Spotify and Netflix need to hit the next button

• Global
• Nasdaq, Netflix, Spotify, Tech
• June 14, 2021

The world’s biggest streamers are slowly exiting their Cool Eras. Every innovative company eventually goes from being Cool, where every new development they announce is exciting and widely talked about, to Commonplace, where the company is ubiquitous and well-regarded but consumers are satisfied that they’ve seen all the tricks it can offer.

That’s the trouble. Commonplace often correlates with stagnation.

Social media has largely been stagnant since 2016 – when Instagram copied Snapchat’s Stories feature and Facebook cornered the market. TikTok’s groundbreaking algorithm and Clubhouse’s drop-in audio features are promising for the space – but both face tough competition from Twitter, Facebook and Snap.

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Ride-hailing and food delivery services haven’t innovated as much as they’ve spawned multiple ‘race to the bottom’ competitors to Uber. However, if they can’t agree with regulators on how to classify their drivers, they’ll find themselves transitioning into the worst of the eras: the Uncool Era. No one wants to be questioning their ethics when ordering a burger.

This is where streaming’s biggest giants find themselves. Spotify is trying to find a path to profitability in audio while Netflix is trying to stave off competition in film and TV.

Spotify’s Big Bet

Spotify has its roots in music streaming but has since pivoted to bet big on all things audio – podcasts, audiobooks and live conversations. While Spotify is known for its remarkable scale (356 million monthly active users) and impeccable algorithm, its financial statements are fairly unremarkable in comparison:

• Due to it being dependent on major music labels for content, much of Spotify’s revenue is paid to rights holders, and this has a large impact on its gross margin.
• Spotify’s Q1 2021 gross margin percentage was 25.5% – consisting of 27.9% from its Premium segment and 4.4% from its Ad-Supported segment (which has been the largest driver of its podcast business).
• Furthermore, Spotify’s Ad-Supported monthly active users (MAUs) are growing faster than its Premium MAUs (27% compared to 21%). This may be positive for its podcast business, but will further erode its gross margin.
• Spotify reported a rare operating profit of €14m (at a 0.7% operating margin), but its full year guidance is an expected operating loss of between €150m and €250m (FY20 operating loss: €293m), and subscriber growth of 19.4% at the midpoint of the guidance. That’s troubling considering Spotify maintained growth levels of 30% from 2018 through the first quarter of 2020.

Spotify’s share price is down around 20% year to date, compared to the Nasdaq-100 which is up around 10%. Investors seem to be asking themselves: where to from here?

Spotify has spent close to $1 billion on podcast-related acquisitions and production, aiming to replicate Netflix’s model of owning the content on its platform instead of licensing it, but that hasn’t moved the needle on its gross margin nor has it evidently led to an increase in subscriber growth. Plus, where it’s possible to imagine a future where Netflix only has original content on its platform, Spotify has no plans to launch its own record label and cannot rely solely on the quality of its podcast business.

This essentially puts pressure on Spotify’s gross margin and free cash flows into perpetuity, whereas Netflix primarily feels the pressure on free cash flows as it builds a content library.

Spotify reported that 25% of its total MAUs engaged with podcast content and the company is convinced that podcast consumption will drive user retention. Investors will have to be patient as Spotify builds its own stable of original content, which includes podcasts from Joe Rogan, Barack Obama and soon Prince Harry and Meghan Markle, and hope the talent on offer is enough of a drawcard that the currently nascent podcast advertising industry gains steam.

With a price-to-sales ratio of over 5.5x, Spotify will have to prove to both consumers and investors that it can sustain its lead in user growth over Apple, Youtube, Tidal and Amazon, all of which have announced a suite of new features for their music streaming services.

It’s not enough for Spotify to simply maintain its sizable lead (its nearest estimated competitor is Apple Music with 72 million estimated subscribers). The company needs to prove it is capable of drawing and retaining new users at sizable growth levels. It needs to prove that it’s still Cool.

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Netflix’s Big Fight

Netflix’s challenge is much more evolved.

It has held pole position in film and TV streaming for more than a decade. It had to lay a lot of groundwork (and spend a lot of money) to convince consumers to make the switch from traditional TV to streaming – and now it’s facing competition from services that are building on the model it created.

While it took Netflix 10 years to gain 100 million subscribers, it took Disney+ just 16 months. Off the back of Netflix’s successful original content strategy, which was seen as a big risk when it was announced in 2012, multiple TV studios have launched their own services, creating a balkanisation of content across film and television.

There are currently eight major streaming services in the US: Netflix, Disney+, Amazon Prime Video, Hulu, Peacock, Paramount+ and HBO Max (which will soon merge with Discovery+). Each is investing heavily in content while also benefiting from a large archive. In Disney’s case, that archive dates back to 1937. That’s tough to compete with.

While Netflix reported excellent revenue growth of 24% in Q1 2021, it also reported a slowdown in subscriber growth, only adding 3.98m subscribers. This brought its total subscribers to 208m, 2m below its forecast of 210m subscribers by the end of the first quarter. The sluggish growth is expected to continue in the second quarter, with Netflix forecasting only 1m additional subscribers.

Netflix is currently down around 7% year to date, which is a far better performance than Spotify but still far behind the Nasdaq-100.

So what’s next for the big N?

Content, content, content, with a focus on franchises and merchandise. Along with investing billions for this year’s content slate, Netflix recently launched an online store where customers can purchase caps, necklaces and hoodies branded with popular Netflix originals. Where Disney copied from Netflix’s playbook, Netflix is now doing the reverse. It’s looking to branch out into apparel and accessories (a $130bn industry), supported by the strength of its franchises like ‘Stranger Things’ and ‘Lupin’.

Its biggest focus now will be producing a hit. Netflix hasn’t had much luck launching tentpole film franchises. It had minor success with ‘The Old Guard’ last year, but nothing that has inspired Star Wars or Marvel level fandom. Its path may be through acquisitions: it recently purchased the rights to the ‘Knives Out’ sequels for $465m. Netflix may believe it will be easier to capitalise on an already successful title than attempting to build one in-house, and this could signal the future of their tentpole strategy.

With Disney preparing to launch Phase 4 of their Marvel Cinematic Universe and HBO Max queuing up its DC content, Netflix needs to prove that it can still produce excellent content that keeps subscribers (and investors) locked in.

Netflix has been a frequent topic on thefinanceghost.com and it’s brilliant to get a variety of different views on the company. For more on this topic, listen to Episode 13 of Magic Markets in which The Finance Ghost and Mohammed Nalla debated the merits of Netflix vs. Disney in February 2021. 

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