As one of the best performing stock of the 2010s, it is no surprise that Netflix is also one of the most talked-about stocks on the internet. But despite the seemingly endless discussions online, I still think there are some aspects of the company that some investors may be overlooking.
I want to discuss these aspects in this article.
#1 There is a clear path to positive free cash flow generation
Netflix had a negative free cash flow of US$3.5 billion in 2019, extending a streak of eight years of increasing cash burn. This burn rate certainly cannot go on forever and it is what’s putting many investors off. The negative free cash flow is even more alarming when you add the fact that the company is in a net debt position of around US$9 .7billion.
However, Netflix’s high cash burn rate may soon be a thing of the past. Netflix’s CEO, Reed Hastings, believes a turnaround is on the cards. In its most recent 2019 fourth-quarter shareholder letter, Netflix said:
“For the full year, FCF was -$3.3 billion which we believe is the peak in our annual FCF deficit. Our plan is to continually improve FCF each year and to move slowly toward FCF positive. For 2020, we currently forecast FCF of approximately -$2.5 billion… With our FCF profile improving, this means that over time we’ll be less reliant on public markets and will be able to fund more of our investment needs organically through our growing operating profits.”
I think management’s confidence is entirely warranted. Let’s break it down. The majority of the cash Netflix is spending is for the licensing and production of content. In 2019, Netflix spent US$14.6 billion on streaming content, meaning around 75% of its US$20 billion in revenue was spent on content alone.
To improve its free cash flow metric, Netflix needs to spend much less as a percentage of its revenue. And I think its entirely possible that this scenario will play out sooner rather than later.
The math is simple.
There is a fixed cost to producing content but the value of the content scales as the user count grows.
For instance, the content that Netflix is producing today can reach its 167 million global subscribers. But as the number of subscribers grows, the content it is producing will reach a larger subscriber base. Put another way, the fixed amount spent on each movie or series will be spread out across a much larger revenue base as user count grows.
Over time, the amount of cash spent on content will take up a much lower percentage of revenue and, in turn, free cash flow should eventually be positive.
#2 Content retains value over a long time frame
Another point to note is that the company is actually already profitable and has been for a few quarters. Then why is the company free cash flow negative?
For one, the company is spending money upfront for content that it is only releasing in the future. As such, it does not recognise this into its income statements. Think of it as capital expenditure for the future.
The second reason is that the content is amortised over a multi-year time frame. I think investors underappreciate the fact that much of the original content that Netflix is producing will be in its content library forever. Good content, while most valuable when it’s first released, retains some of its value to viewers for years. Case in point include hits such as Friends and Seinfield, which fans love to rewatch.
I think investors often overlook these two facts: (1) that Netflix’s current cash burn includes its spending for the future, and (2) good content retains its value over a multi-year period.
#3 Competition is not hurting Netflix as much as feared
When Disney and Apple announced that they would be entering the online streaming market, I’m sure many Netflix watchers (shareholders included) must have feared the worse. Disney has a vast library of intellectual property and Apple is flush with cash. Surely, Netflix would be in trouble.
However, competition has not hurt Netflix as much as some may have feared. In the fourth quarter of 2019, Netflix’s paid memberships in the United States increased by 400,000. While this fell short of analyst estimates, the growth in paid subscribers at a time when Disney Plus was released shows how sticky Netflix’s user base is. More impressively, the gain in member-count in the US in 2019 coincided with an increase in the membership price by US$2.
Internationally, growth continues at a breakneck pace. Paid memberships outside of the US increased from 80.8 million in 2018 to 106 million in 2019, a 25% increase.
There are a few things to glean from these trends.
First, Netflix’s subscriber base is sticky. The lure of original content that customers love and the fact that Netflix’s price point is still considerably lower than cable TV means customers are willing to stick around despite price hikes.
Second, Disney Plus, Apple TV, Amazon Prime, and Netflix can co-exist.
A recent survey of Netflix subscribers showed that they are willing to subscribe to multiple streaming video subscriptions. The trend is fueled by consumers reducing their spending on traditional TV offerings by turning to streaming services.
On top of that, subscribers who want to watch Netflix Originals have no alternative besides subscribing to Netflix.
In its most recent shareholder letter, Netflix explained:
“We have a big headstart in streaming and will work to build on that by focusing on the same thing we have focused on for the past 22 years – pleasing members.”
With Netflix’s content budget dwarfing all its competitors (US$15 billion in 2019 vs US$6 billion for Amazon Prime, the second-largest spender of content), the chances that subscribers switch to another online streaming platform looks much slimmer than what investors may have initially feared.
The Good Investors’ conclusion
Netflix is one of the more divisive stocks in the market today. There seems to be an endless discussion between bears and bulls online.
In my view, I think there are a few crucial aspects of Netflix that some investors may be overlooking:
- Netflix has a clear path towards free cash flow generation
- It is spending wisely on well-loved content that retains value over a multi-year period
- The threat of competition is not as bad as it looks
Moreover, management has a knack of spotting trends well before they develop. As such, shareholders should be confident that management will be able to adapt and thrive even as operating environments change.
Given all this, I think Netflix looks poised to prove its doubters wrong.
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