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Netflix, Inc. (NASDAQ:NFLX) has dropped by almost 70% over the past year towards a market capitalization of roughly $100 billion. The company has attempted to handle decreased subscriber count by putting pressure on account sharing and, now, moving into new businesses. As we’ll see throughout this article, we expect Netflix’s video game business to hurt it more.
Netflix Video Game Push
The company has announced video games as its next market for a while now. The company has announced a substantial expansion in its video game catalog from 24 to 50 games. However, less than 1% of its subscribers are engaged with the video games daily. Unfortunately for Netflix, these low utilization games are part of the same subscription bundle you already pay for.
What does that mean?
It means a company that’s already struggling with capital spending is spending capital to enter a new market completely for free. It’s an interesting strategy to say the least. It might have panned out if the launch was a hit, but the data seems to indicate otherwise. More so, it’s worth noting that initial subscriber growth is much faster than continued growth.
That indicates the current performance is the peak.
Another risk we see for the company is that, unlike streaming, there’s no first mover advantage with gaming. Other companies have been in the subscription business for a while. The company is already dropping $10s of millions on acquisitions here, while Microsoft (NASDAQ: MSFT) is spending $10s of billions it can comfortably afford.
We expect it’s unlike for the company to achieve a major foothold here and instead the business will become another source of capital.
Netflix Capital Conundrum
Netflix’s problem, accelerated by the video game push, is the company’s capital spending.
The company is up to $8.5 billion in net debt and it’s barely managing to maintain content spend with competitors. The company’s 2022 content spend forecast is roughly $17 billion. Disney’s (NYSE: DIS) content spending forecast for 2022 is expected to be $33 billion, Warner Bros. Discovery (NYSE: WBD) at $18 billion, and Amazon (NASDAQ: AMZN) at $12 billion.
More so, there’s two things worth noting here. First, Disney and Warner Bros. Discovery have been in the business much longer. Their existing production, talent, staffing, etc. are all lower cost because the company has more established networks. Second, the companies have many more sources of revenue from their content (i.e., Disney Cruises).
That means they don’t need the streaming business to cover all costs. The company’s annual revenue are roughly $30 billion, which means it spends around 60% of its revenue on content. Disney’s number is 43%, Warner Bros. Discovery is 45%, and ViacomCBS is at 51%. The similarity of the established companies indicates a more sustainable number.
It’s tough to generate strong profits when 60% of your revenue goes to content alone before any other expenses are factored in from day-to-day operations.
Our View
At the end of the day, corporate valuation is about reliable profits.
The company’s revenue growth has stagnated. After modest 1-2% revenue growth from 1Q 2022 to 2Q 2022, the company expects 3Q 2022 revenue to drop 2% QoQ with <5% YoY growth. That’s despite a slight increase in subscriber count. The company is struggling to break 220 million subscribers / $30 billion annualized revenue.
Competition across the industry is strong. Competitors haven’t been raising prices like the company has for subscribers. The company’s free cash flow (“FCF”) for the TTM is negative. From these factors, we struggle to see how the company will build the financial results to justify a $100 billion valuation or even growing from that valuation.
Thesis Risk
The largest risk to the thesis is Netflix’s ability to manage expenses and switch to FCF. Historically, the company has needed to ramp up content spending to compete, but as indicated by Warner Bros. Discovery’s recent earnings, there’s a desire in the industry to spend less and a race to spend less. The company’s costs could go up as revenue maintains or increases, supporting profits.
Conclusion
Netflix’s 2Q 2022 results were better than the company guided for, however, still nothing to write home about. The company lost 1 million subscribers with slight revenue growth. For the 3Q 2022, the company is forecasting to get those subscribers back, but with a decline in revenue as a result. The company’s video game business, in our view, adds to that problem.
It’ll cost the company capital expenses, but most subscribers seem to be ignoring it, and we don’t see a path to the business paying off. We do see a path to higher capital requirements. Overall, we don’t see a path to the company justifying its valuation or growth from its current share price, making the company a poor investment.
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