Netflix (NFLX -1.15%) made waves last week when it reported a strong recovery in subscriptions. After subscriber count fell in both the first and second quarters, it came back strong in the third quarter, topping the 2021 fourth quarter number to reach 223 million. Even better, management is forecasting nearly 227.6 million in Q4, or a 4.5 million sequential increase.
The company is going through a transition right now as it faces increased competition and changes in the streaming industry. Investors are hyper-focused on Netflix's new ad-supported tier, which debuts in November, and they applauded the subscription rise.
But I wouldn't buy Netflix stock even with these developments until it deals with what I see as a critical impediment to its progress.
How it got here
Netflix has been around since before streaming. Its first iteration was as a DVD rental service, but it pivoted to streaming as the technology became available and continues to enjoy a first-mover's edge in the market.
The company benefited tremendously from lockdown measures, which provided an unexpected boost to subscriber count. It added close to 16 million new subscribers in Q1 2020, when the pandemic started. With that huge cash influx, it also became cash flow positive for the first time. Netflix has posted profits for a long time despite being cash flow negative, since it amortizes its content and only counts a portion of it as an expense.
NFLX Net Income (Quarterly) data by YCharts
That was the good part of changes over the past two years. The bad -- or we'll say challenging -- part is that nearly every movie studio on the planet decided to dive into streaming as it exploded.
This was all a buildup to explain how different the streaming landscape is today, and how the stakes are so much higher. That brings us to Netflix's big problem.
The big problem with Netflix's model
There are essentially two types of streaming companies today. There are studio-sponsored networks, such as Disney and Paramount+. These are streaming vehicles for the studios. The other model is the free streaming model, promoted by companies such as Roku and Paramount's PlutoTV. They're supported by advertisements.
Netflix's model is more similar to the premium studio network model, with one key difference: It does not typically feature its content in theaters. This could be a big problem moving forward, and I would not buy Netflix stock before it turns to this model. I'll tell you why.
When Netflix was the only party in town, it had important partnerships with the major studios to feature their content on its site. The company began to produce its own content in 2012, which prepared it for the current wave of studios pulling their content from Netflix to stream on their own sites.
Netflix has been creating quality original content that competes with big film studios for awards, so at least some of its content creation is on par. However, Netflix loses out on the ticket sales that have been the main sales generator for studios for decades.
Dancing at two parties
The other major studios are also exploring ad-supported tiers, so Netflix's decision to go there isn't necessarily diluting its brand. But despite being the streaming leader, it still stands out as not quite fitting into either of the streaming categories: free or premium.
To seriously become part of the premium crowd, it needs to release enough films that it can feature in theaters and that viewers will pay money to see. In other words, it needs to become a studio. This is a bigger switch than offering ads on its site.
With the new ad-supported tier, Netflix can successfully compete with other ad-supported networks and maintain its dominance. Without high-quality films and ticket sales, it will be challenging to maintain its position against giants like Disney.
More specifically, it will need to invest in comparable content, but it will be tough to stay cash positive and profitable unless it begins to act like a real studio, including showing films in theaters. Co-CEO Ted Sarandos addressed the possibility of embracing theater releases in the Q3 earnings call, basically nixing it for now. As the streaming wars intensify, I don't see how Netflix can compete as a premium streamer without that model.
It can still come out on top
Netflix has the advantage right now, as it has retaken the title of largest streaming network by subscriber count, which it temporarily lost to Disney last quarter. Netflix does not have its head in the sand and is taking its challenges very seriously. It has changed its model in the past to reflect the reality on the ground, and it's doing so again right now. The ad tier gets a vote of confidence.
Investors are appreciating it, and Netflix stock is up 25% over the past month. However, it's not out of the water, and Netflix stock remains down 57% over the past year.
Shares look cheap now, trading at 24 times trailing 12-month earrings. But while Netflix is in flux, I would hold off on buying it.
