Subscription software stocks like Zoom Video and Atlassian have been one of the hottest tech sectors on Wall Street in the past couple of years, thanks in part to their reliably recurring revenue. Investors love the predictability of subscription businesses.
But that predictability disappears when subscriber growth is driven by hit products as ephemeral as a popular TV show. That’s an issue for Netflix right now, which last quarter reported its first drop in U.S. streaming subscribers since 2011. Netflix stock has since fallen 15%. Netflix’s explanation—that the quarter’s “content slate drove less growth” than expected—suggests its business has become more hit driven. Given the ease with which subscribers can cancel, that implies Netflix’s business going forward will be more volatile than investors may realize.
If Netflix’s subscriber growth is becoming more driven by the popularity of its content, then the company deserves a lower valuation than subscription software peers valued in part for their predictability.
This presents a challenge for investors, who have to figure out how to value a hit-driven subscription business. On the one hand, revenue won’t be as volatile as at a film studio, where successes can produce blowout profits but duds can bankrupt the company. But revenue won’t be as reliable as is typical for software subscription businesses. Netflix isn’t the only one in this situation. As Disney makes streaming the center of its business, its revenue is also likely to become more volatile. Disney has a film studio whose profits bounce around, but its profit engine is the more reliable TV business.
This likely means a reassessment of Netflix’s valuation. After its recent sell-off, Netflix’s enterprise value of $143 billion—its market capitalization plus debt—is about 5.7 times next year’s expected revenue. That’s only a little higher than the multiple at which subscription software leader Salesforce has been trading, around 5.2. But a hit-driven subscription streaming service, which can lose subscribers with the click of a mouse, is an inferior business to subscription software. Giving Netflix a multiple of 4, instead, puts the stock at around $210, compared to its price on Friday of $308.93.
Americans have been paying for their TV service through subscriptions for decades, of course, so it’s not the business model that is new. The difference is that in the past viewers signed up for large bundles of TV channels supplied by cable and satellite operators, who offered very little opportunity to pick and choose.
The channels in the bundle got a cut of the overall subscription fee that bore no relation to whether anyone was watching. As a result, there was no short-term subscriber-revenue impact from hit shows (although they could sell more advertising and over a long period of time, a consistently popular channel could negotiate for higher fees from cable and satellite providers).
In theory, the exception in that model was a premium channel such as HBO, available as an add-on at a significant extra cost of as much as $15 a month. That should have made HBO, to some extent, a hit-driven business—particularly starting in 1999 when its long spate of successful programming heralded by “The Sopranos” began. But there’s little evidence that HBO’s subscriber numbers—which for the most part weren’t disclosed by its parent, Time Warner—were volatile in that period.
While there is anecdotal evidence that some people signed up to watch a particular show and then canceled, the barriers to cancellation likely kept that behavior to a minimum. Over the past 20 years HBO enjoyed steady but unspectacular growth: its subscribers rose from 24.3 million at the end of 1999 to 35.6 million at the end of 2018, estimates Kagan, a media research group within S&P Global Market Intelligence.
It’s a different story today with HBO’s standalone streaming service, HBO Now, which people can subscribe to through Amazon—where cancellation is as easy as a click of a mouse. The same goes for Netflix and, presumably, Disney’s forthcoming services.
Disney may have reduced the potential for volatility with plans to bundle its flagship streaming service Disney Plus with its sports offering, ESPN Plus and the broader-interest entertainment service Hulu, which Disney now controls. The three will cost only $12.99 a month—an approach that could lock people into more than one service.
If Disney does well, Netflix may seek to strike similar bundling deals. Perhaps it could use its stock to consolidate the wide array of niche streaming services and offer a bundle to compete with Disney.
A hit-driven subscription streaming service is an inferior business to subscription software.
Otherwise, the key question for investors should be whether Netflix management can reduce volatility by ensuring that even if people sign up for a hit show, there is enough other programming on the service to keep them hooked.
HBO executives used to argue that what drove the majority of its viewing wasn’t its big name shows but its movies. The point was that people would be less inclined to cancel when their favorite show’s season ended if they liked what else was on the channel.
Netflix’s wide array of programming, across different genres and formats—from documentaries to big-budget movies to niche series—should serve the same purpose.
That’s why the second quarter dip in U.S. subscribers raised concerns.
It doesn’t help Netflix that the well-known reruns which have been a pillar of Netflix programming—such as “Friends” and “The Office”—are disappearing. A recent survey by MoffettNathanson found both were among the top 10 viewed shows on the service, although the most popular were originals “Stranger Things” and “Orange is the New Black.”
And as competition grows from new services, including Disney and WarnerMedia’s HBO Max, Netflix will have to keep betting on costly original shows whose chance of success is unknown. At the same time, its ability to continue growing in the U.S., at least, has to be limited. Having signed up 60 million subscribers, Netflix has been more successful than any comparable service ever before. While Netflix claims its long term goal is to get to between 60 million and 90 million subscribers, the worry for investors is that its subscriber numbers may simply fluctuate around current levels in the future, based on the popularity of its programming lineup.
Investor nervousness about Netflix has been apparent since the middle of last year, when the stock’s yearslong rally stalled out at $391. But even with the stock having fallen to $303, Netflix shares remain too rich for the business it’s in.