Netflix Is Dead, Long Live Netflix

Netflix film 'Don't Look Up'
(Image credit: Netflix)

Netflix stock fell again Friday (April 22), ending the day at $215.52 (down 1.2%) and capping a three-day decline that saw the company shed 38% of its share price, more than $55 billion in market capitalization and the unofficial title of Streaming Champion of the World. Now with expectations low for Q2, the company is faced with a dilemma: what to do to regain its crown. 

The last time Netflix stock fell like a stone -- remember January 21? -- there was a quick response from hedge fund managers who saw the drop off as an opportunity to take advantage of the panic, to snap up a good stock for a bargain price and rake in the money later. Now, three months later, during Netflix’s latest share cratering, those earlier white knights have left the castle, and there doesn’t seem to be any replacements at the drawbridge, at least anytime soon.

Back in January, hedge fund Pershing Square and its chief Bill Ackman said they had bought 3.1 million shares of Netflix for about $1 billion, claiming he was “all in” on the streaming space and was ready to reap the profits once Netflix turned itself around, probably in the first quarter. At the time, Netflix predicted that it would add about 2.5 million global subscribers in Q1, substantially lower than in past Q1’s -- typically one of the strongest growth periods for the company -- but strong enough. A few days later, Netflix founder and co-CEO Reed Hastings said he bought $200 million of Netflix stock personally, showing his commitment to the company and the stock. 

Also: Netflix Comeback Could Take a While 

Fast-forward to earlier this week and Ackman sold his Netflix stake for a $450 million loss on April 19, and Netflix didn’t add 2.5 million global customers, it lost 200,000 of them. Adding insult to injury, the company said it would lose another 2 million subscribers in Q2. 

In a note to shareholders on April 19, Ackman said that while he and the Pershing team believe in Netflix’s management, its “enormous operating leverage” means that any fluctuation in the company’s future subscriber growth can impact value. 

“In our original analysis, we viewed this operating leverage favorably due to our long-term growth expectations for the company,” Ackman wrote.

“While Netflix’s business is fundamentally simple to understand, in light of recent events, we have lost confidence in our ability to predict the company’s future prospects with a sufficient degree of certainty,” he continued, adding that given its management’s track record, Netflix can still be a successful company and a good investment. “That said, we believe the dispersion of outcomes has widened to a sufficiently large extent that it is challenging for the company to meet our requirements for a core holding.”

In other words, Ackman and Pershing, like just about every other fund that invested in Netflix, believed that the subscriber growth train would never stop. Only a few years ago, analysts were predicting Netflix would have 300 million global subscribers by 2023. Now, analysts like Needham & Co. 's Laura Martin are wondering if 222 million (its current global tally) is the peak.  

Despite the irrational exuberance that fueled a lot of Netflix’s unprecedented run in the past few years -- its stock price more than doubled from $302.60 on November 18, 2019 to $700.99 on November 17, 2021 -- investors had to think, at least in the very back of their minds, that it couldn’t last forever. Like the booms and busts of past stock market bubbles -- tech in the 2000s, real estate in the mid-2000s, everything in the late 1990s -- it eventually has to come to an end. In the past week, Netflix stock has fallen 38%. Shares are down 63% since the beginning of the year. The ride, it seems, is over.

Who or What is to Blame?

To some analysts, the pandemic is partly to blame -- Netflix added nearly 55 million subscribers globally between 2019 and 2021, the height of stay-at-home orders that forced people indoors and in front of their TV sets. Broadband experienced the same slowdown after a booming two years -- Comcast and Charter alone added a combined 7 million high-speed data customers between 2019 and 2020 and just 2.5 million in 2021. Netflix was different because it kept spending money on content -- $15 billion last year, by some estimates -- had some of its most-watched shows ever during the pandemic and even though the North America market was pretty saturated (about 60% of pay TV households have a Netflix subscription), they were going to make it up in spades internationally.

But COVID was a global problem, and even international customers had more streaming choices in the last couple of years -- Disney Plus, for example, has about 46 million subscribers in India alone, a market that Netflix is just-now taking seriously. In the U.S., Netflix was becoming a victim of its own success. Couple that with very aggressive competitors and international instability -- Netflix suspended its Russian operation in March after that country’s invasion of Ukraine -- and it's no wonder that Netflix has had a tough go finding new customers. 

“In hindsight, COVID pulled forward Netflix to maturity in its oldest markets (North and Latin America and Western Europe),” wrote Evercore ISI Group analyst Mark Mahaney in a note to clients, adding that Netflix has about 60% penetration of North American broadband households, 80% when password sharing is counted. “It’s not easy to raise penetration beyond that level.” 

Netflix says it is going to crack down on password sharing and will introduce an ad-supported tier, but there are questions about how soon either of those can be implemented and whether it will make much of a difference. Wedbush Securities analyst Michael Pachter, a long-time bear on Netflix stock, told CNBC in March, when talk began to circulate that Netflix, like other streamers, would consider an ad tier, that it likely wouldn’t be big enough or fast enough to make that much of a difference. He added that Hulu has an ad tier that brings in about $10 per month per subscriber in advertising revenue. 

“The question is do they make more money at $10 per month for advertising or do they make more money charging $15.49 [for service]?” Pachter told CNBC. “I think it’s a push. …Five bucks, six bucks per month plus $10 advertising, that’s a push. What’s the point?”

Needham & Co.’s Martin believes that the ad-tier will help Netflix, but advertising alone won’t solve its problems. In an April 20 research note, Martin wrote that in addition to a lower-priced ad-supported version, Netflix needs to add sports and news content, bundle the service with other products and/or purchase a large film or TV content library. 

“Every streaming competitor does one or more of these things, which puts Netflix at a structural competitive disadvantage, we believe,” Martin wrote. “Another alternative is for Netflix to acquire other companies that provide one or more of these attributes, as it has done for video games.”

Borrowing For Growth 

Pachter has been a harsh critic of Netflix's seemingly endless habit of continually increasing its content spend -- $17 billion last year, according to some estimates, compared to $4 billion for Disney Plus -- by borrowing. Increasing leverage was OK'd by Wall Street as long as the subscriber growth was strong. When it started to trail off, then investors began to worry.

Netflix still has a junk-bond rating on its debt, but it was expected to move into investment grade territory soon. Moody’s Investors Service raised Netflix’s debt rating two notches to Ba1 in April 2021, based on revenue and subscriber growth, and the belief that as that continued, Netflix would begin to report positive, sustained free cash flow soon. Having steady, sustainable free cash flow would allow Netflix to take its leverage ratio below 2.5 times, consistent with its current rating.    

Moody’s is still optimistic that Netflix will be able to pull itself out of the hole. 

“We still see the company continuing to build on its significant scale to penetrate the world's 800 million pay TV homes and the global addressable homes of over 1.5 billion (both excluding China), sustaining competitively low cost per viewing hour leadership, growing average revenue for member, and reinvesting in even more content as it benefits from this virtuous cycle,” Moody’s SVP Neil Begley wrote. 

But that confidence does not come without caveats. In his Friday note, Begley warned that the causes of the Q1 losses and the “potentially sharp” first half declines in subscribers are still there: price increases; competition; and customers that are taking a break from in-home binge-watching as COVID restrictions are lifted. Moody’s said it will continue to monitor those conditions. 

Not Such a Big Surprise 

Pachter had warned that this day would come for years. In a 2019 article by then-Bloomberg columnist Joe Nocera, the analyst remembered being asked to justify his $183 price target on Netflix shares when the stock was already trading at $368 each. He said to justify his price target, Netflix would have to show a $2 billion improvement in free cash flow and have around 300 million subscribers paying $20 per month. Pachter believed Netflix could get there in a competition-free environment, but that wasn’t the case.

“What will happen if competitors are charging $7?” Pachter asked.

Well, that day is here. Hulu raised the price of its ad-supported service to $6.99 monthly in October, Disney Plus raised its price to $7.99 per month earlier this year and Apple TV Plus and Peacock’s premium tier are still at $4.99 per month. Netflix upped the monthly charge for its standard service to $15.49 per month in January.

Back in 2016, Nocera wondered in an article he wrote for the New York Times what would happen if the Netflix hamster wheel of constantly escalating spending to fuel subscriber growth ever slowed down. In his mind, it would lead to a lower stock price, which would increase the cost of debt, forcing Netflix to increase prices or cut back on costs or both. In a New York Times article at the time, he wrote that it would turn the “virtuous circle” of increased spending fueling increased subscriber growth, into a “vicious circle.” 

For years, Netflix was the bratty younger brother in the media business, making fun of its slower, older and less stylish cousins, while spending the equivalent of dad’s money like it was going out of style. That behavior was tolerated, even encouraged by lenders and Wall Street as long as it kept up its blistering growth pace. Now that growth has appeared to stop, or at least slowed considerably, Netflix’s hijinks just aren’t so cute anymore. 

But probably more important is that despite the ups and downs of the streaming market, Netflix was always a pretty predictable company. Sure, subscriber growth would fluctuate, but in the end it would always be higher than before. Today, a hedge fund that three months ago thought it was a good move to take a $1 billion plunge in buying Netflix stock, now thinks it’s better to take a $450 million bath just to get out of the water. ■

Mike Farrell

Mike Farrell is senior content producer, finance for Multichannel News/B+C, covering finance, operations and M&A at cable operators and networks across the industry. He joined Multichannel News in September 1998 and has written about major deals and top players in the business ever since. He also writes the On The Money blog, offering deeper dives into a wide variety of topics including, retransmission consent, regional sports networks,and streaming video. In 2015 he won the Jesse H. Neal Award for Best Profile, an in-depth look at the Syfy Network’s Sharknado franchise and its impact on the industry.