In the year 2000, executives at the then mighty Blockbuster video company, were on the receiving end of a pitch from a loss-making start-up company, seeking $50m to fund their expansion in the nascent market for rental DVDs by post.
The pitch was made by the company’s co-founder Marc Randoph, and its name was Netflix. Blockbuster’s CEO famously “laughed (Marc) out of the room”, rejecting the business model as being “dot-com hysteria”. The rest, as they say, is history.
Having taken on the DVD rental market and won, Netflix’s ultimate success came from its strategic decision to move away from that market and into the nascent and competing world of streaming video content. A bold and visionary decision to sacrifice its core offering for an ultimately much bigger prize.
Netflix took advantage of faster and larger broadband and mobile connectivity capabilities to offer streaming content, in real time, direct into homes and mobile devices. Whilst YouTube gets the credit for being the pioneer in this technology, Netflix was the first to master taking studio-made content and distributing it to consumers for a monthly subscription fee.
Its early success was supported by exclusive content such as Breaking Bad and House of Cards, where word-of-mouth spread rapidly and provided incredible free viral marketing for the brand.
Initially the legacy Hollywood studios saw Netflix as just another means of distribution and they sold it their content on license. This quality content further fuelled Netflix’s success as it more rapidly acquired new subscribers and captured a greater share of viewing hours.
The established studios realised, too late, that they had allowed the fox into the hen house and before they could remove their content, Netflix had disrupted them and “stolen” their share of viewing hours. Equally importantly, Netflix had established a clear technological lead over its peers that persists to this day.
For its first decade of streaming success, Netflix funded its growth largely through debt. To grow subscribers it needed lots of content and it was willing to pay the highest price for the top talent in Hollywood.
Ryan Murphy left Fox to join Netflix in a $300m deal and Shonda Rhimes joined from ABC for $150m. Hollywood stars also signed big deals, Adam Sandler completed a four-movie contract for $275m and Barack and Michelle Obama and Prince Harry also signed big-ticket deals.
This investment in talent has been rewarded, especially as the rise of streaming TV has enabled global distribution to maximise ratings. In 2023 the series The Night Agent was viewed in total for a staggering 972 million hours by Netflix subscribers, or four hours by every single global subscribing household.
The top 100 series in 2023 were collectively viewed for 34.5 billion hours. These figures dwarf typical legacy domestic ratings. In a relatively short period of time, Netflix has become the undisputed champion of streaming TV content.
Today, Netflix has more than 280 million subscribers around the world, all paying a monthly subscription. In 2022 it reached a size and scale that resulted in accelerating incremental margin expansion that enabled the company to become self-funding and cash flow positive.
In 2023 Netflix’s free cash flow was $7bn and its net-debt to EBITDA ratio had fallen to 1.3x. This sets the company up very well for the next phase of growth to come, driven by the following opportunities:
Advertising
In late 2022 Netflix launched a subscription offering that included adverts that today has 70m subscribers worldwide. The low monthly cost is just $6.99 (or £4.99 in the UK), vs. the premium no-ads price at $22.99 a month and, of course, Netflix is now earning advertising revenues that covers the gap in the lower subscription fees.
The offer has reduced customer churn levels to an estimated 2%, by far a best-in-class level, making its business more defensive in the process.
Subscriber growth
Netflix surpassed expectations with its efforts to clamp down on password sharing. This boosted subscriber growth in its mature markets, but it is fair to say that growth in the US and Europe has now matured. However, Netflix is a global company with global content. Latin America and Asia-Pacific both have more than 45 million subscribers with both regions growing at a double-digit rate.
Pricing
Netflix’s most expensive price point is $22.99 a month whilst a typical cable TV package costs $100 a month (and can go as high as $250 a month). A Netflix subscription is extremely cheap in comparison.
New content
Netflix is broadening the range of content it offers to attract new subscribers and generate advertising revenues. In October it streamed a live boxing match between Mike Tyson and Jake Paul that was watched by 108m households.
On Christmas Day it streamed a live NFL game with Beyoncé performing a half-time show. Netflix has also launched a streaming gaming offering which, as compute power advances, has the potential to replace the need for gaming consoles in the future.
The outlook for Netflix and its investors today is encouraging. It has become the clear global leader in both content creation and content distribution, it has built a defensive subscription revenue business model with low churn to which it can now add highly profitable advertising revenues, without the need to increase content costs. The implications of this for margin expansion and cash flow growth are very positive.
Earlier this year we initiated a position in Netflix on the promise of its future growth in advertising, subscription revenues, margin, earnings and cash flow, as well as the outstanding quality of its management. The company has disrupted the entire global media industry, whilst at the same time delivering its customers an outstanding product.
Gerrit Smit is manager of the Stonehage Fleming Global Best Ideas Equity fund. The views expressed above should not be taken as investment advice.