Is Subscriber Growth Enough for Netflix Stock (NFLX)?

Netflix Stock
Credits:iStock.com/guirong hao

Netflix Stock Up After Earnings

Netflix, Inc. (NASDAQ:NFLX) reported second-quarter earnings this week, and although the NFLX stock price jumped more than 10% in response, I think we should re-examine why we love Netflix stock. For example, what is the yardstick for measuring NFLX stock?

Revenue? Profit? Cash flow? Of course not. We measure Netflix’s progress by subscriber growth. Which means that the current bump in the NFLX stock price is based on popularity.

In the last quarter, the number of subscribers grew from 99 million to 104 million. Much of the expansion comes from overseas, where Netflix added 5.2 million users in three months. (Source: “Netflix 2017 Second-Quarter Letter to Shareholders,” Netflix, Inc., July 17, 2017.)

That’s all well and good, but investing is a money game.

Sooner or later, Netflix has to make a profit. But I’m not sure the company can…it’s burning too much cash right now. And rather than trimming those costs, the company is deliberately increasing them.

Just look at the amount of money Netflix spends on “original content.” The company backs up a Brink’s truck for shows like House of Cards, Stranger Things, and Orange is the New Black. Why? Because these shows are supposed to draw in new subscribers.

And they do, for the most part.

Netflix added 19 million users last year, 17.4 million in the year before that. This crescendo of new subscribers is mostly due to increased “original content” spending, which rose from $4.0 billion to $5.0 billion. (Source: “Netflix 2016 Fourth-Quarter Letter to Shareholders,” Netflix, Inc., January 18, 2017.)

But there’s a hidden cost that no one is talking about. Namely, the cost of “customer acquisition,”or to put it in clearer terms, how much Netflix spends to get each new customer.

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The numbers are eye-opening. In 2015, Netflix spent $230.00 per customer, and in 2016, that number jumped to $263.00. New subscribers are getting more expensive!

What Does This Mean for Netflix Stock Price?

This can’t be good for the NFLX stock price. Even if you dig further into Netflix’s past, the trend remains true. In 2014, for instance, the company was spending around $230.00 per customer. (Source: “Netflix 2014 Fourth-Quarter Letter to Shareholders,” Netflix, Inc., January 20, 2015.)

Now let’s put that in context of the Netflix stock price. At the same time that customer acquisition costs were rising, the share price climbed 193%.

NFLX stock chart

Chart courtesy of StockCharts.com

Investors were (and are, for that matter) so starstruck by Netflix’s subscriber growth that they kept rewarding the company. Never mind that Netflix would need to keep those customers locked in for more than two years before breaking even.

Economics 101 says that unit costs should fall as companies get big. I think, at 104 million users, it’s safe to say that Netflix is “big.” So why is Netflix finding it more expensive to bring in new customers?

I personally blame “Amazon Prime,” “Hulu,” and “HBO GO.” Although they don’t spend nearly as much on original content, they are an existential threat to Netflix. Which basically means that Netflix has no choice but to expand its roster of original content.

Netflix needs to cement its relationship with viewers.

Let me give you an example for clarity’s sake. Imagine this were a naval war. Netflix is a powerful ship sailing through hostile territory. Suddenly, it’s besieged by an armada of enemy ships. Torpedoes are fired on both sides.

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One of them lands a devastating hit on the U.S.S. Netflix, leaving the hull in tatters. Water gushes into the ship! Everyone on board starts pumping furiously, trying to get water out just as quickly. Are we to be impressed at how fast they are pumping out water? Of course not!

All that matters is that more water is coming out than going in, because if not, the ship will sink.

Just to be clear, I don’t think Netflix’s situation is quite as serious as a sinking ship. My main point is that Netflix sends more money out than in and that perhaps we should pay more attention to that fact.

Conclusion

It may surprise you—especially after reading this article—but I am bullish on Netflix stock.

I love Netflix. I use it every day. Heck, Reed Hastings is even one of my favorite CEOs. But that doesn’t mean I follow him blindly. If you don’t want to get sideswiped by “black swans,” you have to consider it from every angle.

In other words, you need to find the weak spots of the investment. Just take a look at the past correlations between Netflix’s subscriber growth and its impact on NFLX stock price:

Date Subscriber Growth NFLX Stock Reaction
2Q 2017 5.0M +16.0%
1Q 2017 5.0M Flat
4Q 2016 7.0M +4.0%
3Q 2016 3.6M +21.6%
2Q 2016 1.7M Flat
1Q 2016 6.74M +7.4%
4Q 2015 5.59M -3.2%

You may notice that the correlation isn’t that strong. Each time the market found something new to gripe about. Sometimes it was “domestic additions are subpar”; other times it was “international subscribers aren’t getting on board quickly enough.”

Only one thing will silence the critics: Profits, and lots of it. No matter how complicated investing seems, it ultimately comes down to that one metric.