While there are plenty of ‘Netflix bears’ out there pointing to perceived risks over subscriber churn and cash burn as worrisome mitigating factors to the company’s stock price, at least one analyst says that investors should focus on long-term scale advantages from building in-house content and the levelling off of show licence costs.
Investor concerns centre on the fact that Netflix is spending billions on its original content strategy, and is currently ripping through its free cash at a rapid clip. The company has burned more than $1 billion in cash for the first nine months of 2016 alone.
And sure, to date, the streaming giant clocked 87 million video streaming customers in the third quarter, and it is on track to exceed $8 billion in revenue for 2016. But Rishi Kaul, an analyst with Ovum, noted that if one breaks down Netflix’s business at a per-subscriber scale, one can see that its cash burn is getting worse, not better, as it grows in scale.
Seeking Alpha analyst Alex Cho, however, believes that while content costs will increase in the short term, Netflix is reaching that key inflection point where it can sustain enviable margins in the next 10 years.
“Netflix's content costs ramped due to the licensing of Walt Disney films, inclusive of Marvel, Lucas Films and Pixar,” he said in a post.
“Strict content licensing isn't going to increase much further upon the full phase-in of the Disney licensing agreement, because there's not a single movie publisher that's more dominant at the box office, or has more pricing power globally.
“NFLX's contribution margin has trended higher, as original programming paired with the upfront cost of Disney, Sony, Warner Bros, CBS, DreamWorks, AMC and various other TV/movie studio licences are levelling off.”
At the same time, Netflix's shift towards cheaper in-house show productions should translate into a more linear cost ramp that's far more controllable, at roughly $30 million per original season. The cost per programmable hour can be managed to higher levels of efficiency depending on genre.
“Obviously, highly expensive war-themed series like Marco Polo could prove difficult to scale, whereas crime thrillers like House of Cards are much more economical with a stronger base of mainstream appeal,” Cho said.
He added, “Some will cost more while others will cost less, but will likely average out at perhaps $30 million to $50 million depending on season length and genre. This will contribute to NFLX's profitability, because it doesn't need to produce more than 5,000 original programming hours (costing $10 billion/annually), or license more than half of the Hollywood box office hits to make a viable streaming product.”
In all, Cho is forecasting that Netflix will spend $13.3 billion on content licensing and original programming by 2020, compared with the $5.8 billion it is projected to have spent on content in 2016 (of which $1.1 billion or 19% was spent on Netflix's in-house productions, according to a UBS estimate).
“If original programming shifts to 50% of Netflix's total content budget (which it likely will) by 2020, Netflix can produce 3,325 original programming hours or 166 different TV season at 20 episodes per annum,” Cho said. “This is more than enough content for its global audience, regardless of language barriers and segmentation of preference. Who could honestly follow more than 10 to 20 TV series in a year?”
Investors have also mentioned that churn was another risk factor for Netflix stock, but the Q3 results show that the recent price increase did not negatively affect its current base of subscribers significantly. It reported a churn rate of around 2.5% above historical trends.
“Now, NFLX is in a better position to recapture content costs with its now-elevated tiered pricing structure,” Cho said. “Furthermore, the Q4'16 guidance for 1.45 million subscriber growth compared favourably to Q4'15 subscriber growth of 1.56 million. NFLX's domestic subscriber ramp is set to stabilise, or revert to the mean.”
Bottom line? “I continue to reiterate my high conviction buy recommendation and $144.46 price target,” Cho said.