Author: Chong Ser Jing

Amazon.com (NASDAQ: AMZN) is one of the 50-plus companies that’s in my family’s investment portfolio. I bought Amazon’s shares a total of four times. The first was in April 2014 at a price of US$313, then again in July 2014 at US$322, once more in December 2016 at US$767, and yet again in August 2017 at US$955. I’ve not sold any of the shares I’ve bought.

All the purchases of Amazon’s shares have performed well for my family’s portfolio, with Amazon’s share price being around US$1,785 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Amazon’s shares.

Company description

Jeff Bezos founded Amazon in 1994. A year later, the company started business by selling just books online. Over time, Amazon expanded its online retail business that now provides an incredible variety of product-categories for consumers. In 2006, the company launched its cloud computing business, AWS (Amazon Web Services), which has since grown into the largest cloud computing service provider in the world.

Amazon currently has three business segments: North America, International, and AWS. The North America and International segments consists of Amazon’s online retail as well as other retail-related subscription businesses. The AWS segment houses well, AWS, which offers computing power, database storage, content delivery, and other services to various organisations.

The table immediately below shows the revenues and operating profits from Amazon’s three segments in the first nine months of 2019. Although Amazon’s retail operations make up the lion’s share of revenue, it is AWS that is currently generating more operating profit for the company.

For a geographical perspective, the US was the source of 69% of Amazon’s total revenue of US$232.9 billion in 2018. Germany, the UK, and Japan are the other countries that Amazon reports as individual revenue sources, but the US is the only market that accounted for more than 10% of the company’s revenue. 

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use it to describe my investment thesis for Amazon.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

On the surface, Amazon’s massive revenue (total of US$193 billion in the first nine months of 2019) makes it seem like the company has exhausted its room for growth. But if you dig deeper, a different picture emerges.

First, let us consider Amazon’s online retail business. The St Louis Federal Reserve’s data show that online retail sales in the US was just 11.2% of the country’s total retail sales in the third quarter of 2019. Moreover, total retail sales in the US in the first 11 months of 2019 (excluding food services) was over US$5 trillion. Amazon’s current revenue is merely a drop in the ocean. For more context, Walmart, a bricks-and-mortar retailer in the US, earned US$392 billion in revenue in the 12 months ended January 2019.

The chart below shows ecommerce sales as a percentage of total retail sales in the US for each quarter going back to 1999’s fourth-quarter. From then to today, the percentage has increased from just 0.6% to 11.2%. Ecommerce activity has clearly been growing in the US over a long period of time, and that’s a tailwind on Amazon’s back.

Next, let us look at the cloud computing landscape. AWS on its own, can be considered a huge business too with revenue of US$25 billion in the first nine months of 2019. But again, the runway for growth is long.

According to Gartner’s latest forecasts released in November 2019, the public cloud computing market is expected to grow by nearly 16% per year from US$197 billion in 2018 to US$355 billion in 2022.

Then, there’s Amazon’s digital advertising business which is reported within the North America and International business segments. In the first nine months of 2019, Amazon’s advertising business brought in revenue of around US$9 billion, up 38% from a year ago. The market opportunity is huge and fast-growing; global digital advertising spend was US$283 billion in 2018, and is expected to grow to US$518 billion in 2023, according to eMarketer.

The thing about Amazon is that we should not be surprised to see the company expand into new markets in the future. After all, Amazon “seeks to be Earth’s most customer-centric company.” This audacious statement also means that any industry is fair game for Amazon if it sees an opportunity to improve the customer experience. It helps that Amazon is highly innovative (more on this when I discuss Amazon’s management) and the company embodies a concept called optionality. Motley Fool co-founder David Gardner describes optionality as a company having multiple paths to grow.

Here are a few of Amazon’s irons-in-the-fire that I think hold high growth-potential:

• Amazon is making inroads in physical retail. Amazon Go is the company’s bricks-and-mortar retail store that requires no checkout. Customers walk into an Amazon Go store, grab what they want, and simply leave. Amazon Go is powered by computer vision, sensor fusion, and deep learning. The company reported in the second quarter of 2019 that it had 13 Amazon Go stores across the US, namely in Seattle, Chicago, San Francisco, and New York.  In August 2017, the company also acquired Whole Foods Market, an organic grocer, for US$13.2 billion. Whole Foods Market has around 500 physical stores today in North America and the UK. 
• In early 2018, Amazon set up a non-profit entity together with the US banking giant J.P. Morgan Chase, and Warren Buffett’s Berkshire Hathaway. The non-profit was named Haven in early 2019 and is meant to tackle rising healthcare costs in the US. In September 2018, Amazon acquired online pharmacy and drug delivery outfit PillPack in 2018 for US$753 million. Then in September 2019, Amazon launched Amazon Care, its telemedicine and in-person healthcare platform. As far as I know, Amazon Care is currently only available for Amazon’s employees in Seattle. Shortly after in October, Amazon acquired Health Navigator, a digital healthcare startup, and grouped it under the Amazon Care platform. All these moves by Amazon suggest that it’s working hard to crack the US$3.5 trillion US healthcare market.
• Amazon has been flexing its financial muscle in video streaming. The company’s original content budget for 2019 for its Prime Video streaming service is estimated to be around US$6 billion. The streaming market is rapidly growing. And although Netflix is a formidable – and larger – presence in the space, there is likely enough room for more than one winner. 
• In Amazon’s 2018 annual report, it included for the first time “transportation and logistics services” companies as its competitors. Amazon started leasing delivery planes for the first time in 2016 and it is expected to have a fleet of at least 70 delivery aircraft by 2021. The company is also investing US$1.5 billion to develop an air cargo hub in Kentucky with a scheduled 2021 opening date. 

2. A strong balance sheet with minimal or a reasonable amount of debt

Amazon meets this criteria. As of 30 September 2019, the company’s balance sheet held US$22.5 billion in debt and US$37.1 billion in lease liabilities against US$43.4 billion in cash and marketable securities.

There’s more debt than cash, but Amazon has been adept at generating cash flow. That’s something I will discuss later.

3. A management team with integrity, capability, and an innovative mindset

On integrity

Jeff Bezos, 55, has been leading the charge at Amazon since he founded the company. Today, he’s Amazon’s president, CEO, and chairman. I believe that Bezos’s compensation plan with Amazon shows that he’s a leader with (a) integrity, and (b) interests that are aligned with the company’s other shareholders, myself included. There are a few key points to note:

• Bezos’s cash compensation in Amazon was merely US$81,840 in 2018. His annual cash compensation has never exceeded that amount at his request, because he already has a large stake in Amazon. His total compensation in 2018 was US$1.68 million if business-related security expenses were included. But even then, the sum is more than reasonable when compared to the scale of Amazon’s business.
• Bezos has never received any form of stock-based compensation from Amazon, because he believes he is already “appropriately incentivised” due to, again, his large ownership stake in the company.
• As of 25 February 2019, Bezos controlled 78.8 million Amazon shares (16% of the existing shares) that are worth around US$141 billion at the current price. Bezos divorced his wife, MacKenzie Sheri Tuttle, in July 2019 and transferred a quarter of his Amazon shares to her. This means that Bezos still controls roughly 59 million Amazon shares with a current market value of around US$105 billion. In my opinion, Bezos’s huge monetary stake in the company puts him in the same boat as other shareholders.

On capability and innovation

There’s so much to discuss about Bezos’s accomplishments with Amazon and his ability to lead innovation at the company. But for the sake of brevity, I want to focus on only a few key points.

First is Amazon’s tremendous track record of growth. There will be more details later, but as a teaser, consider that Amazon’s revenue has increased from just US$148 million in 1997 to US$232.9 billion in 2018. Over the same period, operating cash flow was up from less than US$1 million to US$30.7 billion.

Second is Amazon’s willingness to think long-term, and experiment and fail. I want to highlight Amazon’s long-term thinking through something Bezos said in a 2011 interview with Wired. Reading Bezos’s words directly will give you a window into his genius. Here are Bezos’s words in 2011 (emphasis is mine) :

“Our first shareholder letter, in 1997, was entitled, “It’s all about the long term.” If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people.

But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow—and we’re very stubborn. We say we’re stubborn on vision and flexible on details.”

Amazon has the courage to constantly seek new ground. Often, the trail turns cold. A sample of Amazon’s long string of failures include: The Fire Phone (Amazon’s smartphone); Amazon Wallet (Amazon’s digital payments service); Amazon Local Register (a device to help mobile devices process credit cards); and Destinations (Amazon’s hotel-booking website). But sometimes the trail leads to gold. Bezos has written about this topic. Here’s a relevant excerpt from Amazon’s 2015 shareholders’ letter (emphases are mine):

“One area where I think we are especially distinctive is failure. I believe we are the best place in the world to fail (we have plenty of practice!), and failure and invention are inseparable twins. To invent you have to experiment, and if you know in advance that it’s going to work, it’s not an experiment. Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there.

Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a ten percent chance of a 100 times payoff, you should take that bet every time. But you’re still going to be wrong nine times out of ten. We all know that if you swing for the fences, you’re going to strike out a lot, but you’re also going to hit some home runs.

The difference between baseball and business, however, is that baseball has a truncated outcome distribution. When you swing, no matter how well you connect with the ball, the most runs you can get is four. In business, every once in a while, when you step up to the plate, you can score 1,000 runs. This long-tailed distribution of returns is why it’s important to be bold. Big winners pay for so many experiments.”

The following is another relevant passage on the company’s willingness to experiment, from Bezos’ 2018 shareholders’ letter (emphases are mine):

“Sometimes (often actually) in business, you do know where you’re going, and when you do, you can be efficient. Put in place a plan and execute. In contrast, wandering in business is not efficient … but it’s also not random. It’s guided – by hunch, gut, intuition, curiosity, and powered by a deep conviction that the prize for customers is big enough that it’s worth being a little messy and tangential to find our way there.

Wandering is an essential counter-balance to efficiency. You need to employ both. The outsized discoveries – the “non-linear” ones – are highly likely to require wandering.

AWS’s millions of customers range from startups to large enterprises, government entities to nonprofits, each looking to build better solutions for their end users. We spend a lot of time thinking about what those organizations want and what the people inside them – developers, dev managers, ops managers, CIOs, chief digital officers, chief information security officers, etc. – want.

Much of what we build at AWS is based on listening to customers. It’s critical to ask customers what they want, listen carefully to their answers, and figure out a plan to provide it thoughtfully and quickly (speed matters in business!). No business could thrive without that kind of customer obsession. But it’s also not enough. The biggest needle movers will be things that customers don’t know to ask for. We must invent on their behalf. We have to tap into our own inner imagination about what’s possible.

AWS itself – as a whole – is an example. No one asked for AWS. No one. Turns out the world was in fact ready and hungry for an offering like AWS but didn’t know it. We had a hunch, followed our curiosity, took the necessary financial risks, and began building – reworking, experimenting, and iterating countless times as we proceeded.”

One instance for Amazon of the trail leading to gold is, of course, AWS. It has been a smashing success. When AWS was 10 years old, it was bigger than Amazon was at the same age and was growing at a faster rate. The table below shows AWS’s outstanding revenue and operating income growth since 2014. Bear in mind that AWS has grown despite Amazon having lowered the service’s price a total of 67 times from its launch in 2006 to September 2018 – voluntarily. 

I think it’s worth noting too that AWS has a commanding lead over other cloud computing platforms. In 2018, the IaaS (infrastructure-as-a-service) segment in the cloud computing market was US$32.4 billion, according to Gartner; AWS accounted for nearly half of that.

The third key point I want to discuss about Amazon’s management is Jeff Bezos’s unique obsession over the customer experience. In fact, I think it is an unreplicable competitive advantage, because it stems from Bezos’s own unique way of thinking. You can’t clone Jeff Bezos – at least not with current science!

In his 2003 shareholders’ letter, Bezos illustrated his willingness to dent Amazon’s short-term sales for longer-term benefits (emphasis is mine):

“Another example is our Instant Order Update feature, which reminds you that you’ve already bought a particular item. Customers lead busy lives and cannot always remember if they’ve already purchased a particular item, say a DVD or CD they bought a year earlier.

When we launched Instant Order Update, we were able to measure with statistical significance that the feature slightly reduced sales. Good for customers? Definitely. Good for shareowners? Yes, in the long run.”

I mentioned earlier that AWS has dropped prices over the years for the benefit of customers. Back in his 2005 shareholders’ letter, Bezos already gave an excellent window on his thinking behind his obsession on lowering prices for customers. He thinks it can build strong customer loyalty that is not easily measurable but that is real. Most importantly, he thinks this loyalty translates into higher future free cash flows for Amazon. I agree. Here’s what Bezos wrote (emphases are mine):

“As our shareholders know, we have made a decision to continuously and significantly lower prices for customers year after year as our efficiency and scale make it possible. This is an example of a very important decision that cannot be made in a math-based way.

In fact, when we lower prices, we go against the math that we can do, which always says that the smart move is to raise prices. We have significant data related to price elasticity. With fair accuracy, we can predict that a price reduction of a certain percentage will result in an increase in units sold of a certain percentage.

With rare exceptions, the volume increase in the short term is never enough to pay for the price decrease. However, our quantitative understanding of elasticity is short-term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or ten years or more.

Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com. We’ve made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and—we believe—important and valuable in the long term.”

The last point I want to discuss regarding Jeff Bezos’s leadership is the unique corporate structure he has built in Amazon. Tech entrepreneur Zack Kanter wrote an amazing blog post in March 2019 (please read it!) that describes Amazon’s brilliant culture. Here’re the key passages (italics are his):

“In 2002, Jeff Bezos had the most important insight he would ever have: in the world of infinite shelf space – and platforms to fill them – the limiting reagent for Amazon’s growth would not be its website traffic, or its ability to fulfill orders, or the number of SKUs available to sell; it would be its own bureaucracy.

As Walt Kelly put it, “we have met the enemy, and it is us.” In order to thrive at ‘internet scale,’ Amazon would need to open itself up at every facet to outside feedback loops. At all costs, Amazon would have to become just one of many customers for each of its internal services.

And so, as told by former Amazon engineer Steve Yegge, Jeff Bezos issued an edict: 1) All teams will henceforth expose their data and functionality through interfaces, 2) teams must communicate with each other through these interfaces, 3) all interfaces, without exception, must be designed from the ground up to be exposed to developers in the outside world, and 4) anyone who doesn’t do this will be fired.

This principle, this practice, this pattern, would enable Amazon to become the sprawling maze of complexity that it would eventually become without collapsing under its own weight, effectively future-proofing itself from the bloat and bureaucracy that inevitably dragged down any massive company’s growth.”

Bezos’s edict that Kanter mentioned allows Amazon to innovate rapidly. That’s because any service or technology that Amazon builds for internal uses can very quickly be pushed to external customers when the time is right. In fact, that was how AWS came to be: It was first developed to meet Amazon’s own computing needs before it was eventually shipped to the public.

So after a really long discussion on Amazon’s leadership (and that’s after I tried to be as brief as possible!), I want to make it very clear: My investment in Amazon is also very much a long-term bet on Jeff Bezos. 

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

Amazon’s business contains highly recurrent revenue streams. There are a few key things to note:

• According to Statista, there were 206.1 million unique visitors to Amazon’s US sites in the month of December 2018. These are visitors who are likely using Amazon’s online retail sites to purchase products regularly. 
• Amazon also has subscription businesses, most notably Amazon Prime. Subscribers to Amazon Prime gain access to free shipping (from two days to two hours depending on the products), the Prime Video streaming service, and more. Amazon Prime typically charges subscribers US$12.99 per month or US$119 per year. In his 2017 shareholders’ letter, Bezos revealed that Amazon Prime had more than 100 million paying subscribers around the world.
• AWS provides cloud computing services, and that is likely to be something its customers require all the time, or frequently. AWS also sometimes enters into significant long-term contracts of up to three years.

I also want to point out that it’s highly unlikely that Amazon has any customer concentration. The company’s retail websites welcome hundreds of millions of visitors each month, and AWS also has “millions of customers” ranging from startups to large enterprises, and government entities to nonprofits. 

5. A proven ability to grow

The table below shows Amazon’s important financial figures from 1997 to 2018:

There are a few points to note about Amazon’s financials:

• Revenue has compounded at an amazing rate of 42% from 1997 to 2018; over the last five years from 2013 to 2018, Amazon’s topline growth was still excellent at 25.6%. The company also managed to produce strong revenue growth of 29% in 2008 and 28% in 2009; those were the years when the global economy was rocked by the Great Financial Crisis.
• Operating cash flow has increased markedly for the entire time frame I’m looking at. The compound annual growth rates from 2007 to 2018, and from 2013 to 2018, were robust at 32% and 41%, respectively. Moreover, just like Amazon’s revenue, the company’s operating cash flow had strong growth in 2008 and 2009.
• Free cash flow, net of acquisitions, has mostly been positive and has also stepped up significantly from 1997 to 2018. But it’s worth noting that Amazon has spurts of heavy reinvestments into its business which depresses its free cash flow from time to time. I also want to point out that 2017 was an anomaly because of the huge US$13.2 billion Whole Foods Market acquisition I mentioned earlier. 
• The balance sheet was in a net cash position in most years, and even when there was debt, it looks trivial compared to the company’s cash flows.
• Amazon has been diluting its shareholders, but the dilution has happened at a glacial pace of 3% annually since 1997. From 2007 to 2018, the annual increase in the diluted share count has been just 1.5%, which is negligible given the rate at which Amazon’s business is growing.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

Jeff Bezos has attached his 1997 shareholders’ letter to every subsequent shareholders’ letter he has written. In the 1997 letter, Bezos wrote:

“When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”

In Amazon’s 2018 annual report, the company stated that its “financial focus is on long-term, sustainable growth in free cash flows.”

The two comments above – from Bezos’ 1997 shareholders’ letter and from Amazon’s latest annual report – highlights the emphasis that the online retail giant places on free cash flow. I like this focus. And crucially, Amazon has walked the talk. Its free cash flow has grown over time as I mentioned earlier, and hit US$15.1 billion in 2018 and US$18.0 billion over the last 12 months. 

Valuation

I like to keep things simple in the valuation process. Given Amazon’s penchant for free cash flow (which is absolutely correct!), I think the price-to-free cash flow (P/FCF) ratio is a suitable gauge for the company’s value when free cash flow is abundant. When free cash flow is light because Amazon is reinvesting into its business, the price-to-sales (P/S) ratio will be useful. 

With US$18.0 billion in free cash flow right now, Amazon has a P/FCF ratio of around 49 at the current share price. That’s a high valuation. But Amazon is still growing rapidly – revenue was up nearly 24% in the third quarter of 2019, which is incredible and all the more impressive given the company’s already massive revenue base. More importantly, Amazon aces my investment framework. For that, I’m happy to pay up. 

The risks involved

Key-man risk is an important concern I have with Amazon. Jeff Bezos is an incredible and fair businessman in my opinion. If he ever leaves the company for whatever reason, his successor will have giant shoes to fill – and I will be watching the situation closely.

I also recognise that there’s political risk involved with Amazon. The company has been under scrutiny from US regulators for antitrust reasons, but I’m not too concerned. In his 2018 shareholders’ letter, Bezos gave a succinct sweep of the retail landscape which shows that Amazon’s share of the overall market is still tiny: 

“Amazon today remains a small player in global retail. We represent a low single-digit percentage of the retail market, and there are much larger retailers in every country where we operate. And that’s largely because nearly 90% of retail remains offline, in brick and mortar stores.”

Staying with political risk, current US president Donald Trump is at loggerheads with Jeff Bezos. Amazon recently lost out on a cloud computing contract (worth up to US$10 billion) with the US’s Department of Defense, and the company has accused Trump of meddling with the outcome of the deal. It does not help too that the Amazon CEO’s personal ownership of the high-profile US national newspaper, Washington Post, likely also pulls political attention toward Amazon. 

Lawmakers in the US, such as Elizabeth Warren, have even gone as far as to propose plans to break up large technology firms in the country, including Amazon. I’m not worried about a break up, because it could actually unlock value for Amazon’s shareholders. For example, it’s possible that an independent AWS could win more customers compared to its current status. It was reported in 2017 that Walmart had told its technology vendors not to use AWS. Nonetheless, I’m keeping an eye on politicians’ moves toward Amazon.

Lastly, there’s valuation risk. Amazon is priced for strong long-term growth. I’m confident that the company can continue growing at high rates for many years into the future, but there’s always the risk that the wheels fall off the bus. If Amazon’s growth slows materially in the years ahead, the high valuation will turn around and bite me. It’s something I have to live with, but I’m comfortable with that.

The Good Investors’ conclusion

In my view, Jeff Bezos is one of the best business leaders the world has seen. I have good company. Warren Buffett, himself an extraordinary investor, called Bezos “the most remarkable business person of our age” in a 2017 interview. Charlie Munger, Buffett’s long-time right-hand man, also said around the same time that Bezos “is a different species.”

Amazon has Bezos as its leader, and that in itself is an incredible competitive advantage for the company. Besides excelling in the management-criteria within my investment framework, Amazon also shines in all the other areas: 

• The company is operating in large and growing markets including online retail, cloud computing, and digital advertising. Moreover, it is constantly on the hunt for new opportunities.
• Amazon’s balance sheet carries a fair amount of debt, but is still robust when the debt is compared to its cash flows.
• The nature of Amazon’s business means there are high levels of recurring revenues.
• The company has an amazing long-term track record of growth – its business even managed to soar during the Great Financial Crisis.
• Amazon has a strong focus on generating free cash flow, and has proven to be adept at doing so.

The company’s valuation – based on the P/FCF ratio – is on the high side on the surface, and that’s a risk. But Amazon is a very high quality business, in my view, which means the high valuation currently could be short-term expensive but long-term cheap. Other important risks I’m watching with Amazon include key-man risk and scrutiny from politicians. 

After weighing the risks and potential rewards, I’m more than happy to have Amazon continue to be in my family’s investment portfolio.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Berkshire Hathaway (NYSE: BRK-B) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Berkshire shares for the portfolio in August 2011 at a price of US$70 and again in September 2015 at US$130. I’ve not sold any of the shares I’ve bought.

The first two purchases have performed well for my family’s portfolio, with Berkshire’s share price being around US$223 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Berkshire shares.

Company description

Berkshire is one of the most fascinating companies I have come across.

The story starts in 1965, when Warren Buffett took over the company because of anger. Back then, Buffett was a hedge fund manager. He had bought Berkshire shares a few years prior because they were cheap compared to the company’s assets.

In 1964, Berkshire’s then-leader, Seabury Stanton, offered to buy Buffett’s shares for US$11.50 each. Buffett agreed to sell. But Stanton’s official offer was slightly lower, at US$11.375 per share. Buffett was livid about being lied to, to the extent that he amassed a controlling stake in Berkshire to fire Stanton.

Berkshire was merely a struggling textile manufacturer when Buffett became its leader. But over the years, Buffett has thoroughly transformed the company through numerous inspired acquisitions and deft stock market investments.

Charlie Munger joined Berkshire in 1978. But for many years prior, he and Buffett were already collaborating. In fact, Munger helped Buffett to refine his already formidable investing prowess. 

Today the 88-year old Buffett and 95-year old Munger continue to lead Berkshire as chairman and vice-chairman, respectively. The company can also be rightfully described as a truly diversified conglomerate, with more than 60 subsidiaries across a wide range of industries. Here’s a sample of the companies under Berkshire’s umbrella:

• Berkshire Hathaway Reinsurance Group – provider of insurance products to other reinsurers and property, casualty, life, and health insurers globally
• GEICO – second largest insurer in the US auto insurance market (share of 13% at end-2018)
• Burlington Northern Santa Fe – one of the North American continent’s largest railroad companies
• Berkshire Hathaway Energy – one of the largest energy utilities in the US, and the second-largest residential real estate brokerage firm in the same country
• IMC International Metalworking Companies – among the top three manufacturers of consumable precision carbide metal cutting tools in the world 
• Precision Castparts – manufacturer of metal parts and components that go into aircraft
• Borsheim’s – fine-jewellery retailer
• Nebraska Furniture Mart –  furniture retailer (as its name suggests) 
• See’s Candies – chocolate and confectionary producer 

Berkshire’s reach extends beyond its subsidiaries. It also has a massive investment portfolio that is worth more than US$220 billion as of 30 September 2019. The portfolio consists of shares of more than 40 publicly traded companies that are mostly listed in the US. Some of them are also in my family’s portfolio, such as Apple, Amazon.com, and Mastercard. The investment portfolio is overseen by Buffett, Munger, Todd Combs, and Ted Weschler. 

Investment thesis

I had previously laid out my investment framework in The Good Investors. I will use the framework, which consists of six criteria, to describe my investment thesis for Berkshire.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

Berkshire is already a massive company, with US$247.8 billion in revenue in 2018. But I believe there’s still plenty of room to run for the conglomerate, although I’m not expecting rapid growth. 

I think a growth rate in the high single-digit or low double-digit percentage range for Berkshire is reasonable. This is because Berkshire’s diversified collection of US stocks and high-quality subsidiaries puts it in a great position to ride on the US’s long-term economic growth.

There are a few points I want to expand on. First is regarding the US economy. Over the years, Buffett has not been shy in sharing his enthusiasm about the US . In Berkshire’s 2018 shareholders’ letter, Buffett wrote:

“Charlie and I happily acknowledge that much of Berkshire’s success has simply been a product of what I think should be called The American Tailwind.

It is beyond arrogance for American businesses or individuals to boast that they have “done it alone.” The tidy rows of simple white crosses at Normandy should shame those who make such claims.

There are also many other countries around the world that have bright futures. About that, we should rejoice: Americans will be both more prosperous and safer if all nations thrive. At Berkshire, we hope to invest significant sums across borders.

Over the next 77 years, however, the major source of our gains will almost certainly be provided by The American Tailwind. We are lucky – gloriously lucky – to have that force at our back.”

(Do read the “The American Tailwind” section of Buffett’s 2018 letter.)

To build on Buffett’s American Tailwind idea, I want to highlight that the working-age population in the US is estimated to increase by 13% from today to 2050. That’s one of the brightest demographics among developed economies across the world. Here’s a chart from Morgan Housel showing this:

The second point I want to expand on is the quality of Berkshire’s subsidiaries. If you’re a long-time observer of Berkshire, you’ll know that a durable competitive advantage is one of the key qualities that Buffett seeks when making acquisitions. 

There are numbers to prove this point: Berkshire’s manufacturing, service, and retailing businesses earn healthy after-tax returns on net tangible assets while holding plenty of cash and using very little debt. The table illustrates this from 2012 to 2016 (the last year that Buffett reported the after-tax return on net tangible assets employed by this group of businesses).

A last note from me on Berkshire’s room for growth: Buffett and Munger are, in my eyes, two of the best investors in the world today, and they’re still constantly looking for bargains in the stock market and private businesses to acquire to strengthen Berkshire’s portfolio. 

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 30 September 2019, Berkshire’s balance sheet has US$102.2 billion in borrowings – that’s a fair amount of debt. 

But Berkshire also has a massive cash hoard of US$128.2 billion, including US$53.4 billion in short-term investments in US Treasury bills, which can be considered as cash for liquidity purposes. So Berkshire does have tremendous resources to invest for growth as well as withstand shocks.

There are huge insurance businesses within Berkshire. So I think it’s also important for me to watch the company’s ability to payout huge insurance claims from time to time. 

Buffett believes that “the annual probability of a US mega-catastrophe causing [US]$400 billion or more of insured losses is about 2%.” For perspective, a US$400 billion insured-loss is nearly four times the highest amount that the US has seen since 1980. This is illustrated in the chart below (the dark blue bars indicate insured losses in each year):

In the event that US$400 billion of insured losses happen in a year, Berkshire’s share would be just US$12 billion or so. This is a huge sum of money. But it is far less than the annual earnings the company expects from its non-insurance businesses. For context, Berkshire’s non-insurance businesses generated US$20.8 billion in pre-tax income in 2018, up 24% from 2017. Although Berkshire will be bruised by a US$400 billion mega-catastrophe event in the insurance industry, most other insurers would go bust according to Buffett. 

The diversification present in Berkshire adds another layer of financial resilience. I mentioned earlier that the conglomerate controls over 60 subsidiaries across many industries. This is also true of Berkshire’s investment portfolio. The 40-odd stocks in the portfolio belong to technology, banking, media, consumer products, and more.

3. A management team with integrity, capability, and an innovative mindset

On integrity

Buffett’s overall reputation, in business and in life, is pristine. The excerpt below, taken from Berkshire’s latest official proxy statement released in March 2019, will also shine tremendous light on the integrity of Buffett and Munger (emphases are mine):

“Due to Mr. Buffett’s and Mr. Munger’s desire that their compensation remain unchanged, the Committee has not proposed an increase in Mr. Buffett’s or Mr. Munger’s compensation since the Committee was created in 2004. Prior to that time, Mr. Buffett recommended to the Board of Directors the amount of his compensation and Mr. Munger’s.

Mr. Buffett’s annual compensation and Mr. Munger’s annual compensation have been [US]$100,000 for more than 25 years and Mr. Buffett has advised the Committee that he would not expect or desire such compensation to increase in the future…

...Mr. Buffett will on occasion utilize Berkshire personnel and/or have Berkshire pay for minor items such as postage or phone calls that are personal. Mr. Buffett reimburses Berkshire for these costs by making an annual payment to Berkshire in an amount that is equal to or greater than the costs that Berkshire has incurred on his behalf.

During 2018, Mr. Buffett reimbursed Berkshire [US]$50,000. Berkshire provides personal and home security services for Mr. Buffett. The cost for these services was approximately [US]$290,000 in 2018. Berkshire’s Board of Directors believe that in light of Mr. Buffett’s critical role as Berkshire’s CEO and given that Mr. Buffett spends a significant amount of his time while at home on Berkshire business matters that such costs represent bona fide business expenses.

None of Berkshire’s named executive officers use Company cars or belong to clubs to which the Company pays dues. It should also be noted that neither Mr. Buffett nor Mr. Munger utilizes corporate-owned aircraft for personal use.”

Buffett and Munger earn their riches predominantly from their ownership of Berkshire shares. As of 6 March 2019, Buffett controlled Berkshire shares that are worth around US$90 billion at the current price; Munger’s stake also makes him a billionaire (around US$1.5 billion). These high ownership stakes give me comfort that their interests are aligned with mine.

Although Buffett and Munger’s philanthropic actions are not directly-related to investing, I think they speak volumes about the characters of the two elder statesmen of business. The actions also inspire me, so I want to include a brief discussion. In 2006, Buffett pledged to donate more than 99% of his wealth to charitable causes during his lifetime or at his death. Since then, Buffett has already given more than US$34.5 billion to charities. Munger, meanwhile, has given hundreds of millions of dollars over the past 30 years toward the building of school facilities.

On capability

On the topic of capability, Berkshire’s track record of growth since 1965 has been nothing short of stunning. More on this soon.

On innovation

For a long time, Buffett was averse to technology stocks because he couldn’t understand them (he first broke the duck by investing in IBM in 2011, and of course Berkshire now has a big stake in Apple). So it’s no surprise that Berkshire is not the first name that comes to mind if we mention the word “innovation.”

But what Berkshire lacks in technological innovation, it makes up for with a unique mindset in business.

Let’s first talk about Buffett’s view toward acquiring companies. I want to discuss this because acquisitions will be one of Berkshire’s key growth drivers in the years ahead. The excerpts below from Berkshire’s 2008 shareholders’ letter are instructive (emphases are mine):

“Our long-avowed goal is to be the “buyer of choice” for businesses – particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises; avoid leveraging up acquired businesses; grant unusual autonomy to our managers; and hold the purchased companies through thick and thin (though we prefer thick and thicker).

Our record matches our rhetoric. Most buyers competing against us, however, follow a different path. For them, acquisitions are “merchandise.” Before the ink dries on their purchase contracts, these operators are contemplating “exit strategies.” We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses.

Some years back our competitors were known as “leveraged-buyout operators.” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage.

Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing.

A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.”

I believe that Buffett’s mindset of wanting to be long-term (eternal?) owners when acquiring companies, alone, is a competitive advantage in the private markets that is not easily replicable. Berkshire has walked the talk of being a responsible long-term owner of businesses and implementing decentralised management – these traits have made the conglomerate a preferred buyer when owners of good private family-built businesses are looking to sell. In his 2018 shareholders’ letter, Buffett again emphasised that Berkshire wants to be a long-term owner of the businesses that it acquires:

“You may ask whether an allowance should not also be made for the major tax costs Berkshire would incur if we were to sell certain of our wholly-owned businesses. Forget that thought: It would be foolish for us to sell any of our wonderful companies even if no tax would be payable on its sale. Truly good businesses are exceptionally hard to find. Selling any you are lucky enough to own makes no sense at all.” 

Some of you reading this may be wondering, “Is Buffett’s competitive advantage in acquiring companies really so simple? Isn’t that easy to replicate?” My response will be something Munger once said: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

Next, Buffett also does not push for short-term gains at the expense of Berkshire’s long-term business health. A great example can be seen in Berkshire’s excellent track record in the insurance industry: Its property and casualty (P/C) insurance business has recorded an underwriting profit for 15 of the past 16 years through to 2018. In contrast, the P/C industry as a whole often operates at a significant underwriting loss; in the decade ended 2018, the industry suffered an underwriting loss in five separate years.

4. Revenue streams that are recurring in nature, either through contracts or customor-behaviour

There are two main components to Berkshire’s operating businesses: Insurance, and non-insurance companies.

The insurance part consists primarily of GEICO, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group. Insurance is a service that organisations and individuals require on an ongoing basis, so there’s high levels of recurring activity there. GEICO, in particular, focuses on auto insurance, and that’s something drivers need every year.

For the non-insurance portion, two big entities are Burlington Northern Santa Fe (BNSF) and Berkshire Hathaway Energy. The former runs railroads in North America and the latter is an energy utility. Physical products will regularly need to be transported across the continent while energy (such as natural gas and electricity) is something that organisations and individuals require daily.

5. A proven ability to grow

Buffett is quite possibly the best capital allocator the world has seen to-date. The table below is taken from Berkshire’s 2018 annual report, and it shows the incredible 18.7% annual growth in the company’s book value per share since 1965, the year Buffett assumed control. ‘Nuff said.

In my explanation of this criterion, I mentioned that I’m looking for “big jumps in revenue, net profit, and free cash flow over time.” So why the focus on Berkshire’s book value per share? That’s because Berkshire’s main assets for many decades were public-listed stocks. Although, it’s worth pointing out that the company’s book value per share is increasingly losing its relevance as a measure of the company’s intrinsic economic worth  – Berkshire’s main value now resides in its subsidiaries.

It must also be said that Berkshire’s no slouch when it comes to free cash flow. The table below shows the record of the conglomerate’s annual growth in free cash flow of 11% going back to 2007. I picked 2007 as the starting point to show that Berkshire was still gushing out cash even during the Great Financial Crisis of 2008-2009.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

Berkshire has excelled in producing free cash flow from its businesses for a long time and has The American Tailwind on its back. So, I don’t see any reason to believe that Berkshire’s ability to generate cash from its businesses will change any time soon.

Valuation

In Berkshire’s 2018 shareholders’ letter, Buffett wrote:

“I believe Berkshire’s intrinsic value can be approximated by summing the values of our four asset-laden groves and then subtracting an appropriate amount for taxes eventually payable on the sale of marketable securities.”

The four groves Buffett mentioned refers to Berkshire’s (1) insurance operations, (2) non-insurance businesses, (3) ownership stakes in a quartet of companies – Kraft Heinz, Berkadia, Electric Transmission Texas, and Pilot Flying J – that it shares control with other parties, and (4) treasury bills, cash, and fixed-income investments.

I like to keep things simple in the valuation process, so I’m going to use an even simpler but sound heuristic to value Berkshire: Its price-to-book (P/B) ratio.

Earlier, I mentioned that Berkshire’s book value per share is losing relevance in being a proxy for the company’s true economic worth, so there’s a contradiction. I believe the contradiction can be resolved by simply allowing Berkshire to be seen as a bargain even if its PB ratio is significantly higher than 1. Buffett’s recent actions suggest this makes sense too.

For several years, Buffett had a standing order for Berkshire to repurchase shares if its P/B ratio fell below 1.2. But the order was amended by Buffett in July 2018: Now Berkshire can repurchase its shares at any time when he and Munger believe that the share price is “below Berkshire’s intrinsic value.”

Buffett publicly stated in his 2018 shareholders’ letter that over time, Berkshire is likely “to be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value.” From the third quarter of 2018 to the third quarter of 2019, Berkshire has spent a total of US$3.48 billion to repurchase 2,744 Class A shares and 12.04 million Class B shares. These buybacks have happened when the company’s PB ratio was clearly higher than 1.2 and averaging around 1.4.

The risks involved

Succession is the biggest risk I’m watching with Berkshire. Buffett and Munger are both getting on in years – I will be truly sad the day they are no longer around.

Berkshire has very capable senior leaders who are supporting Buffett and Munger, including Ajit Jain (head of all insurance operations), Greg Abel (head of all non-insurance operations), and the investing duo of Todd Combs and Ted Weschler. All four are much younger too, with ages ranging from 46 to 67. Buffett has also tasked his son, Howard Buffett, to assume a non-executive chairman role in Berkshire when Buffett-senior eventually departs. The younger Buffett would be responsible for protecting and nurturing Berkshire’s culture.

I am confident in Buffett and Munger’s succession plan. But it remains to be seen whether Berkshire’s dealmaking prowess, competitive advantages, and culture will diminish when the octogenarian and nonagenarian leave the scene.

A massive catastrophe is another key risk I’m watching. I mentioned earlier that Berkshire is able to brush off a US$400 billion industry-wide catastrophe event in the US. It will take a huge disaster to result in insured losses of US$400 billion. For context, the sum is nearly four times the highest amount that the US has suffered since 1980, as I already mentioned. But there’s no upper limit to Mother Nature’s wrath, especially given the alarm bells that scientists have been ringing in recent years on climate change.

The Good Investors’ conclusion 

Berkshire is not the fastest-growing company around, and its rapid-growth days are clearly over. But what it lacks in pace, it makes up for in stability. The conglomerate excels against my investment framework by having (1) the American Tailwind behind its back; (2) a diverse collection of excellent businesses; (3) a robust balance sheet and finances; (4) strong recurring revenues; (5) a great track record of growth; and (6) two brilliant leaders at its helm who have been there for decades – Warren Buffett and Charlie Munger – and who are as safe a pair of business-hands as anyone can find.

Every investment has risks, and so does Berkshire. Succession (because of the advanced age of Buffett and Munger) and major disasters (because a big part of Berkshire’s business is in insurance) are two big risks for the conglomerate that I’m watching.

But on balance, I believe that Berkshire is one of the lowest risk stocks there are in the world for producing a long-term annual return in the low-teens range. 

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

News broke yesterday that the embattled water treatment firm Hyflux has finally signed a S$400 million rescue deal with Utico, a utilities company based in the Middle East.

Although Hyflux has now been given a lifeline with Utico injecting capital, shareholders and creditors of the water treatment company don’t have much to smile over. There are important lessons we can learn from Hyflux’s experience.

Painful lifeline

Hyflux and Utico’s agreement came after months of talks between the two. It had also been over a year since Hyflux filed for bankruptcy protection in May 2018 and suspended the trading of its ordinary shares, preference shares, and perpetual securities.

The rescue deal will see Utico take a 95% stake in Hyflux at a value of S$300 million. This means that all of Hyflux’s existing owners of ordinary shares will emerge holding 5% of the company, with a value of merely S$15.8 million. Just prior to the May 2018 trading suspension, Hyflux had a total market value (or market capitalisation) of S$165 million. In other words, Hyflux’s ordinary shareholders are now facing a haircut of around 90%.

Meanwhile, there are 34,000 individuals who hold Hyflux’s preference shares and/or perpetual securities that collectively have a face value of S$900 million. Utico’s rescue deal will see these 34,000 individuals receive total payment ranging from only S$50 million to S$100 million. Even at a S$100 million payout, the owners of Hyflux’s preference shares and perpetual securities are still staring at a loss of 89%.

Avoiding disasters

It’s great timing that a user of the community forums of personal finance portal Seedly asked a question yesterday along the lines of “How can we avoid Hyflux-like disasters?” I answered, and I thought my response is worth sharing with a wider audience, hence me writing this article. Parts of my answer are reproduced below (with slight tweaks made for readability): 

“I’m not a pro, nor will I wish anyone to follow my investing thoughts blindly. But I used to write for The Motley Fool Singapore, and I wrote a piece on Hyflux in May 2016 when the company issued its S$300 million, 6% perpetual securities [the offering was eventually upsized to S$500 million].

The Fool SG website is no longer available, but there’s an article from The Online Citizen published in June 2018 that referenced my piece.

Back then, I concluded that Hyflux’s perpetual securities were risky after looking through the company’s financials. That was because the company had a chronic inability to generate cash flow and its balance sheet was really weak. Those risks sadly flared up in 2018 and caused pain for so many of the company’s investors.

What I wrote was this: “According to data from S&P Global Market Intelligence, Hyflux has been generating negative cash flow from operations in each year from 2010 to 2015. Meanwhile, the company currently has a net-gearing ratio (net debt to equity ratio) of 0.98, which isn’t low.””

What I shared was the financial traits I found in Hyflux that made me wary about the company. The great thing about those traits are that they can be applied to most situations in investing.

Simple rules

In my response to the Hyflux question in Seedly, I also mentioned (emphasis is added now):

“There are many things about a company to look at when investing. But I believe there are some simple rules that can help us avoid trouble. The rules are not fool-proof and nothing is fool-proof in investing, but they do work in general. The rules are: (1) Be careful when a company is unable to produce cash flow from its business consistently; and (2) be careful when the company’s balance sheet is burdened heavily by debt.”

The parts in italics above are rules that I believe are simple, yet incredibly effective. They also form part of my investment framework. Those rules are sometimes meant to be broken, as is the case with my decision to stay invested in Netflix, which has trouble generating cash flow and a heavy debt load for a good reason. But if we stick to the two rules with discipline, I believe we can keep ourselves out of trouble in the stock market most of the time.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Netflix (NASDAQ: NFLX) is one of the companies that’s in my family’s portfolio. I first bought Netflix shares for the portfolio in September 2011 at a price of US$26, again in March 2012 at US$16, and yet again in August 2017 at US$170. I’ve not sold any of the shares I’ve bought. 

The company has done really well for my family’s portfolio, with its share price rising to around US$300 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Netflix’s shares. 

Company description

Netflix is based and listed in the US. When it IPO-ed in 2002, Netflix’s main business was renting out DVDs by mail. It had 600,000 subscribers back then, and had an online website for its members to access the rental service. 

Today, Netflix’s business is drastically different. In the first nine months of 2019, Netflix pulled in US$14.7 billion in revenue, of which 98% came from streaming; the remaining 2% is from the legacy DVD-by-mail rental business. The company’s streaming content includes TV series, documentaries, and movies across a wide variety of genres and languages. These content are licensed from third parties or produced originally by Netflix. 

Many of you reading this likely have experienced Netflix’s streaming service, so it’s no surprise that Netflix has an international presence. In the first nine months of 2019, 48% of Netflix’s revenue came from the US, with the rest spread across the world (Netflix operates in over 190 countries). The company counted 158.3 million subscribers globally as of 30 September 2019. 

Investment thesis

I will describe my investment thesis for Netflix according to the investment framework (consisting of six criteria) that I previously laid out in The Good Investors. 

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

Netflix already generates substantial revenue and has a huge base of 158.3 million subscribers. But there’s still plenty of room for growth. 

According to Statista, there are 1.05 billion broadband internet subscribers worldwide in the first quarter of 2019. Netflix has also been testing a lower-priced mobile-only streaming plan in India. The test has done better-than-expected and Netflix is looking to test mobile-only plans in other countries too. Data from GSMA showed that there were 3.5 billion mobile internet subscribers globally in 2018. 

I’m not expecting Netflix to sign up the entire global broadband or mobile internet user base – Netflix is not in China, and I doubt it will ever be allowed into the giant Asian nation. But there are still significantly more broadband and mobile internet subscribers in the world compared to Netflix subscribers, and this is a growth opportunity for the company. It’s also likely, in my view, that the global number of broadband as well as mobile internet users should continue to climb in the years ahead. This grows the pool of potential Netflix customers.

For another perspective, the chart immediately below illustrates clearly that cable subscriptions still account for the lion’s share of consumer-dollars when it comes to video entertainment. This is again, an opportunity for Netflix. 

Subscribers to online subscription video services across the world has also exploded in the past few years. This shows how streaming is indeed a fast-growing market – and in my opinion, the way of the future for video entertainment. 

As a last point on the market opportunity for Netflix, as large as the company already is in the US, it still accounts for only 10% of consumers’ television viewing time in the country, and even less of their mobile screen time.  

2. A strong balance sheet with minimal or a reasonable amount of debt

At first glance, Netflix does not cut the mustard here. As of 30 September 2019, Netflix’s balance sheet held US$12.4 billion in debt and just US$4.4 billion in cash. This stands in sharp contrast to the end of 2014, when Netflix had US$900 million in debt and US$1.6 billion in cash. Moreover, Netflix has lost US$9.3 billion in cumulative free cash flow from 2014 to the first nine months of 2019. 

But I’ll explain later why I think Netflix has a good reason for having so much debt on its balance sheet.

3. A management team with integrity, capability, and an innovative mindset

On integrity

Netflix is led by CEO Reed Hastings, 58, who also co-founded the company in 1997. The long-tenure of Hastings in Netflix is one of the things I like about the company. 

Although Hastings is paid a tidy sum to run Netflix – his total compensation in 2018 was US$36.1 million – his pay has reasonably tracked the company’s revenue growth. From 2014 to 2018, Netflix’s revenue nearly tripled from US$5.5 billion to US$15.8 billion. This matches the 326% jump in Hastings’ total compensation from US$11.1 million to US$36.1 million over the same period.  

Hastings also owns 5.56 million Netflix shares as of 8 April 2019, along with the option to purchase 4.50 million shares. His ownership stake alone is worth around US$1.7 billion at the current share price, which will very likely align his interests with other Netflix shareholders.

On capability and innovation

Netflix was an early pioneer in the streaming business when it launched its service in 2007. In fact, Netflix probably wanted to introduce streaming even from its earliest days. Hastings said the following in a 2007 interview with Fortune magazine: 

“We named the company Netflix for a reason; we didn’t name it DVDs-by-mail. The opportunity for Netflix online arrives when we can deliver content to the TV without any intermediary device.”

When Netflix first started streaming, the content came from third-party producers. In 2013, the company launched its first slate of original programming. Since then, the company has ramped up its original content budget significantly. 

The table below shows Netflix’s total content cash spending from 2014 to 2018. There are two things to note. First, total content spending has been increasing each year and has jumped by around 340% for the entire time frame. Second, around 85%, or US$11 billion, of Netflix’s content spending in 2018 was for original content. Netflix’s content budget for 2019 is projected to be around US$15 billion, most of which is again for original content.

All that content-spending has resulted in strong subscriber growth, which is clearly seen from the table below. Netflix’s decade-plus head start in streaming – a move that I credit management for – has also given the company a tremendously valuable asset: Data. The data lets Netflix know what people are watching, and in turn allows the company to predict what people want to watch next. This is very helpful for Netflix when producing original content that keeps viewers hooked. 

And Netflix has indeed found plenty of success with its original programming. For instance, in 2013, the company became the first streaming provider to be nominated for a primetime Emmy. In 2018 and 2019, the company snagged 23 and 27 Emmy wins, respectively. From a viewership perspective, the third season of Stranger Things (I love the show!), launched in the third quarter of 2019, had 64 million households tuning in within the first month of its release. Adam Sandler’s comedy film, Murder Mystery, welcomed views from over 73 million households in the first month of its release in June this year.  

The move into originals by management has also proved to be prescient. Netflix’s 2019 second quarter shareholders’ letter name-dropped nine existing and would-be streaming competitors – and there are more that are unnamed. I think Netflix’s aforementioned data, and its strong library of original content, should help it to withstand competition.   

I also want to point out the unique view on Netflix’s market opportunity that management has. Management sees Netflix’s competition as more than just other streaming providers. In Netflix’s Long-Term View letter to investors, management wrote:

“We compete for a share of members’ time and spending for relaxation and stimulation, against linear networks, pay-per-view content, DVD watching, other internet networks, video gaming, web browsing, magazine reading, video piracy, and much more. Over the coming years, most of these forms of entertainment will improve.

If you think of your own behavior any evening or weekend in the last month when you did not watch Netflix, you will understand how broad and vigorous our competition is.

We strive to win more of our members’ “moments of truth”.”

Having an expansive view on competition lessens the risk that Netflix will get blindsided by competitors, in my view.

4. Revenue streams that are recurring in nature, either through contracts or customor-behaviour

Netflix’s business is built entirely on subscriptions, which generate recurring revenue for the company. As I already mentioned, nearly all of Netflix’s revenue in the first nine months of 2019 (98%) came from subscriptions to its streaming service, while subscriptions to the DVD-by-mail service accounted for the remaining small chunk of revenue.

But just having a subscription model does not equate to having recurring revenues. If your business has a high churn rate (the rate of customers leaving), you’re constantly filling a leaky bucket. That’s not recurring income. According to a recent estimate from a third-party source (Lab42), Netflix’s churn rate is just 7%, and is much better than its competitors.

5. A proven ability to grow

2007 was the year Netflix first launched its streaming service. This has provided the impetus for the company’s stunning revenue and net income growth since, as the table below illustrates. It’s good to note too that Netflix’s diluted share count has actually declined since 2007. 

In my explanation of this criterion, I mentioned that I’m looking for “big jumps in revenue, net profit, and free cash flow over time.” I also said that “I am generally wary of companies that (a) produce revenue and profit growth without corresponding increases in free cash flow.” So why am I holding Netflix shares when its free cash flow has cratered over time and is deeply in red at the moment? 

This is my view on the situation. Netflix has been growing its original content production, as mentioned earlier, and the high capital outlay for such content is mostly paid upfront. But the high upfront costs are for the production of content that (1) could have a long lifespan, (2) can be delivered to subscribers at minimal cost, and (3) could satisfy subscribers who have high lifetime value (the high lifetime value is inferred from Netflix’s low churn rate). In other words, Netflix is spending upfront for content, but has the potential to reap outsized rewards over a long period of time at low cost. The shelf-life for good content could be decades, or more – for instance, Seinfeld, a sitcom in the US, is still popular 30 years after it was produced. 

In Netflix’s Long-Term View shareholder’s letter, management wrote (emphases are mine):

“People love movies and TV shows, but they don’t love the linear TV experience, where channels present programs only at particular times on non-portable screens with complicated remote controls. Now streaming entertainment – which is on-demand, personalized, and available on any screen – is replacing linear TV.

Changes of this magnitude are rare. Radio was the dominant home entertainment media for nearly 50 years until linear TV took over in the 1950’s and 1960’s. Linear video in the home was a huge advance over radio, and very large firms emerged to meet consumer desires over the last 60 years. The new era of streaming entertainment, which began in the mid-2000’s, is likely to be very big and enduring also, given the flexibility and ubiquity of the internet around the world. We hope to continue being one of the leading firms of the streaming entertainment era.”

I agree with Netflix’s management that the company is in the early stages of a multi-decade transition from linear TV to internet entertainment at a global scale. With this backdrop, along with what I mentioned earlier on Netflix’s business model of spending upfront to produce content with long monetisable-lifespans, I’m not troubled by Netflix’s negative and deteriorating free cash flow for now. Netflix’s management also expects free cash flow to improve in 2020 compared to 2019, and “to continue to improve annually beyond 2020.”

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

I understand that Netflix’s free cash flow numbers look horrible at the moment. But Netflix is a subscription business that enjoys a low churn rate. It is also spending plenty of capital to pay upfront for long-lived assets (the original content). I believe that these provide the potential for Netflix to generate high free cash flow in the future, if it continues to grow its subscriber base.

Valuation

“Cheap” is definitely not a good way to describe Netflix’s shares. The company has trailing earnings per share of US$3.12 against a share price north of US$300. That’s a price-to-earnings (PE) ratio of around 100. But Netflix has the tailwinds of expanding margins and revenue growth. The company is currently on track to achieve its goal of an operating margin of 13% in 2019, up from just 4% in 2016. It is targeting an operating margin of 16% in 2020. 

Let’s assume that in five years’ time, Netflix can hit 300 million subscribers worldwide paying US$12 per month on average. The lowest-tier plan in the US is currently US$9 per month, and Netflix has managed to grow its average revenue per user at a healthy clip, as shown in the table below. 

With the assumptions above, Netflix’s revenue in five years would be US$43 billion. If we apply a 20% net profit margin, the company would then earn US$8.6 billion in net profit. With an earnings multiple of just 30, Netflix’s market capitalisation in five years would be US$258 billion, nearly double from the current market capitalisation of US$134 billion. This equates to an annualised return of 14%. I think my assumptions are conservative. Higher subscriber numbers, higher average revenue per user, and fatter margins will lead to much higher upside.

The risks involved

There are three key risks that I see in Netflix. 

First, Netflix’s cash burn and weak balance sheet is a big risk. I think Netflix’s strategy to produce original content is sound. But the strategy necessitates the spending of capital upfront, which has led to debt piling up on the balance sheet. I will be watching Netflix’s free cash flow and borrowing terms. For now, Netflix depends on the kindness of the debt markets – that’s a situation the company should be getting itself out of as soon as possible.

Second, there’s competition. Tech giant Apple and entertainment heavyweight Disney recently launched their streaming offerings, and the space is getting more crowded as we speak. As I mentioned earlier, I think Netflix should be able to withstand competition. In fact, I think the real victims will be cable TV companies. This is not a case of Netflix versus other streaming options – this is a case of streaming services versus cable. Different streaming services can co-exist and thrive. And even if the streaming market has a shakeout, Netflix, by virtue of its already massive subscriber base, should be one of the victors. But I can’t know for sure. Only time will tell. Netflix’s subscriber numbers in the future will show us how it’s dealing with competition.

Third, there’s key-man risk. Reed Hastings has been a phenomenal leader at Netflix, but he’s not the only important member of the management team. Ted Sarandos, 54, Netflix’s Chief Content Officer, is also a vital figure. He has been leading Netflix’s content team since 2000, and was a driving force in Netflix’s transition into original content production that started in 2013. If Hastings and/or Sarandos were to leave Netflix for whatever reason, I’ll be concerned.

The Good Investors’ conclusion 

Despite already having more than 158 million subscribers worldwide, Netflix still has a large market opportunity to conquer. The company also has an excellent management team with integrity, and has an attractive subscription business model with sticky customers. Although Netflix’s balance sheet is currently weak and it has trouble generating free cash flow, I think the company will be able to generate strong free cash flow in the future.

There are certainly risks to note, such as a high debt-burden, high cash-burn, and an increasingly competitive landscape. Key-man departures, if they happen, could also significantly dent Netflix’s growth prospects. 

But in weighing the risks and rewards, I think the odds are in my favour. 

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.