Netflix (NFLX +0.14%) management has often talked about pursuing a virtuous cycle that will sustain rapid streaming membership growth for years to come. By having more members than competitors such as Amazon.com (AMZN 1.66%) or Hulu, Netflix can afford to spend more on content, improving the quality of the service and attracting even more members.
The company's long-term view states, "Success relative to these competitors-for-content would be us having substantially larger revenue and therefore sustainable increasing content, tech and marketing spending, leading to further growth, and a virtuous cycle."
This expectation of a virtuous cycle is one of the primary reasons Netflix CEO Reed Hastings believes that the company will ultimately attract 60 million to 90 million U.S. streaming subscribers. As he explained during the company's recent earnings interview: "[B]y the time we get to 40 million and 50 million, we get the content better and the service better. So, it's not 60 million or 90 million for the current service, it's 60 million or 90 million for the future service that's much improved, with maybe a lot more originals and incredible streaming."
There's just one problem: The much-talked about "virtuous cycle" is a myth. As the membership base grows, Netflix does have more streaming revenue, allowing it to increase its content budget. However, that is very different from the picture of "increasing content" that Netflix describes.
In fact, inflation in the cost of content is likely to outrun Netflix's U.S. subscriber growth rate for the foreseeable future. In other words, Netflix will spend more on content but will get much less for its money. This will force Netflix to either ramp up content spending at an even faster rate than membership growth or else face the possibility of a vicious cycle a few years down the road, whereby decreasing content leads to fewer subscribers, leading to further content cuts.
New competitive landscape
Netflix's top executives seem to realize that they face a potential content cost inflation issue, but they aren't willing to admit the severity of the problem. On the company's Q1 conference call, Hastings noted that Hulu and Amazon had begun bidding more aggressively in the past 12 months, driving up content prices. By contrast, Netflix had been the only serious bidder for U.S. streaming rights until last year.
In the long-term view, Netflix tries to reassure investors that it won't get caught up in a bidding war with competitors. The company claims, "Competitive pressures in bidding for content would lead us to have slightly less content than we would otherwise, rather than overspending."
Netflix's Q2 results provide ample evidence of that strategy at work. While the domestic streaming subscriber base hit just above the midpoint of the 29.40 million-30.05 million guidance range, domestic streaming contribution profit of $151 million beat the top of Netflix's guidance range. Moreover, the domestic streaming contribution margin expanded by 190 basis points, nearly double the company's target.
This unexpected increase in profit and contribution margin may seem like a good thing. However, since revenue and subscriber growth was in line with expectations, the higher profit must have been the result of lower costs; i.e. not overspending on content. With Netflix suddenly economizing, how will it continue to drive strong subscriber growth through a "virtuous cycle"?
Losing ground
Let's take a step back and look at the competition between Netflix and Amazon from a user perspective. Earlier this year, Amazon won the exclusive streaming rights to the popular PBS show Downton Abbey. Until the new agreement went into effect a month ago, Netflix and Hulu also streamed old episodes of the popular show. Downton Abbey is the most-watched show on Prime Instant Video, which suggests that it was also heavily watched on Netflix and Hulu.
More recently, Netflix declined to renew a broad licensing deal with Viacom (VIAB +0.00%) for a variety of content, including popular kids shows such as Dora the Explorer and SpongeBob SquarePants. In Netflix's Q1 investor letter, management stated that it was interested in renewing a few popular titles from Viacom on an exclusive basis rather than having a bulk, non-exclusive deal. However, it didn't win any of that content, as Amazon happily stepped in and bought the streaming rights to Viacom's shows.
Netflix is still spending more money on streaming content each quarter. However, for every major new addition to the content library, there are big subtractions. Netflix seems happy so far with its recent move into original programming, but it remains to be seen whether the long-term value (dollar-for-dollar) of Netflix's originals will outweigh that of the programming it is losing. Downton Abbey averaged more than 10 million viewers in its most recent season on PBS (Season 3), whereas Arrested Development drew just 4 million viewers on average in its third season.
Netflix doesn't release viewing statistics, so it's impossible to know how many people are really watching its original shows. However, given the known popularity of the shows it's dropping, investors should question whether the service is really "better" today than it was six months ago in the eyes of the marginal subscriber.
Beware the coming vicious cycle
So far, Netflix hasn't suffered any ill effects from the loss of key content deals to Amazon. However, much of the lost content has departed Netflix in the past three months. We shouldn't expect to see 1 million Downton Abbey fans cancel Netflix and sign up for Amazon Prime on the day that Netflix lost that content. Instead, the loss of content at Netflix and the improvement at Amazon (and, to a lesser extent, Hulu) will gradually lead to higher churn at Netflix, as users become disillusioned upon seeing that some of their favorite programs are gone.
For example, when Downton Abbey fans want to catch up on old seasons of the show before the Season 4 premiere next January, they may decide to subscribe to Amazon Prime. Some may keep their Netflix subscriptions as well, but many others will drop Netflix to save money. This type of behavior will lead to lower subscriber growth over time.
Netflix bulls often argue that Netflix's viewing data allows it to drop the shows that aren't cost effective, and therefore investors shouldn't worry about content losses. However, bulls seem to ignore the fact that Netflix has to work within a budget. Two years ago, the lack of competition for streaming content allowed Netflix to avoid tough choices on content. Today, Netflix is dropping hugely popular content because it simply can't afford to pay for everything that's popular without crushing its streaming margins.
Over the next two years, Netflix's domestic growth is likely to peter out, as rising content costs and budget constraints prevent Netflix from improving the overall quality of its offerings. In its recent investor letter, Netflix stated it expects content costs to continue rising, but that it has many multi-year deals in place to mitigate the effect. However, the flip side is that as these cheaper deals expire over the next few years, Netflix will continually be faced with an unpleasant choice between paying vastly more to renew the deals, or losing even more content.
Time to get realistic
Netflix's growth days aren't over just yet. But with the stock still trading for almost 80 times 2014 earnings estimates, investors appear to be counting on many more years of rapid growth. This scenario seems highly unlikely. Reasonable people can disagree about the quality of one show versus another, but it's hard to make a convincing argument that Netflix has dramatically improved its content library this year. The content Netflix has lost is just as high-profile as the content it has added.
Time Warner's (TWX +0.00%) HBO service has been incredibly successful in maintaining a big subscriber base despite offering a limited content library. If Netflix can develop some of its originals into popular franchises, the company may realize its dream of becoming the next HBO, even if its content library shrinks on a "net" basis.
However, investors should be careful of what they wish for. If Netflix continues to dump lots of popular third-party content to free up money for originals, user defections could soon balance out new subscribers. Then Netflix really would be on the way to becoming the next HBO: a highly acclaimed, popular service that can't seem to grow. Somehow, I don't think investors will be very happy when they get there.
