I have made a few media appearances over the past 48 hours worth a short read, a short watch, and a short listen:
Netflix investors brace for subscriber losses as company works on long-term fixes (Alex Sherman, CNBC.com)
Netflix loses nearly 1 million subscribers, and its stock soars (Hamza Shaban, Washington Post)
Netflix Streaming Slowdown (NBC Nightly News with Lester Holt, at ~14:10)
Streaming Subscriber Slump (Wake Up to Money with Sean Farrington, BBC Radio at ~4:40)
I will be surprised if anyone can accurately predict what Netflix’s advertising business will look like after Netflix’s Q2 2022 earnings call yesterday.
Chief Operating Officer and Chief Product Officer Greg Peters set the expectations for investors of "an iterative approach" for its advertising model - or " the Crawl, Walk, Run model” - when it launches in early 2023. It announced its upcoming ad-supported tier will start in "a handful of markets where advertising spend is significant."
We got some clarity on the terms of the deal - it is advertising-focused and perhaps will involve gaming (which Peters described as “go-to-market partnerships”). As for a rumored Azure cloud deal, Netflix is “super excited” about its partnership with AWS.
But otherwise, most answers about the Microsoft advertising partnership were buzzword salads about a secret blueprint for a sophisticated, multi-dimensional advertising business that will not launch for another six to nine months.
With marginal clarity on where Netflix's business may be headed after the pandemic, investors are asking: Can Netflix still grow?
I think the simplest answer is, yes. The longer answer is the Q2 earnings call highlighted advertising (above) and four additional solutions for growth:
Animation
Franchises
India
Password Sharing & Total Addressable Market (TAM)
The other looming question for these four solutions is, will they be enough to get Netflix back on track for its ambitions to be a next-generation Disney? The answer generally seems to be, no.
Animation
I thought the most significant news was Netflix’s announcement it will be acquiring the animation studio Animal Logic. The deal will give them “~800 amazing people mostly in Sydney and Vancouver, which will help us accelerate the development of our animation production capabilities and reinforces our commitment to build a world-class animation studio.”
Notably, Animal Logic has worked on all of the Lego Movie feature films, including "The Lego Batman Movie" and "The Lego Ninjago Movie". As former Disney executive Emily Horgan tweeted, “A load of Lego Movies, Peter Rabbit, DC League of Super Pets, with this acquisition Netflix have got themselves a family animation studio that has the potential to make real commercial hits.”
Moreover, Netflix has been working with Animal Logic for two years, both on "The Magician’s Elephant" (directed by Wendy Rogers) and the recently announced "The Shrinking of the Treehorns" (directed by Ron Howard).
The move notably comes in the wake of the dramatic implosion of Netflix’s animation division reported by The Wrap this past April. 150 jobs were cut after the “inevitable end" of "a deeply chaotic period for Netflix Animation, particularly its Kids & Family division, which saw a boom of talent and creativity give way to corporate pressure, mixed messages and accusations of ‘staged data’."
The animation business is key to Netflix management's has promise to investors that building a Disney-like ecosystem was their long-term objective:
In September, Netflix co-CEO Reed Hastings told the New York Times that two of the best authors in the entertainment industry were Neal Gabler, who wrote the definitive biography of Walt Disney, and Bob Iger, who literally ran Disney. In February, Hastings told investors that Netflix’s long-term aim is to beat Disney at animation: “We’re very fired up about catching them in family animation, maybe eventually passing them, we’ll see. A long way to go just to catch them.”
After the implosion of its animation division, the Animal Logic acquisition is a big move back in that direction. The open question after this call remains: will it be enough to solve for the damage done?
Franchises
On the earnings call Co-CEO Ted Sarandos emphasized how Netflix’s “biggest hits have all come out in the last 12 months, which is really kind of a phenomenal sign of progress.” He added:
I think that this is -- and again, this is kind of back to back to back, where I think Gray Man will join Red Notice and Adam Project and Don't Look Up as among the most popular movies of the year, not just on Netflix, but period. And I think that really is a testimony to these teams and the teams around the world, working great with creators to create a platform for them to do the best work of their lives.
The data from Netflix and Nielsen suggests Sarandos is not wrong. But the open question is, if the long-term objective is to become Disney, how and why do these films bring them any closer?
The Wrap’s Brian Welk reported:
Netflix has two “Red Notice” sequels in development with stars Johnson, Gal Gadot and Ryan Reynolds all expected to return, but sequels for some of Netflix’s other most expensive hits such as “Bright” and “6 Underground” have yet to materialize. Instead, Netflix is only now in the works on follow-ups to some of its more mid-budget hits, including “The Old Guard 2,” “Enola Holmes 2” and “Extraction 2,” which also hails from the Russo brothers’ AGBO banner. And it’s also found success with its lower-budget teen films like the “To All the Boys,” “The Kissing Booth” and “The Princess Switch” franchise, among others.
All of these are positive developments but none of these look or sound like Disney-type mega-IP franchises. As Jeff Bock, senior media analyst with Exhibitor Relations, told Welk:“‘Cocomelon’ has more staying power than their big-budget popcorn pics. Simply put — they’re disposable.”
But even if they were actual foundations for a franchise, The Wrap's Drew Taylor highlighted Netflix's ecosystem is not fertile territory for franchises:
Levers that other animation studios at bigger corporations can pull, like consumer products releases or promotional tie-ins, aren’t pulled at Netflix. There weren’t “Kid Cosmic” action figures lining the shelves of Target. You couldn’t get a “City of Ghosts” Happy Meal toy at McDonald’s. There’s no theme park or dedicated retail space to exploit either. On the official Netflix Shop, there isn’t a single Kids & Family animated series represented.
In this light, I think Sarandos' story for investors in Q2 unintentionally reinforced my recent argument that Netflix needs different leadership to build franchises:
If the evolution into a next-generation Disney is a necessary objective to accomplish in order to create marginal value for consumers and marginal revenues for shareholders, then Hastings and Sarandos have proven to be the wrong management team for accomplishing that objective.
A Quick Note on Content Spend
Netflix management told investors it is “moderating our growth in content expense” with the $17B of cash content spend predicted to stay flat in 2023 and 2024. CFO Spencer Neumann shed some light on the “pretty big transition” towards a more original content-driven business, saying about 60% of its content assets on the balance sheet are originally produced content.
He also shed light on how the pandemic had impacted content spend: “We've got into production when we could, as quickly as we could in some things, including when talent was available. So that pulled forward some cash content spend in 2021 and 2022.”
Neumann sounded like he was managing the perception of Netflix burning cash on original content that generally fails to hit. That is not an unfair perception from investors given the struggle to build franchises. Without lasting franchises, Netflix will continue to struggle with its story justifying $17B in content spend.
India
On the Q4 2021 call, Co-CEO Reed Hastings admitted to investors with unusual candor that “the thing that frustrates us is why haven't we been as successful in India.” We saw both the positive and negative fruits of its solution of a new, aggressive pricing strategy in India.
Amazon has found success with aggressive pricing (Rs 129 or $1.73/month), and Netflix had originally opted to compete with a more expensive pricing plan. That changed in December 2021, when it announced it had reduced its pricing across the board by as much as 60%.
The positive fruits from this cost-cutting in Q2 2022 were subscriber growth in the Asia Pacific region (APAC) of 2.2MM subscribers since January 1, 2022, and a 10% increase in paid memberships in the region.
The negative fruits were financial: “[Average Revenue per Membership (ARM)] in APAC was -2% year over year on a F/X neutral basis, due to the impact from our price decrease in India last December as well as plan mix, which was partially offset by higher ARM in Korea and Australia. Excluding India, APAC ARM grew 4% year over year on a constant currency basis.”
This tells us that the necessary growth in India was dilutive, as management had originally feared when it originally launched with the highest prices in India.
Password Sharing & TAM
Sarandos closed the earnings call with an interesting statement: “Billions of people around the world love streaming TV and film, and we only serve a few hundred million of them. So the opportunity for growth here is enormous.”
But, is it “enormous”?
Former WarnerMedia CEO Jason Kilar thinks the ceiling for streaming “will be closer to 1 billion versus 200 million and change.” Netflix CFO Spencer Neumann recently told the Morgan Stanley Technology, Media & Telecom Conference that Netflix could replicate its market penetration in the U.S. globally because there will probably be “roughly 1B connected TVs around the world”.
Their password-sharing initiative - which they now describe as “paid sharing” - was described as being in the “early stages of working to monetize the 100m+ households that are currently enjoying, but not directly paying for" Netflix (they just launched a new test in Latin America).
By that math, assuming its 3 to 4 people per household, they’re only reaching 520MM to 620MM. So the opportunity very well could be 1B.
But if the right estimate is three to four members per subscriber, which would be mean Netflix may already reach almost 900MM people. So, it is not clear how they envision getting from 220MM to 1B by charging for password sharing and introducing a new ad-supported model.
The target of 1B subscribers seems, at best, hypothetical.
Conclusion: The PARQOR Hypothesis
The PARQOR Hypothesis argues that the media businesses most likely to succeed in streaming and beyond must meet five attributes, and highlights any missing pieces they (arguably) may need to solve to optimally succeed.
Those attributes are summed up in the BEADS acronym:
an Aspirational Brand
Existing user base at scale
Multiple Avenues to monetizing the same IP, and
Daily value proposition (something new for fans to consume daily)
Sales Channels: Online (digital) and offline (physical) commerce
I like to apply the PARQOR Hypothesis to Netflix because:
it assumes that Disney is the paradigm of the ideal media business model and,
Netflix management has consistently promised investors a Disney-esque future for Netflix and its library of original IP.
Netflix has 2.5 out of 5 attributes above because it is lacking an aspirational Brand, Multiple Avenues to monetizing the same IP, and offline Sales channels. Other than the acquisition of Animal Logic (IP), nothing in the Q2 earnings call seemed to bring Netflix marginally closer to solving for these missing pieces.
What will Netflix become if it fails to solve for the pieces it needs to build a next-generation Disney?
I think this earnings call did not give us any good answers. They are nowhere near building Disney's library of lasting IP or reaching 1B subscribers. Buying an animation studio seems like a marginal improvement given the failures of the past year.
So, even with five proposed solutions for growth, Netflix left important questions on the table about its post-pandemic future.
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