September 09, 2019 - 4:08pm EST by
2019 2020
Price: 294.57 EPS 0 0
Shares Out. (in M): 438 P/E 0 0
Market Cap (in $M): 128,000 P/FCF 0 0
Net Debt (in $M): 8,000 EBIT 0 0
TEV ($): 120,000 TEV/EBIT 0 0

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Concerns about a price increase on U.S. subscribers, a disappointing net international subscriber growth, worries about intensifying competition, both at home and abroad, and a volatile broader market (exacerbated by the Brexit) in which it is difficult to own stocks that pay no dividend, repurchase no shares, have high ownership turnover, and generate negative free cash flow, have created an attractive risk/reward in Netflix.

Sound familiar? It looks like the above paragraph would serve well as an introduction to a long Netflix pitch today, following the stock's 20%+ sell-off following a weaker than expected Q2 2019 print. However  it is in fact a lightly edited version of Winbrun's prescient 2016 long pitch on Netflix. Since Winbrun's pitch, Netflix shares have more than tripled, whilst global subscribers have almost doubled from 88mn to over 150mn.

Similarly, we believe that the market isn't seeing the forest from the trees following Netflix's weaker than expected second quarter results, and believe that the recent pull back provides an excellent entry point into a company that is scratching the surface of a huge international market opportunity, has ample pricing power and is rapidly growing in a business (global SVOD), where it has a huge head start versus rivals and where almost every aspect of its business model benefits from greater scale.

Strengths of Netflix Business model

The bull thesis on Netflix's business model is relatively well-known. It is basically to invest in content, which will then spur member growth, which will then allow the company to raise membership fees due to the better experience, which then affords the company more money to invest in greater content and thereby creating this virtuous flywheel.

Source: Netflix Citi presentation 2016

I think this business model bears similarities with other winner-take-all models, such as Costco and Amazon. Nick Sleep, an investor who I'm sure many on VIC are acquainted with, refers to such a model as having shared economies of scale. This is whereby, rather than retaining the benefits of scale through higher margins, these efficiencies are shared with the customer thereby strengthening the company's moat.


In an investment pitch on Costco featured in VII in 2006, Sleep writes, “In the office we have a white board on which we’ve listed the very few investment models that work and that we can understand. Costco is the best example we can find of one of them: scale efficiencies shared with customers. We often ask companies what they would do with windfall profits, and almost no one replies ‘give it back to customers’. How would that go down with Wall Street? That is why competing with Costco is so hard to do. The firm is not interested in today’s static assessment of performance. It is managing the business to raise the probability of long term success."


Similarly as Jeff Bezos articulated in an Amazon investor letter in 2005, “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. 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”

With Netflix's business model, they are focussed on cementing their position as the dominant global leader in SVOD. Therefore, the benefits of Netflix's scale are being passed back through to members in the form of greater, more varied and higher quality content, thereby accelerating further member growth. This lends multiple strengths to Netflix's business model including:

·        Scale Benefits: With the most number of subscribers, Netflix can afford to pay the most for high quality content, and amortize the production over a larger user base, thereby allowing it to be the lowest cost producer for a given piece of content on a per subscriber basis. This will be further amplified as Netflix continues its torrid rate of growth overseas. Furthermore, media analyst (and former Amazon Studios Strategy Head) Matthew Ball brings up Netflix's content ceiling. It is only limited by the number of subscribers it can attract and retain, whereas linear TV has only a set amount of primetime timeslots. Ball believes it only makes sense for Netflix to exploit this by ramping up content spend, noting, "Free of structural limitations, Netflix’s output is bound only by the company’s ambition and its ability to attract audience – both of which are unprecedented in its category. It follows that content spend would be, too."

·        Ability to attract creatives: Netflix's large cheque book has allowed it go up the value chain and lock-up the output of A-List creatives on multi-year deals. Notable announcements include luring Shonda Rhymes (Grey's Anatomy/Scandal) from ABC, Ryan Murphy (Glee, Nip/Tuck, American Horror Story) and Benoiff/Weiss (Game of Thrones) on large nine-figure deals. In addition, the Obamas have partnered with Netflix to produce a number of films and documentaries and explicitly stated that ability to impact the large subscriber base that Netflix provides was a major factor in their decision.

·         Network effects in customer data: Even before Netflix made a serious move into producing original content, it has an extensive database of its user's viewing habits and preferences. This creates a network effect, as Netflix's subscriber base increases, as it will continue to gain a better understanding of its members, which will allow it to massively increase the efficiency of its overall content spend to increase user engagement.

·        Pricing Power: Netflix strategically underprice their subscriptions in order to drive subscriber growth. The value that Netflix members receive from their membership is well in excess of the cost paid, and this will only increase as Netflix continues to ramp up its content spend, thereby maintaining/increasing the value/cost gap, even as Netflix continues to pass through membership price hikes. Netflix is not currently priced to maximise revenue in the near term, and the value/cost gap will only close as Netflix's member base matures.

However, following the release of Netflix's Q2 results, they saw a small decline for the first time ever in domestic subs , whilst international subs came in well below expectations (+2.8mn actual vs 4.7mn expected). This shocked the market and raised questions as to i) Netflix's pricing power (given this followed the largest price hike in Netflix's history, adding $2/mo to standard/premium and $1/mo to basic), ii) whether domestic TAM was largely penetrated and iii) whether international TAM lower than expected. In addition, the bear arguments returned in force, with concerns over increased competition (notably Disney+), loss of licensed content, the quality of Netflix's originals and concerns over their funding content spend cash-burn (driven by cash costs being higher than amortisation) with high-yield debt.

I'll look to address some of these concerns below

·        Losing popular content: Netflix is set to lose license rights to Friends and The Office (US) in 2020 and 2021, respectively. These were two of the most popularly streamed shows on Netflix, thereby raising concerns that members could cancel their subscriptions once these are no longer offered. However a few counterpoints to this - i) no one show makes up a large proportion of Netflix's overall offering. Ted Sarandos (Netflix's Chief Content Officer) notes that typically when popular content is lost, then members will typically migrate to different content, but still remain engaged. We're inclined to agree. ii) These losses mainly impact on domestic subs which now accounts for less than half of Netflix's total subscriber base (and progressively becoming smaller), iii) this frees up to budget to invest in Originals or other licensed content, where Netflix is an efficient bidder and iv) it can equally be argued that that the renaissance that shows like Office and Friends have had on Netflix has as much to do with Netflix's product/tech making the shows binge-able (ie, streaming, skipping credits, ad-free, etc).  

·        Increased competition: Alluded to above, the SVOD space is heating up. Disney+ is set to launch later in the year, whilst AT&T is launching a service with HBO as the crown jewel, NBCUniversal is planning to launch a service in 2020, Apple is investing in television content and of course Amazon remains a competitive threat. Despite this, it will firstly take a while for any of these streaming services to gain full access to their libraries as license deals run off. Secondly, Netflix is starting at a huge advantage in subscriber base and technology (Matthew Ball makes the point that Netflix has more technology employees than HBO has employees total). And finally, Netflix will be massively outspending all of them on content, with all the competitive advantages outlined above. Netflix management also point out that more players and content in the SVOD space is not necessarily a bad thing and may even hasten cord cutting, as customers run multiple SVOD offerings to augment their content needs.  

·        Pricing Power diminished: Particularly following the slight decline in domestic subs in Q2, along with the expectation of greater competition, bears believe that contrary to popular belief, Netflix actually has far less pricing power than bulls would have you believe.  However, much like when bears questioned this around the time of Winbrun's 2016 write-up, we believe this is an over-reaction to one quarters worth of results. Looking at the chart below shows the long-term trend in subscriber growth, following price rises and given our contention that for Netflix value still far outweighs cost, we believe Netflix's pricing power remains and more proof is required to believe otherwise.  

·        TAM/scale benefits overstated: The charge levelled by bears here is that Netflix's international TAM is smaller than bulls believe for two main reasons. Firstly, there is a limit to how well its US content will travel overseas (and vice versa) and secondly, that whilst a Netflix subscription may be cheap in a developed markets context, it is still quite expensive in many emerging markets. On the first point, Winbrun pointed out the scale of HBO's international subs, with predominantly US-english content. Add to that, Netflix's investment in overseas content in addition to its very under-rated (and costly) dubbing and subtitling efforts to make sure content can travel as wide as possible, and its direct to consumer model (in several countries, HBO relies on local cable operators for distribution), and it's clear that Netflix should have a substantially larger TAM than HBO. Furthermore, international originals like Money Heist (Spanish), Dark (German) and Sacred Games (Indian) are streaming well outside of their local markets, demonstrating that the global scale argument does stack up for several of the foreign originals. On the second point, Netflix is experimenting with a lower-ARPU mobile-only access in India, which should dramatically increase the global TAM for the Netflix product if rolled-out (yes at lower ARPU, but this would massively increase the TAM from the fixed broadband households ex-China of ~700-800mn that is typically thought of as Netflix's TAM, whilst remaining a source of incremental revenues.)

·        Netflix's cash-burn/weak balance sheet: Whilst Netflix reports modest operating income, bears point to its recent cash burn over the past few years, which Netflix has funded through the high yield bond market. The bear view is that Netflix is on some Ponzi-like path as content spend outstrips revenue/sub growth, and everything will fall like a house of cards if Netflix take their foot off the gas. Firstly, we don't subscribe to that view at all. We acknowledge that cash burn is elevated as producing and globally licensing content is initially more expensive than buying regional licenses. Ultimately, we think this investment phase is wise for the reasons we outlined above, and it is wholly appropriate that Netflix spend on content to cement their leadership status in Global SVOD. As the membership base matures, it would then be appropriate to temper content spend and exercise pricing power to a greater degree.  Secondly, Netflix's debt levels are manageable in the context of their current market capitalization (less than US$8bn net debt (30th June 2019) vs market cap of US$127bn), and when looking at the YTM of outstanding bonds, it is clear that credit markets don't appear concerned with Netflix's indebtedness levels.  


We don't believe conventional valuation methods apply in the intermediate term as Netflix (correctly) focuses on growing its global member base, rather than maximising GAAP earnings. But as a thought exercise, if in the next five years, membership increased at a CAGR of 18% to 300mn members and ARPU increased by slightly over 6%pa (from $11 to $15), Netflix would be making annual revenue of over US$54bn, or 5yr forward Price/Sales of less than 2.4x. Whilst I wouldn't consider these assumptions to be conservative, nor do I consider them to be aggressive, if Netflix succeeds in attaining a dominant market position in Global SVOD. When also considering that, i) all its major expenses (content amortisation, marketing, tech) should favourably scale and that Netflix is still likely to have untapped pricing power and unpenetrated TAM, there remains material upside in NFLX shares, should it successfully achieve its ambitions.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Continued membership/ARPU growth

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