Netflix: The streaming platform launched in 2007 by the company that was once only a DVD-by-mail service provider based in the US is one of the main global entertainment service companies. With almost 222 million monthly subscribers, its offer spans from tv series, movies of several genres, documentaries, to mobile games in several languages, all owned and licensed.
As millions of people found themselves suddenly stuck at home with a limited range of activities to do but plenty of time at hand, Netflix represented a relatively affordable and simple solution to entertain the whole family during the lockdown months. In this period, customer growth spiked for the company and at the same time, the stock price continued to improve, until November 2021.
Nonetheless, the remarkable growth was only short-lived, and only partly due to the return to normality and the related consumer habits. For the first time after more than a decade, the company reported a loss in subscribers, triggering investors’ worries.
Notoriously, Pershing Investors previously acquired 3.1 million shares of Netflix after the decrease in the share price to benefit from the valuation that according to Pershing Square was just temporary, due to the short term views of some investors. However, they had to sell the stake at a loss citing the significant impact of the loss of subscribers on the profitability of the company due to its substantial leverage and, according to Bill Ackman, they “have lost confidence in [their] ability to predict the company's future prospects”, hence the company is not currently suitable as part of their portfolio. The drop in the stock price continued until April 2022, reaching 188 USD per share.
As to the pandemic effect, the subscriber acquisition rate was not sustainable. Indeed, as restrictions were gradually lifted, the need for entertainment that was temporarily met by Netflix was then substituted with holidays, excursions, restaurants, theatres, and cinemas, as well as other out-of-home recreational activities. But this is only part of a wider trend that saw the company become less relevant as we will cover later in the article.
Rising competition
Once the sole leader in the streaming industry, Netflix is struggling to compete against Disney Plus, Amazon Prime Video, Apple, Hulu, HBO, Paramount plus as well as other providers alike. The market tends to change fast, is highly saturated, customers have low switching costs due to monthly subscriptions with possibilities of cancellations and renewals leading to a high churn rate, and consumers can benefit from multiple entertainment providers at the same time.
Indeed, not only do these platforms offer different selections of content and prices, but some of them are now often streaming under exclusive terms their proprietary contents that were once leased to Netflix, such as the case of Disney Plus with Marvel content. Even though competitors are following diverse strategies, particularly regarding pricing, or the franchises they build, they represent a significant threat to Netflix.
In addition, the company raised prices in America to cope with the higher costs borne to produce the content. This had a negative impact on demand in a market that offers plenty of choices to consumers to select other providers. In this view, it is also important to highlight the seasonality and volatility of this market. On the one hand, subscriber growth tends to increase in the fourth quarter and on the other when new highly anticipated and advertised content is added to the platform. But this is also true for competitors, hence several clients are occasional consumers instead of recurring. In addition to the previously mentioned factors, some causes are inherent to consumers’ behaviour of trying to maximise the value obtained for the price paid. Password sharing is common not only among households but also among groups of friends aiming to minimise their costs of subscription.
Markets
The huge drop in Netflix shares was not only determined by internal factors. To this extent, let us analyze what has been happening to the stock market for the last months. We will take the S&P500 index as a benchmark.
After the market crash in March 2020, stocks not only recovered but also hit record highs. For instance, the S&P gauge went from a minimum of 2237.40 to 4796.56 points on 01/03/2022, increasing by 114%. Since that day, however, stock prices dropped. On 04/30/22, the index closed at 4131.93, meaning that it fell by 13.9% in the last 4 months. According to Morgan Stanley, the S&P500 is expected to enter a bear-market territory (i.e., stock prices decline by more than 20% from their highs).
In addition, the IPO market is freezing. After setting an all-time high in both the number and the valuations of IPOs, in 2022Q1 only 18 companies went public in the US (-81% YoY), and they managed to raise about $2 billion (-91% YoY).
The most important factor affecting current valuations is future restrictive monetary policy. During the early stages of the recovery, stocks benefited from ultra-loose monetary policies: lower interest rates increased the present value of future cash flows, and at the same time a massive amount of liquidity poured into the market, accelerating its growth and lowering the perceived risk. Now things are different. The Fed has already ended quantitative easing and increased interest to 0.25% in March. Moreover, according to the March 2022 dot plot, interest rates will go up to 1.75% by the end of this year.
A restrictive monetary policy affects stocks in the following ways. First, higher rates mean a higher cost of financing: when issuing a bond or asking for a loan, companies will have to pay a higher interest, causing costs to go up. Second, rates are negatively correlated with the present value of future cash flows. In other words, as rates increase, so does the discount factor, determining a lower equity value. Finally, if stocks and bonds offer the same expected return, investors will usually go for bonds since they are less risky. At present, the yield on the 10y Treasury note is 2.8%, whereas the dividend yield of the S&P500 is 1.37%. if expectations of future gains cannot offset this difference, investors will dump stocks, putting downward pressure on current valuations.
Apart from higher rates, other external factors which are negatively impacting the market include the uncertainty on the recovery from the pandemic, the war between Russia and Ukraine, and the persisting issues related to supply chain bottlenecks. All these elements lead to higher market volatility, hence a higher equity risk. To this extent, let us look at the CBOE Volatility Index, which measures the implied volatility of the S&P 500. In 2022 the VIX rose from 16.60 to 33.40 points. The following graph shows how the relationship between the VIX and the S&P 500.
As millions of people found themselves suddenly stuck at home with a limited range of activities to do but plenty of time at hand, Netflix represented a relatively affordable and simple solution to entertain the whole family during the lockdown months. In this period, customer growth spiked for the company and at the same time, the stock price continued to improve, until November 2021.
Nonetheless, the remarkable growth was only short-lived, and only partly due to the return to normality and the related consumer habits. For the first time after more than a decade, the company reported a loss in subscribers, triggering investors’ worries.
Notoriously, Pershing Investors previously acquired 3.1 million shares of Netflix after the decrease in the share price to benefit from the valuation that according to Pershing Square was just temporary, due to the short term views of some investors. However, they had to sell the stake at a loss citing the significant impact of the loss of subscribers on the profitability of the company due to its substantial leverage and, according to Bill Ackman, they “have lost confidence in [their] ability to predict the company's future prospects”, hence the company is not currently suitable as part of their portfolio. The drop in the stock price continued until April 2022, reaching 188 USD per share.
As to the pandemic effect, the subscriber acquisition rate was not sustainable. Indeed, as restrictions were gradually lifted, the need for entertainment that was temporarily met by Netflix was then substituted with holidays, excursions, restaurants, theatres, and cinemas, as well as other out-of-home recreational activities. But this is only part of a wider trend that saw the company become less relevant as we will cover later in the article.
Rising competition
Once the sole leader in the streaming industry, Netflix is struggling to compete against Disney Plus, Amazon Prime Video, Apple, Hulu, HBO, Paramount plus as well as other providers alike. The market tends to change fast, is highly saturated, customers have low switching costs due to monthly subscriptions with possibilities of cancellations and renewals leading to a high churn rate, and consumers can benefit from multiple entertainment providers at the same time.
Indeed, not only do these platforms offer different selections of content and prices, but some of them are now often streaming under exclusive terms their proprietary contents that were once leased to Netflix, such as the case of Disney Plus with Marvel content. Even though competitors are following diverse strategies, particularly regarding pricing, or the franchises they build, they represent a significant threat to Netflix.
In addition, the company raised prices in America to cope with the higher costs borne to produce the content. This had a negative impact on demand in a market that offers plenty of choices to consumers to select other providers. In this view, it is also important to highlight the seasonality and volatility of this market. On the one hand, subscriber growth tends to increase in the fourth quarter and on the other when new highly anticipated and advertised content is added to the platform. But this is also true for competitors, hence several clients are occasional consumers instead of recurring. In addition to the previously mentioned factors, some causes are inherent to consumers’ behaviour of trying to maximise the value obtained for the price paid. Password sharing is common not only among households but also among groups of friends aiming to minimise their costs of subscription.
Markets
The huge drop in Netflix shares was not only determined by internal factors. To this extent, let us analyze what has been happening to the stock market for the last months. We will take the S&P500 index as a benchmark.
After the market crash in March 2020, stocks not only recovered but also hit record highs. For instance, the S&P gauge went from a minimum of 2237.40 to 4796.56 points on 01/03/2022, increasing by 114%. Since that day, however, stock prices dropped. On 04/30/22, the index closed at 4131.93, meaning that it fell by 13.9% in the last 4 months. According to Morgan Stanley, the S&P500 is expected to enter a bear-market territory (i.e., stock prices decline by more than 20% from their highs).
In addition, the IPO market is freezing. After setting an all-time high in both the number and the valuations of IPOs, in 2022Q1 only 18 companies went public in the US (-81% YoY), and they managed to raise about $2 billion (-91% YoY).
The most important factor affecting current valuations is future restrictive monetary policy. During the early stages of the recovery, stocks benefited from ultra-loose monetary policies: lower interest rates increased the present value of future cash flows, and at the same time a massive amount of liquidity poured into the market, accelerating its growth and lowering the perceived risk. Now things are different. The Fed has already ended quantitative easing and increased interest to 0.25% in March. Moreover, according to the March 2022 dot plot, interest rates will go up to 1.75% by the end of this year.
A restrictive monetary policy affects stocks in the following ways. First, higher rates mean a higher cost of financing: when issuing a bond or asking for a loan, companies will have to pay a higher interest, causing costs to go up. Second, rates are negatively correlated with the present value of future cash flows. In other words, as rates increase, so does the discount factor, determining a lower equity value. Finally, if stocks and bonds offer the same expected return, investors will usually go for bonds since they are less risky. At present, the yield on the 10y Treasury note is 2.8%, whereas the dividend yield of the S&P500 is 1.37%. if expectations of future gains cannot offset this difference, investors will dump stocks, putting downward pressure on current valuations.
Apart from higher rates, other external factors which are negatively impacting the market include the uncertainty on the recovery from the pandemic, the war between Russia and Ukraine, and the persisting issues related to supply chain bottlenecks. All these elements lead to higher market volatility, hence a higher equity risk. To this extent, let us look at the CBOE Volatility Index, which measures the implied volatility of the S&P 500. In 2022 the VIX rose from 16.60 to 33.40 points. The following graph shows how the relationship between the VIX and the S&P 500.
Pandemic winners are now losers
The aforementioned factors do not affect all firms in the same way. For instance, some companies, such as Netflix, benefited from the pandemic scenario more than others. Indeed, their business model proved to be really effective during the lockdown period. This allowed them to attract investors and their market valuation skyrocketed. But in the current scenario, these former pandemic winners are now becoming the post-pandemic losers and their market valuation is going back to pre-pandemic levels, or even lower! Consider the following examples:
Peloton is a fitness company that produces high-end spinning bikes and provides streaming workout classes. As the pandemic hit, demand for their products skyrocketed: since gyms were closed, people turned to home workouts. The company struggled to meet consumer demand, therefore many of them moved to competitors or went for the digital-only subscription, not buying the hardware. As a consequence, when gyms reopened, the company’s growth started decelerating. Peloton claimed that it had overestimated demand and planned to halt production. Now Peloton is certainly in a worse position than it was before the pandemic, with higher fixed costs and inventories and decreasing sales revenues. Since its peak, market capitalization fell from $50 billion to $7 billion. The company’s founder has recently stepped down as a CEO and active investors are pushing for selling the firm.
The aforementioned factors do not affect all firms in the same way. For instance, some companies, such as Netflix, benefited from the pandemic scenario more than others. Indeed, their business model proved to be really effective during the lockdown period. This allowed them to attract investors and their market valuation skyrocketed. But in the current scenario, these former pandemic winners are now becoming the post-pandemic losers and their market valuation is going back to pre-pandemic levels, or even lower! Consider the following examples:
Peloton is a fitness company that produces high-end spinning bikes and provides streaming workout classes. As the pandemic hit, demand for their products skyrocketed: since gyms were closed, people turned to home workouts. The company struggled to meet consumer demand, therefore many of them moved to competitors or went for the digital-only subscription, not buying the hardware. As a consequence, when gyms reopened, the company’s growth started decelerating. Peloton claimed that it had overestimated demand and planned to halt production. Now Peloton is certainly in a worse position than it was before the pandemic, with higher fixed costs and inventories and decreasing sales revenues. Since its peak, market capitalization fell from $50 billion to $7 billion. The company’s founder has recently stepped down as a CEO and active investors are pushing for selling the firm.
Zoom Inc. is an ICT company that provides software for cloud communication. Its most-known service is Zoom meetings, which allows users to do videoconferences. During the lockdown, employees working from home, as well as students, relied on it. This led to a sharp increase in the company’s valuation, fueled by expectations that working from home would become the new normality. With the recovery and the consequent return to offices, investors realized that their expectations had become too high, so stock prices started a steady decline, which reflected a lower terminal value. Stocks are down more than 80% from their peak and almost back to pre-pandemic levels.
PayPal is a fintech company that allows people to perform electronic financial transactions. The pandemic accelerated the growing trend of online shopping, benefiting digital payment systems. PayPal’s users and revenues soared, while its stock price almost tripled. However, since 2021Q4 stocks have been following a downward trend as the company forecasted lower revenues in the future. Stocks are now even below the 2020 bottom level.
Even though these companies compete in different industries, they all have something in common: their current business model does not allow them to meet investors’ growth expectations. Booming valuations were not backed by fundamentals, therefore making them unsustainable. Indeed, stock prices fell as quickly as they went up. To attract investors, they must craft new strategies to overcome challenges and adapt to the current scenario.
6) Over the last few months, Netflix repeatedly made reference to its willingness to expand into the videogames industry. After the announcement in July 2021, the platform hired experienced executives in the gaming field while releasing mobile games based on Netflix Series “Stranger Things: 1984”. Netflix's strategy would also include the production of movies based on pre-existing games, thus incorporating a niche of the gaming market within its main area of specialisation (namely the video streaming industry). Among the most important examples of this approach from Netflix we find "Arcane", a series based on the game “League of Legends”, and the announcement of the production of a movie and a videogame based on the card game "Exploding Kittens". According to Joost van Dreunen, professor of at NYU Stern school of business, Netflix's entry into the gaming industry would be an indication of the need for it to expand its business besides the video streaming industry.
While markets are investing increasing amounts of money in gaming firms to acquire know-how expendable in the metaverse industry (think of the recent $68.7 billion acquisition of Activision Blizzard by Microsoft), Netflix has acquired 3 game studios.
The acquisition of Boss Fight Entertainment, Next Games and Night School Studio along with the positive prospect of consolidation of the gaming space contribute to making the gaming industry a high potential opportunity that could give Netflix further room to grow.
Among the main problems that have caused the decline in subscriptions is the use of the same accounts by multiple users. According to the company in fact, among the 222 million total users, there would be another 100 million who would use the service without being subscribed. Among the alternatives that are being considered by the firm is to reduce subscription costs and at the same time include advertising, this would represent an important change from the traditional free-ads service that has been offered so far.
From a strategic point of view, Netflix would be at a disadvantage compared to its main competitors (namely Amazon and Disney with their respective streaming platforms). Finding itself obliged to add advertising to its service, users would perceive the decline in quality of the platform and would worsen the customer experience as a whole, with ambiguous consequences to predict.
According to the risk preferences and required yield, investors may either look for growth stocks or value stocks. In the former case, investors are more prone to risk as they are investing in a firm that can be pioneering in its industry and therefore has a long path ahead. In the latter case, however, investors may be looking for more stable returns through constant dividend payments and possibly lower volatility of the stock price.
Indeed growth stocks are renowned for being extremely exposed to new market announcements and for paying virtually no dividends. In fact, these firms are usually very young and have a lot of different profitable investment opportunities that they can pursue. Therefore they will always choose to invest cash in profitable opportunities rather than paying it out to shareholders in the form of share dividends or stock repurchased.
Netflix has always been traded as a growth stock by now, this is mainly because of its nature of being a leader in a fast-paced industry as the tech industry. By looking at the P/E ratio it’s visible that, starting from the end of 2015 this indicator started a deep correction while EPS increased significantly from $0.28 to $11.24 over the same period (2015-2022). However, because of the previously mentioned factors, Netflix's reputation as a growth company may only belong to the past (unless a substantial change of course in the current strategy is reflected in the company's financial performance).
6) Over the last few months, Netflix repeatedly made reference to its willingness to expand into the videogames industry. After the announcement in July 2021, the platform hired experienced executives in the gaming field while releasing mobile games based on Netflix Series “Stranger Things: 1984”. Netflix's strategy would also include the production of movies based on pre-existing games, thus incorporating a niche of the gaming market within its main area of specialisation (namely the video streaming industry). Among the most important examples of this approach from Netflix we find "Arcane", a series based on the game “League of Legends”, and the announcement of the production of a movie and a videogame based on the card game "Exploding Kittens". According to Joost van Dreunen, professor of at NYU Stern school of business, Netflix's entry into the gaming industry would be an indication of the need for it to expand its business besides the video streaming industry.
While markets are investing increasing amounts of money in gaming firms to acquire know-how expendable in the metaverse industry (think of the recent $68.7 billion acquisition of Activision Blizzard by Microsoft), Netflix has acquired 3 game studios.
The acquisition of Boss Fight Entertainment, Next Games and Night School Studio along with the positive prospect of consolidation of the gaming space contribute to making the gaming industry a high potential opportunity that could give Netflix further room to grow.
Among the main problems that have caused the decline in subscriptions is the use of the same accounts by multiple users. According to the company in fact, among the 222 million total users, there would be another 100 million who would use the service without being subscribed. Among the alternatives that are being considered by the firm is to reduce subscription costs and at the same time include advertising, this would represent an important change from the traditional free-ads service that has been offered so far.
From a strategic point of view, Netflix would be at a disadvantage compared to its main competitors (namely Amazon and Disney with their respective streaming platforms). Finding itself obliged to add advertising to its service, users would perceive the decline in quality of the platform and would worsen the customer experience as a whole, with ambiguous consequences to predict.
According to the risk preferences and required yield, investors may either look for growth stocks or value stocks. In the former case, investors are more prone to risk as they are investing in a firm that can be pioneering in its industry and therefore has a long path ahead. In the latter case, however, investors may be looking for more stable returns through constant dividend payments and possibly lower volatility of the stock price.
Indeed growth stocks are renowned for being extremely exposed to new market announcements and for paying virtually no dividends. In fact, these firms are usually very young and have a lot of different profitable investment opportunities that they can pursue. Therefore they will always choose to invest cash in profitable opportunities rather than paying it out to shareholders in the form of share dividends or stock repurchased.
Netflix has always been traded as a growth stock by now, this is mainly because of its nature of being a leader in a fast-paced industry as the tech industry. By looking at the P/E ratio it’s visible that, starting from the end of 2015 this indicator started a deep correction while EPS increased significantly from $0.28 to $11.24 over the same period (2015-2022). However, because of the previously mentioned factors, Netflix's reputation as a growth company may only belong to the past (unless a substantial change of course in the current strategy is reflected in the company's financial performance).
Following a period of unwavering growth in part due to the large-scale quantitative easing undertaken during the pandemic, Netflix has reached a decisive point in their company’s history. The unexpected drop in the number of subscriptions and the consequent panic in the markets posed serious doubt about the sustainability of their business model. Given its cash flows and margins are positive, and that it operates in a relatively mature and competitive industry, perhaps beginning to value it as a value stock, rather than a growth stock, is a step in the right direction within an inflated market.
By Miriam Franceschinelli, Alexjandro Frattini, and Giorgio Gusella