Description

Thesis

Netflix (NFLX) is a compelling long investment idea at a stock price of $64/share and an EV $57/share.  I think that one of the following two outcomes is likely: 1) Netflix continues to grow revenue at double digit rates and shows significant operating leverage in its streaming business, eventually achieving double digit EBIT margins, or 2) Netflix is acquired by another company who seeks to gain the leadership position in the internet television market (commonly referred to as an “over-the-top” offering).

The current valuation for Netflix’s domestic streaming subs is somewhere between $80-100/subscriber, depending on how you calculate it, for a subscriber with an annual ARPU ~$96.  Valuing this company is more an art than a science as it is highly dependent on subscriber base and EBIT margins at maturity, both of which are hard to know precisely, but I think that current margins are clearly depressed as the company is reinvesting to grow as quickly as possible.

Summary Points

• Netflix is a very polarizing stock, as previous Q&A threads on this website illustrate.  I think much of the debate overly inflates the stakes.  I view Netflix as very similar to a cable television network (specifically a pay television network like HBO, Showtime, or Starz), with a few differentiating characteristics that make its model less financially attractive in the short-term and potentially more financially attractive in the long-term.  The conceptual question is not whether Netflix is going to defeat Apple or Comcast in a winner-take-all battle for the television market, it is whether Netflix is as valuable as dozens of other cable networks such as AMC, Starz, or Showtime.
• I think that Netflix has many qualities that make it likely to succeed in the long-term despite increasing competition from deep-pocketed players.  It is the largest player by a significant degree in a business that benefits from scale.  It has an enormous annual content spend and a broad selection of content that is improving over time.  It is developing a niche focus on serialized content.  It has an excellent user interface and a unique database of customer usage patterns and reviews which will help it improve its content purchases and provide a better, more personalized offering as it grows.  The company is solely focused on this niche, unlike any of its competitors.  Finally, I think that management thinks about the business the right way.

Business Description

Netflix is a Los Gatos, CA-based company that sells subscription video & DVD-by-mail plans directly to consumers.  The company is comprised of three pieces: DVD (the DVD by mail business), Domestic streaming (online video content streamed over the internet sold by monthly subscription) and International streaming (same as Domestic only offered in Canada, UK & Ireland, and Latin America). 

DVD - 10m subscribers who pay at various rates depending on the number of DVDs in their plan: 1 DVD = $8/month 2 DVD = $12/month, 3 DVD = $16/month, etc.  This is the legacy core of Netflix.  The company has de-emphasized this segment and it is shrinking fairly quickly, but I believe it will have a decent tail.  The important difference between Netflix DVD and Redbox (DVD rental kiosks) is that a large portion of Netflix’s content is back catalogue instead of new releases, which should give the business a better decline profile

Domestic steaming - 23m paid subscribers at $8/month.  Company guidance is to add 7m net subscribers in 2012 and end the year with 30m subscribers.  This segment is the company’s future.  Netflix uses the subscriber revenue to purchase television and movie content from a wide variety of producers that it then offers its subscribers via the internet.

International streaming - This is the same as Domestic streaming only focused on international markets.   Netflix launched in Canada in September 2010, Latin America in September 2011, and the UK & Ireland in January 2012.  This segment is currently losing quite a bit of money.  Management has stated Canada should be contribution margin positive in 2012 Q2, and that Latin America & Canada should take longer than two years to reach the same point.  Management has also said that Latin American progress is slower than it had expected upon launch.

The company also has a corporate overhead segment that is comprised of R&D and G&A.

Valuation

Stock price $63.44/share, 57m shares, $3.6b market cap, $400m net cash, $3.2b EV.

Each piece of the company has different characteristics and I value them separately.  Netflix reports revenue and “contribution profit” for each piece, which is revenue less COGS (including delivery costs) less S&M.  R&D and G&A (what I call “corporate OH”) are then subtracted to get consolidated EBIT.

DVD = $1b in a runoff valuation.  Contribution profit has only been disclosed the past two quarters and has been $194m and $146m, and this decline should flatten out over time and have a decent tail.  Netflix started breaking out the DVD and streaming segments separately in 2011 Q4.

International streaming = Zero value.  Thus far this segment has lost $218m EBIT since 2010 and will lose several hundred million dollars more before profitability, which will come at different points for the different countries.  On the high side, I would value this business at $1b, which is a rough stab.

Domestic streaming - Subtracting the value of DVD and International streaming off the EV, I get a $2.2b valuation for Domestic streaming.  This business will end 2012 with ~30m paying subscribers and run-rate revenue of $2.9b.  The two key variables to this valuation are revenue growth rate and contribution margin at maturity, both of which are hard to predict.  Contribution margin for 2012 will be 14-15%.  At maturity, I think contribution margin will be 25-30% and consolidated EBIT margins will be 10-15%.  I think a reasonable estimate is that in 2015, Domestic streaming does $4-5b revenue and $500m EBIT.  I think that this piece is worth $4-6b to a strategic player, with possible upside.

Corporate OH – In 2011, R&D was $259m and G&A was $119, for $377m total.  In 2012, the number should be $450-475m.  This is currently above the rate of domestic streaming contribution and thus those two pieces together (which I think is the right way to look at the company) are losing money.  That should change at some point in the next year or two as streaming contribution margin improves.  I think that current corporate OH is elevated relative to maturity due to the company’s rapid growth and international expansion.

Balance Sheet –$400m net cash and company should be cash flow even-to-positive going ahead.

Total - Adding those pieces up: DVD = $1b, International streaming = $0-1b, Domestic streaming = $4-6b, Net cash = $400m, Total = $6.4-8.4b divided by 57m diluted shares = $113-147/share.  I think that in a bidding war, the price could be much higher.

Discussion

Company origins

Netflix was launched as a DVD-by-mail service in 1998 by Reed Hastings.  Hastings was an entrepreneur who had previously founded and sold a software company for $750m (Pure Software, sold to Rational Software in August 1997).  Hastings was frustrated by a $40 late fee for a movie rental from Blockbuster and saw an opening for a subscription movie service.  He named the company Netflix because he believed its distribution would one day shift to the internet.  The company thrived over the next decade in the DVD-by-mail business in the face of fierce competition from Blockbuster, Wal-mart, and a number of other players.

Shift from DVD to Streaming

Starting several years ago, management began aggressively buying online rights to video content and shifting its subscriber base towards the internet.  Two important things that the company did were to establish broad ranging relationships with content providers and device distributors.  The streaming business has grown very quickly in the past several years and should end 2012 with 30m subscribers.  The business is straightforward: $8/month flat rate for unlimited access to all streaming content.  Netflix pays flat fees for fixed periods of time to content providers for video streaming rights.  Netflix has been spending all its incremental dollars to build up its content base, with the goal of getting as large as possible as fast as possible.  Management describes it as a virtuous cycle: the more subscribers they have, the more and better content they get, the more subscribers they have.

Content costs are fixed in the short run (say 1-3 years), and thus the player with the largest subscriber base has a scale advantage.  Netflix began disclosing its streaming contribution margins in 2011 Q4 and it was 10.9%.  In 2012 Q1, it was 13.1%, and management indicated it should grow by 100 bps per quarter for the rest of this year with continued growth going ahead.

When the streaming margin was first broken out, the Street reaction was very pessimistic, as Netflix would barely make any money at such levels.  I think people tend to underestimate mature margins and that eventually streaming could be a 10-15% EBIT margin business (which implies contribution margin in 25-35% range).  Hastings has said as much.  Below is a sample quote from the 2011 Q4 conference call.  He has made many other similar remarks.

January 25, 2012 –2011 Q4 Earnings Conference Call

Reed Hastings  - Netflix, Inc. - CEO

What is Netflix?

Netflix is very similar in model to the existing pay television channels: HBO, Showtime, and Starz.  The key difference is delivery method.   The pay television channels are only sold as part of a bundle with an existing cable television package (Usually $12-17/month each on top of a $50+/month television package), whereas Netflix is delivered via the internet for $8/month.  Netflix should overtake HBO on annual dollar content spend in the next few years, and it has already overtaken Showtime and Starz.  Each of those channels is now buried inside of a larger conglomerate, but their EBIT margins are in the 20-30% range, although these margins are not entirely apples-to-apples.  Netflix currently spends 5% of its content dollars ($75-100m in 2012) on original content and it is ramping up these efforts.  I have seen estimates that roughly ~40% of HBO spend is on original content.

One criticism of Netflix that I have seen frequently is that the company will not make any money going ahead because it is only a middleman buying content from producers and selling it to consumers.  I do not find this argument compelling.  Almost all cable channels are middlemen, some of they between very consolidated groups of players, and many of them have very high returns on capital and make much more money than Netflix.  It is clear to me that Netflix has a reason to exist and offers a compelling service to its customers.

There are a variety of ways that Netflix could develop going ahead, from becoming a full-fledged cable network to the de-facto operating system for internet television.  I think the most likely scenario is the continued development of the existing model, with more exclusive content and original content.  Eventually, I think the company will offer several tiers of service at different prices.

Changes in television landscape

Television is an enormous, valuable, and complex ecosystem.  The industry landscape is slowly starting to change with the advent of internet video delivery.  There will be a huge battle among the main industry players to get the leading position during this shift.  Historically, the pay television providers (cable/telco/satellite) have sold both distribution and content bundled together.  We are starting to see a split where consumers buy distribution (internet access) from the traditional pay television providers and then get content over the internet.  It is hard for the traditional players to prevent this new landscape from emerging, as high-speed internet is an important profit center for them and internet video is the most obvious use and demand driver of this product.  For a variety of reasons I can go into further detail on, I do not think caps on broadband usage will be an issue.  While I believe that the traditional players will maintain healthy businesses for a variety of reasons, I think new players like Netflix, Youtube, and Hulu will thrive.

Strategic asset

Netflix is a highly valuable strategic asset because it it would provide the acquirer pole position in the race to become the leader.  If the stock price stays at or below its current price of $64/share, I think it is very likely to be acquired by one of the following players: Apple, Microsoft, Google, or Amazon.  If one of those players dramatically expands into the streaming market, a clear competitive response by one of the others would be to buy Netflix.  Acquiring Netflix would be a drop in the bucket for any of these players.

Large, rapidly growing paying subscriber base

Netflix has 24m subscribers who pay ~$100/year, and this subscriber base is growing rapidly.  The company has spent a great deal of time and effort building its site and fine-tuning its customer experience.  I think this is perhaps the company’s most underrated advantage.  The user interface is highly intuitive and the “queue” or user video list and recommendation engine make the service somewhat sticky.  These are the results of years of R&D spending and A/B testing on an enormous user base.  I think people often think Netflix is easy to copy because it is easy to use, but I think that ease of use is hard-won and much tougher to do than people think.  Technology history is full of cases like this where the followers never catch the leaders, billions of dollars of capital be damned.

Management

I am extremely impressed with Reed Hastings.  His shareholder communications are excellent.  He writes a 10-15 page letter every quarter, answers submitted written questions on the conference, takes calls from analysts, and appears frequently with other members of management at conferences.  He lays out his thinking very clearly and I think he is long-term greedy.  Hastings is also on the board of directors of Microsoft and Facebook, which indicates to me that others think of him highly and that he has ongoing talks with industry players about the strategic landscape.   He owns 1.1m shares of stock.  I also note that Technology Crossover Ventures (TCV), a pre-IPO investor of Netflix who has had a board seat since 1999 recently purchased $14.5m of stock on the open market at $73/share.  TCV also purchased a $200m convert in November 2011 at with conversion price of $86/share.

Competition

There is a lot of talk of other players entering the space, but the required content spend is a big hurdle, even for players with deep pockets.  Netflix will spend ~ $1.4b on content in 2012 and $1.8b in 2013.  That is a lot of cheddar, even for Amazon.  The roll-out of TV Everywhere, the on-demand offering of the cable industry, has been slow due to industry infighting over rights issues.  In addition, TV Everywhere is hamstrung in these efforts by the high price of a pay television subscription bundle.  I think that a likely outcome is that many people retain their existing pay tv bundle and purchase Netflix as an add-on, and that some people cut the cord to pay television and end up purchasing internet access and Netflix along with other online video options.

Risks

This investment is clearly not without risks.  I have not discussed the company’s ill-fated price hike/company split-up in 2011 and am happy to do so in the comments.  The international expansion story also adds a layer of complexity.  I am not as worried about inflation in content spend as many seem to be.  I see the biggest risk as domestic streaming subscriber growth stalling out, which would combine with increased content spend for growth and would lead to a nasty short-term financial hit.  I think the company would be able to withstand this and could ultimately right-size the cost structure via reduced content spend.

Catalyst