Netflix,
A fundamental analysis!
February 22, 2019
SHARE PRICE: $356,97
MARKET CAP: $155,85B
1. INTRODUCTION
I am analysing what some consider to be the baby Netflix and I will post it here sometime soon but in the meantime I thought it would be a good idea to analyse Netflix. I don’t need to go to their website because I know it very well, but I’ll leave it here. Website!
2. BUSINESS OVERVIEW
2.1. BUSINESS DESCRIPTION
Netflix is an OTT (over-the-top) subscription based streaming service from the USA and is now present in more than 190 countries with more than 139 million paying subscribers.
Funny as it may seem, Netflix started back in 1998 as a subscription based DVD catalog and delivery service. And yes, they are still mailing out DVD’s. Yes. Seriously!
Subscribers, or members as they like to call them, pay a monthly fee and get access to all content on their platform. It’s a simple business with lots of scalability, high operational leverage and low marginal costs. After covering for all their expenses, every dollar that comes in, flows right to the bottom line, which means that every new dollar is more profitable than the previous one.
2.2. LARGEST SHAREHOLDERS
Great to know that the founder is still one of the major shareholders.
2.3. MANAGEMENT TEAM
The founder and CEO, Reed Hastings is the responsible for the now famous slide deck where he outlined the company’s culture.
The CFO is a new guy, Spencer Neumann, who came from Activision Blizzard.
3. HISTORICAL CONTEXT
3.1. LONG TERM CHART
As most tech companies, Netflix’s stock price took a hard plunge in 2018, and is now at $356,97 representing a gain of 33.000% from the IPO price of $1,07 (split adjusted) in 2002. That’s a 41% compound annual rate of return!!!
3.2. MARKET CAP AND SHARES OUTSTANDING
The number of shares outstanding has been quite stable over the years (split adjusted), but not the market cap. Netflix is currently priced by Mr. Market at $157B.
3.3. SALES - OPERATING INCOME - OPERATING MARGIN
The beauty of analysing these american growth companies is that sales are almost always on the rise and they produce these amazing charts.
But let’s get down to the numbers. Sales for 2018 were $15,7B, a whopping 35% higher that in 2017. Operating Income has risen too, reaching the $1,6B, growing 91% from 2017!!!
Operating margin has reached 10% in 2018 and it is expected to go up to 20% in 2021. It was just 4% two years ago, so they seem to be doing things right.
3.4. SUBSCRIBER COUNT
Whenever we talk about a subscription based business we’ve got to look at the number of subscribers. This is one of the metrics Mr. Market focuses on the most.
In 2017 they’ve reached a point where the number of international subscribers overcome those from the US, and this trend should get even more pronounced in the coming years.
3.5. SALES BY GEOGRAPHY
Netflix doesn’t discriminate its revenues by country. They just differentiate the USA from the rest of the World.
Like what we’re seeing in the number of subscribers, the revenue coming from around the globe is growing a lot faster (52%) than the revenue from the USA (24%).
Netflix has reached a point where they can still grow the number of international subscribers at a meaningful rate, but the future growth rate from the US will come mostly from increases to the subscription price.
And they’ve been doing that successfully. Average price per subscriber has gone from $87 in 2013 to $130 in 2018. That’s an average of 8% a year, and it tells me that they’ve had good pricing power so far.
3.6. NET INCOME, NET MARGIN
Net Income is clearly on a rising trend reaching $1,2B in 2018, an amazing 117% more than in 2017. Analysts expect net income to reach $4,4B in 2021.
3.7. CASH FLOW
Cash is a fundamental part of every Netflix analysis. Netflix is spending increasing amounts of cash on content, but that investment is neither recorded as an expense on the P&L, neither as an investment on the Statement of Cash Flows……
…….It is recorded as an expense on the “Cash from operating activities”, and because this figure was $13B in 2018, the “Cash from operating activities” was negative, leading to a negative FCF (green bars).
Because Netflix capitalizes those expenses (which means they are recorded on the balance sheet like if they were assets, and depreciated through the lifetime of each movie/series instead of appearing on the the P&L when they are incurred), net income is positive but cash from operations is negative.
Management is hoping that from 2020 onwards they will grow the operating margin to a level high enough to be able to self fund more of their operations.
3.8. DIVIDENDS
Because Netflix is investing heavily on growth, there is no dividend for the shareholders.
3.9. PROFITABILITY RATIOS
Although the return-on-equity is 23%, this is because the debt level is high and the equity is low. If we take a look at the return-on-assets we can see that at 5%, it tells another story.
3.10. FINANCIAL RATIOS
Both the current ratio and the debt-to-equity ratios have been deteriorating along the years. Although the current ratio is at a healthy level, the debt-to-equity ratio is at a level I consider too high.
3.11. PRICE TO EARNINGS RATIO
Of course such a high growth comes with its perks. In this case it is the price we have to pay to get access to that growth. With a forward 2019 PE of 86, Mr. Market is expecting Netflix to keep growing at the rates we’ve seen until now.
4. GAINING PERSPECTIVE
4.1. INDUSTRY AND OUTLOOK
Netflix’s strategy is somewhat close to Uber’s or Amazon’s. Grow, grow and grow before everyone else, in order to gain market share. While it’s growing, it doesn’t matter if the company is generating cash or not. That’s not the point. At some point they’ll stop spending so much and turn cash generative.
I think they are obviously pursuing the right strategy, but this is an industry with low barriers to entry and an absence of switching costs. Today I might be a subscriber, tomorrow I can just unsubscribe and join another platform.
And yes, Netflix has first mover advantage and has a lot of content already, and it is producing a lot more, it’s true. But do you know who’s already in this game and who’s coming in at the end of the year? Amazon and Disney. (no to mention Youtube). I wouldn’t want to compete with those guys.
So what can Netflix do? They can improve their content and expand into other areas like they are doing with “kids and family” or with foreign languages content.
I’ve even heard someone talk about the possibility for Netflix to go into theatrical releases across cinemas, effectively gaining hundreds of millions of dollars in box office revenue. It might not be a bad idea.
4.2. SEASONALITY
Typically the first and fourth quarters (October through March) are the ones where subscriber growth is the highest. On the annual report they also state that they see a growth in subscribers when they release “high profile original content”.
4.3. RISKS AND COMPETITION
As we’ve seen before, Netflix’s main risk is competition.
4.4. TYPE OF PLAY
Netflix is a growth play.
5. OVERVIEW AND CONCLUSION
5.1. OVERVIEW
Netflix is a major disruptor and a big success story. I bet it will be studied around the world for a long time.
While I don’t go as far as saying that Netflix alone blew out giants like Blockbuster and millions of mom and pop shops around the world, (I think the internet in general was the responsible for that), the truth is that Netflix enabled even the least tech savvy person to access video content without leaving the comfort of their couch.
By the way, do you know what Jim Keyes, Blockbuster’s CEO said about Netflix back in 2008? “Neither RedBox nor Netflix are even on the radar screen in terms of competition“. Do you know what happened 2 years later? Blockbuster filed for bankruptcy.
Netflix is spending huge amounts of cash in order to build up a fabulous library that should keep subscribers from turning to other platforms. I was watching their latest earnings call on youtube and I thought to myself “What else can they do?”, there are no barriers to entry.
As the living legend John Malone said, they should become enormously cash generative when they stop spending. But when will that happen? The management is pointing to 2020, but with the big boys coming into the game, I don’t think they can take the foot off the pedal that easily.
At such a high valuation, I think that even the slightest deviation from expectations will make the stock price plunge. With the industry dynamics changing so rapidly and without a clear picture where Netflix will be 5 year from now (let alone 10 or 20), I prefer to stand on the sidelines and watch the war unfold.
“You don’t have to swing at everything – you can wait for your pitch.” Warren Buffett
5.2. CONCLUSION
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