Description

Disclaimer:  This isn't a bet on the quarter (don't have a differentiated view from MScience, SimilarWeb, Google trends, or any 3rd-party data), but given the move up into the print, I wanted to call out that the risk/reward into tomorrow's earnings is no longer as asymmetric (it was $215-220 a couple days ago).  Nonetheless, I still thought it would be worth sharing in advance of the print as folks tend to be interested in FANG generally, NFLX can alas be valued on traditional metrics (GAAP EPS), and it's one of the few big tech names where you can realistically pencil to numbers moving higher in '23-24.  As always, would be great to hear thoughts from folks on the other side.     

Overview

Netflix is a leading streaming entertainment platform.  At ~$245, it’s a ~$109bn market cap that generates ~$32bn of revenue from ~225mm global subscribers that pay an average of ~$12 per month.  After pulling demand forward through Covid, NFLX is now poised to reaccelerate growth with the tandem of launching a lower cost ad-supported tier in conjunction with cracking down on the ~100mm of global households that NFLX estimates are ‘sharing passwords’.  With estimates reset after several consecutive quarters of cuts and valuation (on a GAAP basis) now reasonable in light of these growth initiatives (and the general quality of the asset / business), the risk/reward on the stock is favorable:  ~$300-350+ base case over the next ~12+ months if the company executes well ($14-15 of ’24 EPS at 20-25x) vs a downside of ~$190 (~$12.70 of ’24 EPS at ~15x).  Given the recurring nature of their subscription business and an ability to keep costs moderated (maintaining cash content spend at ~$17bn over the next few years), the financials should prove quite resilient into a slowing economy.  Moreover, as the leading at-home streaming entertainment platform (~2x+ the viewership of comparable products aside from YouTube), consumers are less likely to cut this form of ‘cheap entertainment’ if the economy were to enter a recession.  Finally, any worries of ‘trading down’ to a lower priced ad-supported tier are misplaced as the ARPU generated from the AVOD product is likely to be accretive out of the gate (potential for ~$20-25 AVOD ARPU vs ~$15-16 on the SVOD product).  Given these dynamics, NFLX has the potential to outperform other ‘FANG” companies like GOOGL/META that are likely more economically sensitive into a downturn.                      

Thesis

The key bet is that AVOD (in conjunction with cracking down on the ~100mm password sharing users) will inflect growth higher into ’23-24 after facing tough comps following the Covid ‘pull-forward’.  AVOD is going to both help unlock the ~30mm UCAN households that don’t currently pay as well as potentially ‘pick-up’ some of the ~50mm of accounts that churn annually (~2% churn rate).  If AVOD turns out to be successful, NFLX will unlock a whole new tier of subscribers both domestically and internationally.  The quick ‘back of envelope’ AVOD math points to ARPU that should exceed $20 ($7 of subscription with $13+ of ARPU from advertising).  The assumptions to get to ~$13 advertising ARPU include: ~40 hours of Netflix watched per user per month (implied from Nielsen data), 4-5 minutes of ads/hour (per the company's announcement a few days ago), 2-3 ads per minute, a ~$45 CPM (conservatively lower than the $65 being discussed for the initial launch), and a ~30% rev share for partners (an assumption).  This ~$13+ seems reasonable compared to Hulu that earns ~$8 a month from AVOD advertising and $5-7 earned by HBO max given the significantly higher engagement (minutes watched) on NFLX vs these other platforms.  Outright monetization of cracking down on password sharing will also be incremental to revenue (NFLX may roll out restrictions to ask sharers to pay an extra ~$3 for these additional accounts), though this is likely to show up in ARPU increases as opposed to net adds.  Between these two initiatives, net adds, ARPU, and revenue are poised to inflect into ’23-’24.   

Other key positives

·         Reasonable street estimates ‘23+:  Street is at 9-10mm net adds in ’23 which seems quite reasonable if you assume ~6-7mm as a base case even without AVOD.  With 100mm password sharers, you would only need to capture ~4mm of those or a small portion of the ~50mm customers that churn annually

·         Attractive GAAP valuation (not excluding SBC):  Trading at less than 20x modeled ’23 EPS and ~15x ’24 EPS.

·         High quality business:  recurring revenue, subscription (despite move into advertising, vast majority of pro forma revenue/eps will remain subscription based).  NFLX should be recession resistant as a cheap form of entertainment.

·         LT Pricing power in industry:  The overall industry is starting to push prices higher (recent DIS moves) which is supportive of continued operating leverage/profitability for the entire industry over time. 

·         AVOD could be a churn reducer:  The churn occurring in SVOD (which at ~2% a month is ~50mm annual subscribers) may come down as some of these accounts are ‘picked up’ by AVOD.

·         Strategic Asset:  Netflix is the industry leader.  It is a highly coveted platform and would garner plenty of consolidation interest if it were ever to get too cheap.

·         No political/regulatory headwinds:  Unlike many other parts of ‘big tech’, Netflix is not currently in the regulatory crosshairs. 

Key risks

·         Saturation: US and much of developed world did see a pull forward to ‘full’ levels of penetration, but NFLX is cracking down on password sharing (100mm users) and rolling out AVOD increases the TAM.

·         Cannibalization:  Any ‘downgrading’ from SVOD to AVOD will turn out to be accretive, and AVOD is more likely to be a churn reducer than anything else.

·         Competition:  There’s obviously a lot of streaming competition, but there has always been a lot and NFLX remains the clear streaming leader.  Recent market share data from Nielsen shows NFLX captures nearly a quarter of all streaming viewing.

·         FCF conversion: GAAP EPS is lower than FCF because of content amortization, but this will normalize.  This ‘bear case’ has existed for a long time, but NFLX is now FCF positive and accelerating FCF Growth. 

·         Content slate: People have pushed back on quality of content as of late (excluding Squid Games), but the go-forward slate actually looks decent into the 2H (The Crown, Dahmer, etc).

·         Execution:  Some are skeptical of how quickly or successfully they can launch an advertising business.  They have much less experience (none) compared to other media companies like DIS, PARA, WBD.  This is something to watch, but recent high caliber advertising hires demonstrate that NFLX will attract the requisite talent to be successful.  Further, the agencies themselves are very excited for this product launch and are likely to be very supportive.   

Attractive risk/reward

·         Upside toward ~$300 (~$14.50+ of ’24 EPS at 20-25x) vs downside of ~$190 (~15x ~12.75 EPS). Base assumes ~12mm net adds in ’23 ramping to ~15mm in ’24 (still below ’21 levels).

Catalyst

Quarterly results into '23 demonstrating success/progress with the AVOD offering and crackdown on password sharing