NFLX 0.00%↑ stats
Market Cap = $163.07B
EV = $183.08B
FCF = -($131,975)
FCF Yield = N/A
EBIT = $6.61B
EV/EBIT = 27.7
ROIC = 14.18%
Reinvestment Rate = 17.15%
ROIC * Reinvestment Rate = 2.43%
Intro
In mid January, Netflix was down almost 50% from all time highs after a disastrous earnings update. The guidance suggested subscriber growth may be slowing, resulting in a single day, 25% drop in the share price.
As I write this my parents are watching Ozark, my partner is watching Love is Blind and I just finished the excellent Arcane. Let’s be clear, users are not cancelling their accounts based on Netflix’s latest investor update.
It’s never been entirely clear whether Netflix deserves their place amongst the FAANGs. Perhaps it just sounds better than FAAMG? It’s counterparts generate contrasting ROIC and Operating metrics (even Amazon, once you strip out their investments in moonshots).
Netflix is burdened with debt, delivers little to no free cash flow and there’s a question as to whether it has a long term moat.
There is a reason why their profitability lags far behind the rest of the FAANGs, Netflix depreciation of their content equates to almost 50% of their annual revenue!
One major concern is that subscriber growth is being eroded by Disney, Apple TV and Prime amongst others. The company's base of 222 million subscribers gives it a significant competitive advantage over services that are in their formative years.
Netflix has had a 10 year head start and produced over 1,500 original titles since it launched original content in 2013. Competitors are now beginning to erode a moat that has been largely undisturbed for a decade. Disney is reportedly spending $33 billion on content in 2022. This will dwarf Netflix’s planned $17 billion.
Let’s dive in.
The Business
Netflix started life as an online DVD rental site back in 1997 by Reed Hastings and Marc Randolph. Amazingly, they still rent a reported 2 million DVDs annually, but have not promoted that side of the business since 2013.
Netflix first introduced streaming in 2007, before debuting the first original production, House of Cards, in 2013.
Netflix offers a tiered Basic / Standard / Premium subscription. Depending on what part of the world you live in, this can vary from £5.99 / $9.99 per month to £13.99 / $19.99. At £5.99 for virtually unlimited content, Netflix is cheap. This low pricing structure is a key tactic of Reed Hastings’ ultimate aim to acquire as many customers as possible, dominate the market and replace almost all of their competitors.
As Matthew Ball succinctly points out in one of his 10 essays on Netflix -
The more subscribers the company amasses and the higher it can push its pricing, the more content it can produce – which in turn drives more subscribers, more engagement and more pricing power.
And Netflix is dominating it’s competition in one key area, churn rate. For almost 3 years their churn rate has remained steady at just above 2%. As the pandemic eases, it’s estimated that some Subscription Video on Demand (SVOD) services could see churn increase up to 30%! Disney+, now the closest competitor, boasts a churn rate of 4.5%, with Apple TV closer to 15%. These figures mean that competitors have to work harder than Netflix to grow, as they are losing more subscribers.
The Economics & Pricing Power
It’s no secret that Netflix is a capital intensive business with increasing costs and competition. The biggest bull case is their pricing power. They burn around a billion dollars a year in cash. Netflix has to raise pricing if it wants to survive. They have raised prices around 13% every 2 years, without damaging the churn. Subscribers appear happy to pay more.
As Netflix acquires more subscribers, the cost per view decreases. If Netflix monopolises the SVOD service, there’s an argument that their pricing will surge, resulting in the business becoming exponentially stronger and more profitable. The revenue from new subscribers will go straight to the bottom lines. In essence, this is what Reed Hastings has been working towards for the past decade.
If this comes to fruition, Netflix becomes a money printing machine. On their investor relations page, Netflix states that ‘We were at a 7% annual GAAP operating margin in 2017, which has grown to 21% in 2021’. They are certainly moving in the right direction.
Content is King
In 2021 Netflix was the most Emmy and Oscar winning studio for their Originals. A Netflix Original is any series or movie that Netflix funds, allowing them to brand, market and control the IP. They plans to spend $17 billion on Netflix Originals in 2022. In some scenarios, Netflix purchases ‘Acquired Originals’ from other studios for exclusive rights.
New Originals tend to drive acquisition and intentional subscribers. Licensed re-runs, such as Friends and the Office, typically create repeat engagement.
Quality productions do not necessarily mean engagement. Red Notice is their most watched movie ever, despite only scoring 6.3 on IMDB and 36% on Rotten Tomatoes. What matters is that subscribers engage, rather than agree with critics.
Netflix Original, Squid Game, was released in September 21 and resulted in 1.6 billion viewing hours. Scale and technology means reaching a larger audience than any of their competitors, de-risking content production.
Netflix is able to launch both below-par or foreign language content to greater effect than the above-par shows released by its competitors. Their larger audience means they do so on a more cost efficient basis.
On what other network would a South Korean drama, that revolves around players risking their lives in children's games (and dying gruesomely), become the most watched ever?
The Streaming Wars
There is a lot to be said about the rise of SVOD platforms. Disney+ has reached a huge audience of 130 million subscribers in less than 3 years. Digital TV Research expects Disney+ and Netflix to reach 271 million and 275 million by 2026 respectively, before Disney+ eventually overtakes in 2027. At this point, it very much looks like a two horse race.
Disney plans to increase its overall content spend to around $33bn in 2022, dwarfing Netflix’s $17 billion, marking an $8bn rise from the previous year. However, this is not fair comparison as this includes ESPN and sport related spend. It was not reported how the $33 billion will be spent, but Disney estimates it will produce around 60 unscripted series, 30 comedy series and 25 drama shows.
In 2019 Disney spent $16.4 billion of it being non-sports-related content that could directly or eventually (in the case of theatrical releases) compete with Netflix. It would be fair to assume that Disney is spending between $20-25 billion on content that can compete with Netflix.
Disney+ has linchpin content - the Disney & Fox (the Simpsons, Family Guy etc) backcatalouges, plus Marvel, Pixar & Star Wars. Disney are universe builders and have been doing this for almost a century. They have been massively successful under Robert Iger, with 7 of the top 10 grossing movies of all time having been released in the past decade.
Although not a key driver for Amazon, Prime video is funded by Amazon’s almost infinite balance sheet. Whether the likes of Amazon’s $1 billion investment in the LOTR’s Rings of Power or HBO Max can challenge, is yet to be seen. Netflix had a mostly free ride at streaming content for the past decade, but their mission to process the most desirable content in the world is going to cost more.
Reed Hastings might be worried about Disney+. However, let’s be clear, Netflix do not view themselves as competing with other SVOD services. They are in competition for every minute of a subscriber's leisure time. Sleep is their competition . They are in an attention war with YouTube, TikTok and Instagram.
To truly understand how competition is differentiated in the streaming wars, we need to look beyond spend and churn rate and look at daily engagement hours per subscriber. According to the business of apps, Netflix share of US streaming minutes was 34%. This was ahead of YouTube (20%), Amazon Prime (8%) and Disney+ (4%).
Netflix can disrupt the industry where other SVOD services fear to tread. As Peter Chernin pointed out on a recent episode of Invest Like the Best, Disney and Amazon are continuing to milk existing franchises. Netflix is not afraid to take risks and potentially create more economic value.
The other services aim to create big budget, hits driven content, Netflix is focusing on volume, which ultimately minimises risk, driving user engagement and operating profit.
Amortization and Accountancy
Netflix has to generate cash when matching today’s revenue with tomorrow’s costs. In 2021, they amortized over $12 billion of content, around 41% of revenue.
If you look at their cashflow statement, they spent over $17.7 billion on new content, almost 60% of revenue! With a 2021 deficit of over $2 billion, Netflix is funding this massive cash burn through debt.
The company has issued over $5 billion of debt in the past 3 years and has over $15 billion of combined debt on their balance sheet. This is not a company that comes across as financially healthy (and certainly not worthy of its FAANG title).
However, their strategy is different, they are either happy to let old content lie without milking it. In a decade how much will the Bridgerton, Stanger Things or Squid Game be worth? The answer is clearly not zero.
Behind the Balance Sheet’s expose, highlighted how Netflix may not be following their own amortisation guidance of ‘90% amortized within four years of release’. They highlight the glaring discrepancy caused between EBIT/EBITDA and FCF, caused by how Netflix treats costs related to content.
How much is intangible, fully amortised content worth? This is the question that may make or break their investment spend. The early Netflix Originals are now valued at $0, according to their amortisation strategy. In theory, Netflix should eventually be able to reduce its annual content outlays as its library accumulates over time with amortised content valued at $0.
However, a key factor worth considering is whether there is an incremental cost of maintaining subscribers. Is current spend, by definition, enough? Are existing subscribers happy with the volume of content - or is increased spend being used to acquire new subscribers? Will a stagnating content spend result in an increased churn? The answer is currently unknowable, but at some point Netflix will stop spending exorbitant amounts on content and this scenario will play out.
What’s Next? Gaming
In November 2021 it was announced that Netflix would launch Netflix games. Five iOS games were made available to all subscribers for no additional cost. Their strategy appears to tie in to their engagement flywheel; more engagement>more users>more content>more engagement.
It’s no secret that Netflix has courted gamers for a number of years. Season 2 of the Witcher topped 142 million viewing hours after a few days after release. The excellent Arcane (9.1 on IMDB) is based on League of Legends by Riot Games. In February 2022 it was announced that Netflix was partnering with 2K and Take-Two Interactive to produce a film adaptation of the renowned video game franchise BIOSHOCK. Is this the early stages of an acquisition?
As Matthew Ball points out, the majority of film/TV/book IP is owned by Netflix’s competitors (e.g. Disney, Warner Bros, Paramount), and therefore inaccessible. Whereas, gaming content offers untapped IP.
Netflix is in a war for attention. It’s estimated that the average American watches 5.5 hours of TV, whilst the average gamer plays 2.5 hours (and growing). Every generation plays more than the one that preceded it. Netflix is no longer just fighting other SVOD services.
Netflix does not yet possess the technology to compete in the gaming sector. It’s unlikely they will pursue iOS and the Google Play stores indefinitely, due to high in-game commission fees. On top of that, they are a decade late to the party, the Xbox and Playstation stores have an almost insurmountable advantage. In comparison, Neflix’s gaming IP and technology are non existent.
To continue to build their flywheel, Netflix needs to offer low cost, quality content that users will engage with. Microsoft have recently scooped up Activision for a cool $70 billion. With a $170 billion market cap, it’s unlikely Netflix could acquire a leading publisher.
At this point, it’s difficult to predict where this goes. Given Netflix’s single minded focus on acquiring subscriber engagement, it's likely this strategy has been long considered ($60 billion Nintendo acquisition anyone)?
International Subscribers
US growth has slowed in recent years. Netflix added an average of 5 million subscribers annually between 2012 and 2018, before slowing in 2019. The pandemic reinvigorated growth.
In 2021, Netflix added 18 million total subscribers, compared with 37 million in 2020. Covid demand is beginning to wear off. A projected 2.5 million new subscribers in Q1 2022 led to their precipitous share price fall. Anyone who wants Netflix in the US, most likely already has it.
Netflix has to find new subscribers outside the US.
They are focused on non-English markets that have high broadband penetration and mobile-focused countries,
such as Germany & Japan. Their global brand campaign, titled ‘One Story Away’ launched in September of 2020 in 27 different countries.
Shows like Spain’s Money Heist and South Korea’s Sweet Home, are driving international subscriber growth. French series Lupin reached number 2 in Netflix’s Top 10 most popular shows in the U.S.
Squid Game, a South Korean language drama, is the most watched show on Netflix. Subscribers are willing to watch content outside their native language.
The fact that Netflix can reach an international audience, regardless of language, decreases their content spend per user, de-risks production and allows them to gain a foothold in foreign markets in which their competitors are too risk averse to target.
Netflix is investing in local productions if there is global appeal. Despite having only around 5 million subscribers in India, Netflix invested with 41 original productions in 2021. Yet, they are still struggling to gain a foothold. In December 2021 they reduced their Indian pricing plans between 18 - 60%!
In a recent episode of Chit Chat Money, Alex Morris discussed why Netflix’s total addressable market may be in the billions if they can successfully execute internationally. However, their growth efforts are being frustrated by local factors including subscribers not having access to banks / credit cards or reliable internet.
Bull Case
Still the go to and best - Anecdotally, you will be hard pushed to find a subscriber in your circle of friends and family who has recently cancelled Netflix. Their churn rate of 2.5% is far superior to their competitors and indicative of the fact that they are giving subscribers what they want.
More than enough room for more than 1 SVOD service per household -Netflix still has time to take plenty of market share from TV. The introduction of new competition is unlikely to result in waves of subscriber cancellations.
Growing revenue and subscriptions - There’s plenty of opportunity for Netflix to expand, particularly into non-english speaking countries. Diversifying into foreign language content has demonstrated that it can be used universally, reducing content spend per subscriber.
Intangible content library - As the early run of Netflix originals are amortised to $0, one thing is clear, this content is not worthless . Fully amortise content should reduce spend moving forward, bulking out the Netflix library as well as adding significant, unaccounted for value off the balance sheet.
10 year head start - Something that should not be discounted is Netflix’s technology and algorithms that provide you with your favourites, plus suggested content. They have had a decade to trial and test their technology. This is an area their competitors are lacking in. Competitors have to continue to spend big and add hit after hit to continue to add new subscribers, whereas Netflix can recommend serval shows, based on viewing habits, which have sat in their back catalogue for years.
Reed Hastings as the CEO - Since 1997, Hastings has been driving Netflix with a single minded focus on user engagement. As Matthew Ball describes it, they are playing a game no one else understands. At 61 with around 1.1% ownership, he still has at least a decade left to execute his grand design.
Bear Case
Unknown effects of competition - Disney+ should now outspend Netflix for the first time ever in 2022. Content will become more expensive as competition increases. The sheer volume of the Disney+ back catalogue plus their strategic acquisitions, will soon become difficult to overcome.
Netflix has to continually invest more to keep subscribers - One question that will be answered within the next decade is ‘what happens when Netflix stagnates their (debt funded) content spend?’ Does investment add new subscribers or just maintain an existing base?
Unable to overcome challenges of international markets - Netflix growth has to come from intentional markets. There appears to be a clear strategy behind this, but it’s already been pointed out how their subscriber numbers have stagnated in India, with only 5 million in a country of 1.4 billion.
Not sticking to their amortisation strategy - The fact that Netflix are burning through cash and funded by debt makes their financial statements all the more dubious. Behind the Balance Sheet pointed out that they may not be sticking to their declared amortisation period and it’s not entirely clear why.
Knee-jerk reaction into video games - The move into video games was a surprise. Netflix wants to offer a new service to increase subscriber engagement, but it’s not entirely clear how? Circumventing the app store commissions will be a challenge and they don’t have $70 billion, the amount Microsoft spent on Activision, to acquire the infrastructure .
Conclusion
Suffering from a Covid hangover resulted in slower subscriber growth, but Netflix is still the best in the business.
As competitors enter the marketplace results in a vicious cycle. The cost of content will be driven up, meaning that Netflix can create less hits, resulting in capturing less subscribers.
It looks feasible (in the near future) for Netflix to increase operating margins through a combination of price hikes and reduction in amortisation, due to already fully depreciated content. Netflix cannot overspend on content indefinitely. They are burdened with debt and increased competition may lead to an inability to achieve the margin expansion and ROIC they are desperately in need of.
Reed Hastings has undoubtedly executed one for the greatest business pivots in history over the past decade. Will he ever achieve his end game? Only time will tell.
-DB
Resources & References