Bull or Bear on Netflix? It Depends on Which Side of the Street You’re On

Debt analysts take a darker view of SVOD sub losses
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By now the news that Netflix actually lost domestic subscribers in Q2 has spread like wildfire throughout the investment community, with pundits and analysts equally taking doomsday and “What me, worry?” stances on what the decline means for the future of the company and for subscription video on demand. But the intensity of the reaction equally rides on whether the pundit is on the debt or equity side of street.

Netflix stock was down as much as 11.6% July 18 to $320.50 per share -- it gained back some of that ground later in the day, trading at $322.11 each, down 11% per share -- after it said it missed its Q2 subscriber targets badly, reporting a gain of 2.7 million new customers versus analysts’ consensus estimates of 5.1 million additions and its own prediction it would add 5 million customers. Perhaps more telling is that Netflix lost about 130,000 U.S. subscribers (compared to guidance of 300,000 additions), the first time it has showed a quarterly loss of domestic customers.

Netflix blamed the shortfall on a number of factors -- a weaker content slate, a price increase during the beginning of the year and a pull-forward from Q1 -- but investors mostly honed in on the price increase. Netflix shareholders have been a fickle bunch -- the stock actually went up nearly 7% on Jan. 15, the day it announced the price increases and fell 13% in after-hours trading when it missed Q2 2018 subscriber growth expectations last July. So far this year, even with today’s declines, the stock is up 20%.

Related: Netflix Shares Tumble Amid Missed Q2 Forecasts

Equity analysts for the most part said that while the domestic losses are a concern, the company continues to dominate the SVOD space -- it has 60 million customers in the U.S. and about 152 million globally -- and should rebound in the third quarter when a stronger slate -- led by season 3 of Stranger Things, released on July 4 -- is expected to boost customer growth.

In a note to clients, Wolfe Research managing director Marci Ryvicker wrote that the Q2 subscriber loss was “unfortunate, but not a disaster,” adding that Neftlix beat estimates on cash flow and average monthly revenue per unit.

As far as the price increases, those are behind the company now -- Netflix said in January it would have all of its customers under the new rate card by the end of the May billing cycle. And while in the past it has low-balled guidance in quarters following a miss, this time the company said it would add 7 million paid customers in Q3, an almost 15% increase over the 6.1 million additions of the prior year. Domestically, Netflix said it would add 800,000 new paid customers in the U.S. in Q3, about the same as the prior year.

Sanford Bernstein media analyst Todd Juenger, who continues to rate Netflix “outperform,” wrote in a note to clients that even though the miss doesn’t change his thesis on the stock, it does make him more nervous, given pending SVOD launches from Disney (Disney+), AT&T (HBO Max), NBCU and Apple (Apple TV +).

“We don’t think the Disney+ launch will have anything to do with Netflix's success or failure,” Juenger wrote. “But if Netflix misses subs in the quarters after Disney+ launches, the market will make the correlation anyway, and we expect the downside effect on Netflix stock will be several times more than usual.”

At Canaccord Genuity, media analyst Michael Graham wrote in a research note that he was concerned about the subscriber miss, but pleased about the revenue and cash flow gains, adding that although the customer losses “will likely weigh on the stock in the short term and pricing power may be in question for now, we still see a strong content strategy and room to add large numbers of international subs as key strengths going forward.”

Tim Blake Nelson in Netflix original, The Ballad of Buster Scruggs

Tim Blake Nelson in Netflix original, The Ballad of Buster Scruggs

But the outlook is decidedly darker on the debt side, which is appropriate because debt analysts’ focus on a company’s ability to meet its leverage payments. Fewer customers, even those that are paying more, can sometimes affect a company’s ability to meet those obligations.

At credit ratings agency Fitch, director Patrice Cucinello noted that weak subscriber results could point to bigger problems in the SVOD sector.

“Fitch believes these weaker-than-expected results could point to potential saturation in the U.S. subscriber video on demand market,” Cucinello wrote, adding that the results were likely the product of the price increases. “But more notably (and potentially more troubling) it illustrated an apparent cyclicality driven by the weak content release slate.”

That, she said, could be troubling because of the sheer size of Netflix’s annual original programming investment, estimated to be about $15 billion this year. While Netflix’s size has helped it weather past storms, it “won’t be able to maintain that lead without quality of content (not just quantity). A weak content slate runs the risk of subscriber losses rather than just slower subscriber growth going forward.”

Cucinello has warned about this before. Back in April, she worried that Netflix wouldn’t be able to maintain its subscriber growth momentum into Q2. She was right.

There is a sense among some people that at 60 million domestic customers, Netflix may be hitting the wall in U.S. subscriber growth -- as one twitter poster with a handle not fit for a family publication asked, “Netflix has 60M domestic customers. Add in password sharing, doesn’t everyone who wants it, already have it?”

That may be a bit simplistic, but the password sharing concern is not limited to random tweeters.

MoffettNathanson senior analyst Michael Nathanson estimated in a July 15 research note (prior to earnings) that about 14% of Netflix streamers are using someone else’s password. That is compared to 11% for Hulu and 6% for Amazon Prime Video. Nathanson used data from a Total Communications Survey conducted monthly by HarrisX, which asked about 8,500 consumers aged 18+ about their video consumption habits. 

But Netflix also had stronger shows -- its two top shows are Orange is the New Black and Stranger Things, each of which have July season premieres. In contrast, Amazon Prime customers in the survey listed 36 titles in their top 100 list of shows that were carried by other streaming services, not Amazon. While Nathanson wrote that could mean brand confusion is increasing as streaming services proliferate, he noted that all of the titles were available for purchase at the Amazon video store.

“So consumers might be confusing the video service for the Amazon video store,” Nathanson wrote. “Perhaps this might be Amazon’s strategy, to use the Prime Video Service as a barker channel to upsell consumers to rent or buy titles they want to see.”

Moody’s Investors Service SVP Neil Begley was also concerned about the subscriber miss, adding that it was “symptomatic of 1) a maturing U.S. market for the company; 2) a pattern of seasonality and continuing positive and negative volatility of additions; and 3) the growing importance of steady cadence of hit content releases.”

Begley was confident that Netflix would continue to grow customers year over year and predicted it would reach 200 million paid streaming subscribers by 2021.

Cucinello also was more concerned about the threat of four new streaming services that are expected to launch in the coming months -- Disney +, HBO Max, Apple TV + and NBC Universal. While other analysts don’t believe the services will put much of a dent in Netflix’s subscriber base -- most believe the services will be able to live with each other -- Cucinello believes that they “could place pressure on Netflix’s domestic subscriber growth moving into 2020, irrespective of the strength of the content slate.”

And though Begley still expects Netflix to gain customers both domestically and globally this year, he added that the lower priced competitors -- Disney + is the cheapest at $6.99 per month, compared to $12.99 per month for Netflix -- could be a factor.

“[W]e believe that initial low-priced new streaming entrants such as Disney+ will garner subscriber attention, which could limit Netflix’s future pricing power until those new entrants reach parity in price and new content,” Begley wrote.

Which begs the question: can Netflix keep spending heavily on content to keep up?

Ted Sarandos

Ted Sarandos

Reportedly, Netflix chief content officer Ted Sarandos has told executives to spend more carefully on content -- no more throwing dollars at the wall to see what will stick. Netflix has denied any changes to its spending strategy. 

Netflix has had good luck with its originals -- it said original movie Murder Mystery (released in June and starring Adam Sandler and Jennifer Aniston), was watched by more than 73 million households in its first four weeks; and Always Be My Maybe (starring Ali Wong and Randall Park) was viewed by 32 million households in its first four weeks.

But maybe it isn’t such a bad idea to rein in some of the spending. Netflix has prided itself on the past on having at least one new content offering per week -- Sarandos boasted last year that the SVOD pioneer would have more than 1,000 original shows and movies on the service by the end of 2018. The loss of two highly watched series in the next few years -- WarnerMedia will take back Friends in 2020 and NBC will take back The Office in 2021 -- is expected to free up more money for Netflix originals, the company said in its Q2 letter to shareholders. Let’s hope they spend it wisely. 

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