CEO Of Netflix, Reed Hastings, attends the red carpet during the Netflix presentation party at the Invernadero del Palacio de Cristal de la Arganzuela on April 4, 2019 in Madrid, Spain. Juan Naharro Gimenez | Getty Images



The record number of Golden Globe and Oscar nominations, better-than-expected Q4 revenue and 8.8 million new international subscribers paint an impressive picture of Netflix's growth metrics, and the stock responded positively to its most recent earnings report. However, those who look closely at the numbers find reasons to worry about the stream media giant's growth story and continue to wonder if it will be forced to lower domestic prices. The company's fourth-quarter earnings report, its first since rivals Apple TV+ and Disney+ hit the market, flagged slowing subscriber growth in the U.S. The streaming giant added only 420,0000 U.S. subscribers, far below the 600,000 guidance, making it the third quarter in a row Netflix came up short on domestic subscribers. A similar story played out in Canada, where Netflix added 125,000 paid subscribers for the quarter, significantly lower than the 218,000 it netted in Q4 the year before. As it spends heavily on original content — up to $15 billion annually — the future of Netflix pricing models is an issue that appears to be growing with each passing quarter. Netflix conceded slowing membership growth in North America was a result of last year's price hike and growing competition in its backyard. The competition will continue to increase, with advertising-funded Peacock from Comcast's NBCUniversal and HBO Max from AT&T's WarnerMedia set to stream into the market this spring. There's a compelling case for price tweaks as a way for Netflix to keep and add consumers and stave off lower-priced rival services that are scrambling to peel away its customers. "Customers are more price-sensitive than previously thought, and competitors like Disney+ are already undercutting Netflix's prices," wrote Morningstar equity analyst Neil Macker in a recent report. "This price differential will cause lower subscriber growth than we had previously expected." In the least, he added, the competition "will constrain Netflix's ability to raise prices without inducing greater churn."

Millions of subscribers in play

Needham analyst Laura Martin, who has had a sell rating on the stock since last year, said Netflix is on course to lose as many as 4 million U.S. subscribers this year. She said the streaming player must roll out a pocketbook-friendly plan if it hopes to remain in the game. "Netflix must add a second, lower-priced service to compete with Disney+, Apple+, Hulu, CBS All Access and Peacock, each of which have $5–$7/month choices," she said. A new $5–$7-per-month pricing tier, subsidized with ads, is the best option for Netflix, she said. It attracts lower-income customers, stems the practice of using other people's passwords and adds a new pricing lever by increasing ad loads rather than raising subscription, Martin said. However, Netflix has ruled out an advertising-based model, at least for now, based on comments from the recent earnings call. The company's executives said it is difficult to compete with internet giants like Facebook, Alphabet and Amazon when it comes to an ads-based model, and the company also worries about the broader internet privacy debate. "If you wanted to succeed in online advertising, you can't just have a little data," Netflix CEO Reed Hastings said on the earnings call. "To keep up with those giants, you've got to spend very heavily on that and track locations and all kinds of other things that we're not interested in doing. We want to be the safer spy where you can explore, you can get stimulated, have fun, enjoy, relax and have none of the controversy around exploiting users with advertising." Netflix did not respond to a request for additional comment.

Indian commuters travelling past large billboards in Mumbai for 'Sacred Games', Netflix's first original Indian series. The streaming giant is locked in a battle with Amazon Prime for a slice of India's fast growing on-demand video market. INDRANIL MUKHERJEE | AFP | Getty Images

Netflix isn't stranger to slimmed-down subscription plans. It has been testing a cheaper mobile-only $3 a month plan in India, one of its key developing markets. The success in India, a highly crowded market bustling with local and global players and low-cost plans, prompted Netflix to expand its skinny mobile offering to Malaysia and Indonesia. "We've added this price at a lower price point [and] we've been able to add incremental subscribers," said Gregory Peters, chief product officer at Netflix, on the Q4 earnings call. "We've seen increase in retention ... and net that's a revenue positive action for us." He added that was "a pretty good indicator that there might be other countries around the world where that kind of offering will work as well." In December, multiple press outlets reported that Netflix introduced subscription discounts of up to 50% for longer-term plans in India — three-, six- and 12-month plans. A company spokeswoman referred to the offering as a "test." There's data linking Netflix's subscriber growth in India to cheaper plans. "What we see in India with regards to Netflix is that daily active users have been picking up since they launched their new pricing last year," said Ed Lavery of SimilarWeb, a U.K.-based mobile analytics firm. But SimilarWeb data also shows Netflix app's daily active users fell an estimated 3% internationally and nearly 6% domestically, prompting Lavery to say, "it's going to be a challenging environment for Netflix." If Netflix doesn't move to trim its pricing, the subscriber churn could escalate, Martin said. "International sub growth will not support NFLX valuations, because U.S. subs are about three times more profitable than offshore subs," she said. International growth is increasingly coming from $3 per month mobile-only subscribers, so it would take four of these subs to offset revenue lost from a single U.S. sub. If Netflix continues to lose U.S. subscribers, it's valuation multiple will plummet, leading to Netflix losing its growth stock credentials, Martin argued. Macker said over time "Netflix will expand further into local-language programming to offset the weakness of its skinny offering in many countries." More local content means more regional subscribers and ultimately more revenue. Macker said the move "will likely generate a competitive response from the firm's global and local rivals, which will augment their own first-party content budgets."

The cost of licensing content will continue to rise as competitors emerge and bid for content that Netflix is interested in, according to Macker. Netflix management has indicated that the cost to develop premium content has increased about 30% over the past year, Macker noted — the company spent more than $14 billion on content in 2019 and reported negative free cash flow of $1.7 billion for the fourth quarter, projecting negative free cash flow of about $2.5 billion for 2020 — that would be lower than the peak cash burn year of 2019, and J.P. Morgan analysts wrote in a post-earnings wrap that Netflix is "turning the corner" with material improvement in free cash flow burn. "Netflix's balance sheet cannot withstand larger cash losses," Martin said, asserting loss of U.S. subscribers will worsen the firm's negative cash flow woes. "Profit contribution of each U.S. sub is about three times higher than each international sub, implying NFLX's negative FCF worsens quickly as U.S. subs fall, which requires more capital from public debt or equity markets." Netflix officials argued on the call that the market's view of cash flow is one of the things most often misinterpreted about it. "I think what's most misunderstood is the business model and what you see in our cash flow generally. And folks thinking that we are losing money, if you will, when we — what we've shown is that we are increasing our profitability ... and growing our profit margins," Spencer Wang, vice president of investor relations and corporate development said on the earnings call. "We've been going through a really kind of pretty significant transition of our business model from licensed content where you pay basically ratably for content you receive over the time and it's on the network to original content not just licensed originals, but self-produced originals where often times we're investing many years before that contents on the service. ... it fundamentally changes that cash flow profile over time." Margins have increased over the past three annual financial periods.

How binge-watching affects Netflix

The binge-watching model Netflix created has contributed to its current financial profile. "Because binge-watching is so prevalent and easy on Netflix, viewers watch Netflix's library faster and run out of things to watch," Martin said. "The more hours a household watches Netflix, the faster Netflix value proposition falls and the lower the probability of subscription renewal." It doesn't help that Netflix has no annual subscription option. Consumers can cancel their subscription whenever they please, without any penalty. Often subs pay for one month of Netflix to binge-watch their favorite original programs or new seasons and then cancel. Guggenheim Securities analyst Michael Morris, who hosted the earnings call with Netflix, asked about annual pricing versus monthly pricing and "perhaps a discount for consumers who choose to take an annual plan." Netflix officials were vague in response to this idea, though, with Peters saying, "I think we'll see sort of what the right solution is for consumers as we shift to this online streaming world," and then quickly shifting the focus to another question posted by Morris about bundled service offerings through partners like pay TV operators. Martin argues a cheaper monthly plan, of roughly $6 a month, is the best way to limit the rate of attrition in the U.S. by offering consumers a "price-to-value ratio comparable to other OTT entrants that have expensive originals, large content libraries and strong free cash flow."

Netflix doesn't have to change its mind, but we think it's valuation multiple will suffer if it loses U.S. subs and is no longer a growth stock. Laura Martin Needham analyst