To Grow Faster, Netflix Must Reinvent Itself Again

Netflix’s growth rate is slowing down. Can its leadership team revive that growth as the pandemic ends? As its second quarter earnings announcement approaches, investors must assess whether expanding its presence in the $180 billion gaming industry will be enough to revive its growth rate or whether Netflix must reinvent itself for the third time.

(I have no financial interest in the securities mentioned in this post).

On July 15 before the market opened, Netflix stock traded 6% below its all-time high of $593.

But over the longer term, it has been doing well. In the decade ending December 2020, its revenues grew at an average annual rate of about 28% while its stock rose at a nearly 36% average annual rate.

Netflix reported a strong first quarter — but disappointed on subscriber additions. According to Tipranks, its first quarter revenues grew 24% to $7.16 billion while EPS more than doubled to $3.75. However, paid net subscriber additions in the quarter were four million — 33% below what Wall Street had estimated.

For the second quarter — which Netflix will report on July 20 — Wall Street expects revenues of $7.32 billion — 19% above the Q2 2020 amount, according to CNBC — and adjusted EPS of $3.16. Netflix predicts it will add a million new subscribers worldwide — 90% below 2020’s second quarter, noted Tipranks.

Netflix expects strong demand in Asia Pacific and Latin America “to fuel top-line growth in the upcoming quarter.” Moreover, churn — the percentage of subscribers who leave Netflix — was down in the first quarter while viewing per household rose, according to Tipranks.

Netflix — which has signed new content deals and will make new seasons to popular shows available to subscribers — noted in a statement, “We are optimistic about the future and believe we are still in the early days of the adoption of internet entertainment, which should provide us with many years of growth ahead.”

The expected growth slowdown from its long-term trend should concern investors. So should declining visits to Netflix’s web site.

Similarweb emailed me on July 15 that its data indicate a decline in second quarter unique visitor growth and audience engagement — as measured by visit duration and number of pages visited.

While the U.S. has experienced a more meaningful drop, things are better outside the U.S. “YoY growth slowed dramatically from 16% in 1Q21 to just 1% in 2Q21. Similarly, for the U.S. total unique visitors dropped from 4% YoY growth in 1Q21 to -8% in 2Q21,” noted Similarweb.

According to Ed Lavery, Director of Investor Intelligence at Similarweb, “We are seeing a strong decline in visitors to netflix.com across both international and US markets, which could be a sign of declining engagement in the platform. However when we look at Net adds, which we can track through visits to the sign up and cancellation pages, we are still seeing nominal growth. The overall impact that we see, is that as countries come out of lockdown, people are probably spending less time streaming, but this probably is not translating into such dramatic churn just yet.”

After reinventing itself twice, the growth imperative may demand that Netflix do that again.

As I wrote in my latest book, Goliath Strikes Back, Netflix’s CEO, Reed Hastings first presided over the successful 1999 launch of a DVD-by-mail service. Its second reinvention came to light in 2007 — after developing a new set of corporate capabilities — when Netflix introduced an online streaming service that by 2019 had attracted 166 million paying subscribers.

In thinking about what Netflix’s next reinvention might look like, it is worth pointing out that new businesses are initially glitchy. In 2007, Hastings debuted Netflix’s second act — online streaming to PCs.

The new service preceded premature predictions of Netflix’s demise at the hands of Walmart’s later-aborted DVD-by-mail service and a service to download movies to TVs offered by Apple and Amazon — which did not gain traction with consumers.

Investors panned Netflix’s online streaming launch — citing the high investment required to introduce the service, the large number of rivals, and Netflix’s lack of competitive advantage (its DVD-by-mail logistics skill would be of no use).

In 2007, Netflix saw two big barriers to widespread adoption of online streaming: Technology had not advanced sufficiently to stream and display video quickly with high visual quality, and the reluctance of movie and TV content producers to cannibalize their theater, cable, and advertising revenues.

Blockbuster, which had launched its own DVD-by-mail service in 2004, was the biggest potential rival to Netflix. Hastings was prescient when he remarked that investors were rightly skeptical of Silicon Valley companies that could not innovate a second “generation of computing.”

It was not until 2011 that Netflix announced it would do something about its inability to stream new content — it spent $100 million to produce 26 episodes of House of Cards. In September 2011, Hastings — who was afraid of being too slow to move away from DVD-by-mail — blundered by announcing the company would split into two: one offering DVD-by-mail and the other online streaming.

Moreover, Netflix boosted the combined subscription fee by 60%. Subscribers balked, and Netflix quickly rescinded the price increase. When House of Cards launched in February 2013, its popularity soared, and Netflix’s stock price ended the year three times higher than it had begun.

Investors should bear in mind Netflix’s online streaming challenges when they consider whether its effort to start publishing video games will be its third reinvention.

As ArsTechnica reported, Netflix has has hired a former EA executive to help it grab a piece of the gaming industry. Gaming is a crowded space — but if Netflix can offer gamers a better experience than rivals, it could gain market share.

It helps that Netflix has hired “Mike Verdu, who most recently worked in developer relations with Facebook’s Oculus VR team (his public profile still says that’s his current job). He has worked in game development and publishing since the early ’90s, and his first studio, Legend Entertainment, was eventually acquired by GT Interactive,” according to ArsTechnica.

However, as with its launch of online streaming, Netflix would need to solve considerable technical problems to deliver games without buffering across all devices. Ars Technica notes, Netflix must be able to support “streamed games on all existing devices and operating systems, which each come with their own hiccups.”

It also poses questions about whether Netflix will offer “competitive, cloud-based button-tap latency” and provide “installation trickery to bypass storefronts’ aggressive rules about individually reviewed and rated games.”

Can Netflix outcompete the many rivals in the gaming industry? If not, what other reinvention does Netflix have up its sleeve to accelerate its revenue growth?

Analysts’ are generally optimistic about Netflix — with an average price target of about $606.

Tipranks notes that JPMorgan analyst Doug Anmuth forecasts 2 million net additions for Q2 — 400,000 more than his previous forecast. Scott Devitt of Stifel Nicolaus sees results inline with the consensus estimate.

He is more optimistic about the second half of 2021. “We expect accelerating subscriber additions in 2H:21 supported by a stronger content slate as the company moves past a period of pull-forward digestion and fewer content additions,” Devitt wrote.

I think Netflix needs to reinvent itself for a third time and I am not confident that gaming will be enough to accelerate its revenue growth rate. Perhaps it can prove me wrong or has something completely different in mind that has yet to see the light of day.

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