. Effectively, Peters is saying that Netflix is willing to sacrifice a specific cohort of its user base in the form of lost subscribers. However, the customers that do stay on the platform and pay the higher monthly fee far outweigh the lost revenue from churn, thereby allowing Netflix to invest in more premium original content and product features.
Image source: Getty Images.
What does Wall Street think?
Netflix has been hinting about offering an ad-supported tier for some time now. The idea is that many other streaming competitors offer a lower-cost option with advertisements, or a premium subscription without ads. Mark Mahaney, a research analyst at Evercore, believes that an ad-supported offering is the most obvious catalyst out there for Netflix. During a recent interview with CNBC, Mahaney stated that his market surveys suggest Netflix could recapture 20% of its churned base. His models suggest that if Netflix succeeds in capturing 10 million paid subscribers, this could equate up to $2 billion in annual revenue.
While these models are sensitive to assumptions around the variables, Mahaney's research doesn't seem too far-fetched. About a month ago, The Wall Street Journal reported that an internal market survey from Netflix showed the company reaching an additional 40 million unique viewers within one year of the ad-tier launch. If the standard Netflix subscriber is a household of four people, then Netflix's internal estimates seem to be in line with Mahaney's independent research as well.
Anmuth has also done his own surveys and just this week published a report that suggests Netflix could acquire 7.5 million subscribers in its new ad tier. While this is slightly lower than in Mahaney's research, the initial general consensus among reputable financial institutions is bullish.
Keep an eye on valuation
While Netflix stock is down over 60% year to date, the stock rallied a bit over the last three months when the company's Q2 earnings were released.
The release of an ad-supported tier definitely carries risks. For example, Netflix may not integrate the ads in a way that the audience accepts, thereby driving lower conversion, click-through rates, and revenue. However, some on Wall Street believe that Netflix is well positioned to recapture market share and diversify its product offering.
At 19 times price-to-earnings, Netflix may be a tad rich in valuation. Prudent investors are better off waiting until the company releases Q3 results next week. It is likely the company will comment on the release of its ad tier and channel partners.
For long-term investors, should the Q3 call indicate positive momentum around the advertising launch, it could soon be a great time to lower your cost basis or initiate a position.
