Regular readers will recall I have been following Netflix (NFLX) for many years (I wrote up some initial thoughts on this blog a few years ago), but as the service has grown from ‘challenger’ to ‘near-ubiquitous’, I find myself returning more often to the company, its growth philosophy, and the underlying existential question for any business: will it every be sustainably cash-generative?

This post was sparked by a recent discussion I had with a friend on the topic. More bullishly-inclined, he made the (reasonable) argument that NFLX was smart to swap profits/cashflows for more subscribers today, because once ‘at scale’ the company could trim its content (and marketing) spend and still provide a compelling service – so compelling, he thought, that NFLX could also raise prices substantially. My bearish counter was based upon two points: 1) the benefits of scale from this point have diminishing returns, because a huge amount of incremental content spend is not universal in demand (the incremental subscriber is not invariably a high-paying English-speaker and so needs unique local-language content that in most cases cannot be amortized globally); and 2) even if we granted them point 1) was theoretically possible, the recent history of the company – as it has grown from 50mm subscribers to 135mm in the last 5yrs – has actually demonstrated the opposite property: more incremental spend on content for less incremental benefit, not the other way around.

This second point in particular got me thinking – can we demonstrate, numerically, exactly how much more expensive it has been for NFLX to grow in recent years as the business has expanded beyond its home market (the US and English-speaking markets)? This is something I’ll explore in this post.

How much is a new subscriber worth? The ‘traditional’ method

Let’s start with some basics. For most subscription-based businesses, Silicon Valley types try to measure the value of the proposition by comparing the cost to acquire a new subscriber (‘customer acquisition cost’, or CAC) with the ‘lifetime value’ (LTV) of that acquired customer. CAC is quite easily defined: it is simply marketing expenses dividend by net new customers acquired in the period. This is how it looks for NFLX since 2014 (using TTM numbers to smooth quarterly fluctuations in marketing spend):

So CAC has increased from <$50 to ~$75/paid member in the last 5yrs – not great, perhaps, but understandable in the context of a largely-penetrated home market that is subject to increasing competition (the US); and more aggressive international marketing in countries where NFLX was less well-known or where OTT TV was less understood (the rest of the world).

Of course, to provide meaning to the CAC, we need to compare it to LTV, since if LTV is similarly increasing, paying a higher CAC wouldn’t really be a problem. LTV, however, is slightly more complex to calculate than CAC, because we need to make an assumption regarding how many subscribers NFLX loses on an annual basis (‘churn’) – a number NFLX conveniently has declined to disclose since 2010. We also need to make an assumption regarding the future earnings power of each subscriber (measured in terms of gross profit per subscriber in a given period).

Still, we can take a shot at it. In the below, I have assumed annual churn is 25% (so just over 6% per quarter); this is actually lower than cable TV churn (around 7% a quarter), despite the fact that NFLX is cancellable any time without penalty, so I would argue this is not aggressive. I have also simply aggregated gross profits (again on a TTM basis to smooth quarterly fluctuations), and as a result LTV (over a similar period) looks something like this:

You can see that despite the fall-off in LTV in recent quarters, the absolute number (around $180) is still well in excess of CAC ($75-80) – meaning when we plot the all-important LTV/CAC ratio chart, we see that despite the decline of late, growing subscribers still appears to be value additive to the enterprise (even if the pace of recent decline should be of some concern):

So when measured in the ‘traditional’ way, NFLX’s astounding subscriber growth still appears to be generating net positive lifetime value per customer to the company (uncertainty around churn not withstanding), validating the bull thesis, right? Not so fast…

The increasing cost of content bogey and the need to adjust LTV accordingly

The main problem with the above approach is a conceptual one: once the customer has been acquired (through marketing spend), the assumption is made that – for those customers that don’t churn out – you don’t need to ‘re-acquire’ them – whatever you spent in marketing dollars to get them in the door, that is the total cost to you to keep them on board. But what about the cost of maintaining them as a subscriber? In many software/SaaS businesses (where this methodology originated), that may truly be a very small incremental cost. But NFLX makes no secret of the need to spend exponential amounts of money on new content that – purportedly – drives more eyeballs – but (and this is the key) in reality exists to maintain existing subscribers. I think it’s fair to consider incremental content spend by NFLX as an added cost to maintaining its subscriber base for three simple reasons: 1) not many people watch the same content twice (meaning once consumed, content needs to be replaced); 2) increasing engagement – something NFLX is ironically proud of – increases the velocity of needed content replacement, effectively driving up the maintenance flywheel against the company; and 3) alluding to my earlier point, a lot of the new content being created in recent years has a much smaller intended audience than earlier content (given increasing localization, etc).

In other words, the traditional metric associated with measuring the value of a customer needs to be modified, to account for the excess $$ being dedicated to growing the content pool which – even if amortized over an increasing number of paid users – should nevertheless be thought of as the cost to ‘re-acquire’ the customer, continually, to stop them quitting and going to another service (of which there are now many, and growing).

Here’s how I’m thinking about it. In the traditional LTV calculation, we look at gross profit per subscriber to estimate what the potential value that customer could bring in over its lifetime could be (before he/she churns out). ‘Gross profit’ is essentially average revenue per user (that is, average monthly subscription cost) less the total cost to deliver the content to the customer (the overwhelming majority of which is content amortization, in other words, content production costs spread over a 10yr assume content ‘life’).

But the strict income statement entry – ‘cost of revenue’ – is, as we have discussed, not the only run-rate cost of content to the company: NFLX has been spending more and more on content, in escalating fashion in recent years, and this is reflected in the difference between the content amortization cost in the income state (‘Cost of Revenues’ in the PnL) and the net incremental cash out spent on content costs (in the Cash flow statement).

Pulling it all together from NFLX’s financials, here is the incremental content spend (again TTM for smoothing) over the last five years:

It’s worth dwelling on the significance of the above. Five years ago, NFLX was spending ~$500mm a year on content than it was currently amortizing; today that number is almost 10x greater ($4.5bn) and they are still guiding to spend more!

Of course, this escalating content spend has come along with massive subscriber growth so we need to relate the increased spend to the enlarged subscriber base. Below, I show the incremental content spend beyond the PnL, on a monthly basis (using the average TTM paying subscriber base as the denominator) – you can see that even on an equalized basis, NFLX is spending >3x the amount on incremental content beyond the PnL, per subscriber, than it was in 2014…

Coming up with a modified LTV/CAC calculation

Considering the above, I think it’s fairly obvious that we need to modify the ‘traditional’ LTV/CAC metric to account for this increasing cash cost of content (even if it hasn’t made its way into the PnL yet). We can do this simply, by subtracting the incremental content spend, from the gross profits, per paying subscriber (we don’t need to change any of the CAC calcuation, since marketing costs don’t need adjustment). We do this, and voila, all of a sudden (what I would argue) the true LTV/CAC doesn’t look so rosy (including the ‘traditional’ LTV/CAC for comparative purposes):

I consider the above chart fairly damning evidence against the NFLX bull narrative, as it demonstrates a) the business has essentially been adding negative value subscribers since late 2016 (when content spend really kicked into high octane); and b) the increasingly negative value nature of the proposition has been accelerating in recent quarters.

However if you were a bull, and even if you were willing to acknowledge my methodology had merit, you might push back in some or all of the following ways:

1. this methodology doesn’t take into account future price increases;
2. NFLX won’t have to spend current levels on content in the future;
3. NFLX can increase revenues in other ways (advertising, etc).

Of these, I think 2) is fairly easy to dismiss, since NFLX has avowed publically they will continue to outspend all the competition on content, for the medium-term – and since competition is only increasing (Disney+, Hulu, Amazon Prime video, HBO go, CBS, Apple, etc etc), and since some of these competitors view OTT almost as a loss-leader (Amazon, etc), I don’t think it’s really credible to envisage a world in which NFLX voluntarily cuts content spend (as opposed to one in which the market forces them to slow down spending ). Similarly, 3) is fairly anathema to what NFLX is purportedly trying to create – ad-free high quality on-demand content – and I would expect churn would sky-rocket if they introduced ads onto the platform. And once again, given the competitive landscape, this seems unlikely unless most/all competitors move in a similar direction.

This leaves price hikes. I think the point is a reasonable one, and has been pursued by NFLX historically – the question is really one of scale. Certainly there is scope to hike prices somewhat, especially in developed markets; but NFLX is increasingly an international story (essentially all sub growth comes from outside the US now) where the legacy of high cable bills (and level of GDP wealth) is simply smaller. Today, over half the subscriber pie is international, and with the US mature, this ratio will only grow – limiting, I think, the upper bound of price for the increasing majority of subscribers

Moreover, we still need to question the scale of any price hikes in relation to the escalating content bill. The chart below shows the percentage of ARPU that is currently consumed by incremental content spend beyond the PnL: this number was 10% in 2014 but is nearly 30% today:

That is to say – NFLX could manage to raise prices 30% across the board, unilaterally – and it would still only bring ARPU into line with the escalating cost of content (assuming it stopped where it is, which it won’t). That kind of price increase may be stomachable in the West (even at the cost of a big jump in churn, perhaps temporarily), but it would necessarily price out large portions of the emerging world (that NFLX needs for its growth story).

Where does that leave us?

This has been a long exploration, but I’m fairly confident reiterating my early prognostication: NFLX is an amazing service, but I really can’t see how it will ever generate sustainable free cash flow, let alone an adequate return on capital – let alone a return adequate to justify the current $180bn valuation (!). That doesn’t make it a short (and I’m not), but unless you expect an uber-benign future where NFLX is free to raise prices with impunity whilst reining in the excessive content spend it and its competitors have been enacting exponentially, it certainly doesn’t make it a long either.

Disclosure: no position in NFLX