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.
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