September 08, 2010 - 3:24pm EST by
2010 2011
Price: 140.00 EPS $3.25 $5.00
Shares Out. (in M): 53 P/E 43x 28x
Market Cap (in $M): 7,420 P/FCF 43x 28x
Net Debt (in $M): -30 EBIT 290 450
TEV ($): 7,390 TEV/EBIT 25x 16x

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Thesis:  NFLX is a potential horse that is in the process of becoming the dominant online rental streaming service.  NFLX could earn $10-15/share over the next 3 years vs consensus expectations of ~$5-7/share.   This implies you are creating the dominant online streaming service for 9-15x eps with potential for additional upside to these #s.

Analogy:  Premium Cable Channels:  They offer a combination of original production and movie content (their movie content has a window of a few months after premiering on VOD) and generate monthly subscription fees through cable/satellite MSOs.  HBO has ~30m+ subs and 30% EBIT margins.  Now that NFLX has competitive content to HBO while also offering the content through a much better digital streaming solution, it has expanded its potential TAM penetration to be in line with or greater than HBO. 

How This Plays Out:
NFLX will continue to grow subs at ~30-40%/year for the next few years and achieve a sub base of 30-40m.  ARPU will decline from $12.20 to $10.50, churn will decline from 4% to 2.8/3% and SAC will decline from $24 to ~$20.  EBIT margins will expand from 14.5% to 20-30%.  They will generate $10-15/share in EPS vs street expectations of ~$5-7/share.   There is upside to these #s as they go international and/or increase pricing.

Bear Case:

  • TAM Saturation: NFLX true TAM is the dvd rental market and it already has ~35%+ market share of all DVDs rented (ie volumes) in the US and the DVD rental market only grows 1-2% annually. It has touched ~30% of all US HHs and only has ~13-14% of US HHs as current subs as the rest have churned off. At the current churn rate, NFLX has to touch 60%+ of HHs in order to meet consensus expectations. This seems very unrealistic and will be even more difficult as consumer's transition to digital consumption where NFLX doesn't have as high quality content as their physical "by-mail" product.
  • Digital Competition: Digital competition from players like AAPL, GOOG, AMZN and Hulu is going to crush NFLX profitability. These players have a lot more financial muscle to invest in a competitive offering and they are all focused on either bringing a digital product to market or improving their current offering.
  • Margin Pressure: NFLX is paying ~$1b for the Epix deal over ~5-7yrs, is likely to have to pay more for Starz digital content when that contract renews and it will have a tough time offsetting increased content costs with reductions in marketing spend or reductions in postage/dvd purchases. As NFLX is forced to buy additional digital content, margins are likely to deteriorate.
  • Valuation:  NFLX trades at 23x consensus 2012/13E EPS which is very rich considering the above dynamics.

1) Incorrect Framing of the TAM:  The Epix deal was a game changer for NFLX.  They now offer a true competitive alternative to HBO and a superior offering to the other premium cable channels for a cheaper price.  This should allow NFLX to achieve similar (if not better) scale to HBO of ~30m+ subs.                                                                                                      2) Dominant Digital Streaming Service:  NFLX has the best digital streaming product in the market today that allows consumers to watch movies/tv shows from a variety of devices and at a lower price/unit than any digital competitor.  As NFLX continues to grow and reinvest additional profitability into additional content, their advantage continues to grow stronger.   
3) Margin Expansion:  NFLX is currently in a virtuous circle of experiencing an improving value proposition, improving key metrics, rapidly growing subs and physical to digital transition of its sub base which drives margin expansion.   This has driven an increase in EBIT margins from 10% to 14.5% while also allowing NFLX to reinvest in digital content.  As NFLX product is now competitive with HBO, they should be able to grow their sub base more in line with HBO and achieve similar ebit margins closer to 30% as they achieve that scale.
4) Valuation:  Assuming NFLX can achieve HBO economics, it trades at ~10x 2012/13E EPS.

Key Points
1) Superior Value Proposition:  NFLX has competitive content to HBO with better digital distribution for a cheaper price.  It also has superior content to other premium cable channels for a cheaper price.

a. Premium cable channels:  Content includes:  1) original production + 2) movie studio content with a 3 month window post VOD and distribution is primarily through cable/satellite MSOs.
     i. HBO:  Content includes:  1) original production + 2) movies from Universal, Time Warner, New Line, Fox and select Dreamworks content for ~$8-15/month (depending on MSO    provider and if its bundled).
     ii. Showtime: Content includes:  1) origination production + 2) movies from Summitt, Weinstein Co and select Dreamworks content for ~$7-13/month (depending on MSO provider and if its bundled)
     iii. Starz: Content includes:  1) origination production + 2) movies from Sony and Disney for ~$7-13/month (depending on MSO provider and if its bundled).
     iv. Epix:  Content includes movies from Paramount, MGM and Lionsgate for $10/month.

b. NFLX:  Content includes:  1) digital content from Starz, Epix (3 month window), Relativity Media + 2) several cable TV shows digitally + 3) back catalogue original production from premium cable channels digitally + 4) digital catalogue content from several studios + 5) DVD by mail content + 6) digital content is distributed via streaming over multiple devices all for ~$9/month. 

2) Dominant Digital Streaming Service:  NFLX is transforming its business model into the dominant streaming service with high quality content and the best viewing experience at the lowest price. 

      i. NFLX currently has the best digital streaming product in the market and continues to reinvest additional profitability back into additional streaming content.  
      ii. This is a very reflexive dynamic where the bigger NFLX gets, the more content it can buy and the more content it buys, the greater TAM penetration they are likely to achieve.   

3) 2-3x Potential:  NFLX is currently  a $7.5b market cap that could be a $15-20b market cap in the next 3yrs as EPS increases from ~$3.30 in 2010E to $10-15 in 2012/13E.

      a. TAM Penetration:  NFLX TAM is the 100m+ cable/satellite HHs in the US.  Given its competitive/superior value proposition to HBO, achieving 30-40% penetration seems reasonable (vs 30% for HBO).  NFLX currently has 25%+ HH penetration in its first market in the Bay Area, up from 20% a year ago.
      b. Margin Expansion:  As NFLX continues to improve its value proposition and strengthens its competitive moat, SAC/churn should continue to decline.  As an example, SAC has declined by 25% over the past 2yrs and churn has declined by ~20-50bps despite the massive growth in gross sub adds.   As customers switch from physical to digital consumption, NFLX will have up to $800m of COGS savings (postage + physical dvd content).  And as customers grow, NFLX will be able to leverage its increasingly fixed cost base.  In the next few years, there could be $800m-1.5b+ of EBIT growth ($10-20 in EPS) that will be reinvested in new content while also driving margin expansion.  This could be a bumpy transition though as they may have to pay for chunks of content upfront and the physical to digital transition could take longer than expected, causing a temporary hit to margins.
      c. Additional Upside:  Additional upside could come from:  1) pricing power as NFLX reinforces its place as the #1 digital streaming service and/or 2) replication internationally.  NFLX is launching its digital streaming service in Canada later this year and is already in discussions with studios for the Canada launch.

Key Signposts:

  • NFLX just announced an exclusive digital streaming deal with Epix giving them access to content from Paramount, MGM and Lionsgate with a few month window post Epix release
  • NFLX announced an exclusive digital streaming deal with Relativity Media with the standard premium cable channel window
  • NFLX is being distributed on AAPL tv and Google TV
  • NFLX now has "new" digital streaming content from 6 studios which is comparable/superior to the premium cable channels
  • Over the past 6-8 quarters, sub growth has accelerated from 25% to 40%+ annual growth , churn has declined by 20-50bps and SAC has declined by ~25%
  • EBIT margins expanded to 14.5% in the latest quarter from ~10% 6 quarters ago


Key Risks:

  • Competitive digital alternatives from AAPL, AMZN, Hulu, etc take share from NFLX and hurt profitability
  • New competitor/technology disrupts the NFLX business model
  • NFLX lack of original production content makes the premium cable channels a bad analogy and NFLX is unable to gain their sub scale




EPS coming in significantly ahead of expectations over the next 2 years as sub growth continues at a strong pace and margins expand dramatically
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