Owning Netflix stock has never been for the faint-hearted. If you got a share of stock last Christmas, its value would have doubled by now—but, on the other hand, it closed Monday at $400.48 per share and opened on Tuesday at just $346.95. (It recovered most of those losses on Tuesday.)
Why is Netflix stock so volatile? The answer is that it’s very close to being a binary bet: Either the company will effectively replace television in hundreds of millions of households around the world, becoming the dominant media monopoly of the 21st century, or else it will go bust. What’s more, both of those outcomes are far too far in the future to be able to predict with any certainty: Every earnings report, every data point coming out of Netflix HQ, is entirely consistent with both stories.
The stock, then, is essentially an attempt to boil a complex bimodal probability distribution down to a single number. Even if you think that Netflix has, say, a 75 percent chance of going bust, its stock still has value, because it would be worth an enormous amount of money in the 25 percent of possible worlds where it succeeds. On the other hand, if the probabilities are reversed, the likelihood of a massive payout trebles and the stock is worth a great deal more. So a small change to any of the factors that determine that probability has a big impact. And the single factor that investors are paying the most attention to is subscriber growth.
In the second quarter of this year, according to the letter it sent shareholders Monday, Netflix added 5.2 million subscribers—an astonishing achievement, considered in isolation. But that’s significantly fewer than the 7.4 million subscribers that came to Netflix in the first quarter, let alone the 8.3 million homes the service added in the fourth quarter of 2017. That drop was enough to briefly shave off more than an eighth of the company’s market cap.
The paramount importance of subscriber growth is explained in a fantastic piece by former Amazon Studios strategy head Matthew Ball, who is probably the most insightful Netflix analyst out there. Ball explains that, as far as Netflix CEO Reed Hastings is concerned, the company is still in the early stages of a very long game, as its 40 percent year-on-year revenue growth suggests. (Mature companies, by definition, never grow that fast.) Netflix’s subscriber base of 56 million U.S. households, on top of another 68 million outside the U.S., is enormous—but it’s still well short of the 250 million households without which, Ball argues, Hastings’ business “will buckle and break.”
Does Hastings need to reach 250 million households in the next year or two? No—not while the capital markets remain willing to hand him billions of fresh dollars whenever he needs them. Netflix raised $1.9 billion in the junk-bond market in April and will surely return to that market before the year is out. (That said, the markets could dry up for exogenous reasons, like another financial crisis; Netflix’s growth story is inseparably linked to the easy money of the past five years.)
Still, investors will only be there for Hastings so long as they believe that he is capable of getting past that 250 million number and maybe even hitting his real goal, which Ball pegs at an astonishing 400 million. That’s why they care so much about subscriber growth.
To achieve that kind of scale, Netflix will have to become TV for billions of people around the world. Netflix’s ambition is not just that you subscribe to its service but that you like it so much you don’t feel the need to pay for any of its competitors. Only then will it have the ability to raise prices with impunity, as the cable companies used to do. (One of the main drivers of Netflix subscriber growth is just that its service is priced so far below competitors like HBO, which offer much less programming.)
Netflix’s world domination strategy means that it needs to be all things to all people. That explains why its content spend is so enormous. But for the time being, Netflix is not where it needs to be. The company was conspicuously lacking in buzzy new shows this quarter, and it’s apparently trying to make up for it with marketing. Last night was a rare TV night for me; I’m a Netflix subscriber, but I watched Succession on HBO and Who Is America? on Showtime. Netflix might have overtaken HBO in Emmy nominations this year, but it’s still behind when it comes to creating cultural resonance.
Netflix famously commissions new shows by looking at enormous amounts of data on who watches what. The assumption is that people watch what they like and that the more they watch, the more they value the service. But that’s not necessarily true: It suffers from the same fallacy as Facebook’s assumption that people click on and engage with the content they most want to see. If people stream hours on end of garbage shows on Netflix six days a week while they wait for the next episode of the show they really care about on a legacy cable channel, then Netflix will never have the market power to raise its subscription price to a profitable level.
That said, the path to global domination never runs in a straight line. Ultimately, what matters for the market is the probability that Netflix will pull off one of the most audacious moves in the history of media. That probability hasn’t changed much over a few days. Quarterly growth rates are noisy and don’t have much to say about the success or failure of the company’s long-term strategy.
And in pursuing that strategy, Netflix has a lot of advantages: a host of empowered creatives, almost limitless access to capital markets (for the time being), and strong and stable senior management. What Hastings is aiming at might not be possible. But if it is possible, there’s a very good chance he’s going to pull it off somehow.
