Description

Concerns about a 2016 $2/month price increase on ~20mm U.S. subscribers, a disappointing Q2 2016 net international subscriber growth forecast (2mm versus consensus estimates >3mm), 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.

            At the current valuation, I believe the Enterprise of $38B is roughly equal to the value of Netflix’s US streaming business. This ascribes very little value, if any, to Netflix’s roughly 40MM international subscribers, including profitable and growing subscriber bases in Latin America, Canada, UK/Ireland, and the Nordics. The profitable subscriber bases are in countries that Netflix has been in since 2010 (Canada), 2011 (Latin America), and 2012 (UK/Ireland; Nordics), and establish a strong competitive position in two strategically valuable markets: 1) Hispanics/Spanish speaking; 2) Large English language markets.        

            The math on the valuation of the US streaming business is roughly as follows. Netflix currently has ~48mm US streaming subscribers. I estimate that it will end 2017 with at least 55mm U.S. streaming subscribers. 55mm US subs at $10/month x 12= E2017 US streaming subscriber revenue of $6.6B. $6.6B in US streaming revenue less $3B in content costs, less $650mm in technology and development costs, less $380mm in marketing costs, less $300mm in corporate SG&A + $200mm in DVD contribution profit = ~$2.5B in US streaming EBIT. At a 15x multiple, the US streaming business would be valued at ~$38B, approximately equal to Netflix’s current EV. I believe that there several companies who would be interested in acquiring 55m U.S. streaming video subscribers, as well as the technology platform and data that would come with it. How powerful would it be for Disney to know who is watching its Marvel movies? How quickly could Apple accelerate and scale an entrance into streaming video by acquiring Netflix’s US subscriber base?

            A few comments on the cost input assumptions. In 2016, Netflix is going to spend $5B on content on a consolidated P&L basis to support a global subscriber base that will reach over 90mm by year-end. I think it is a reasonable that $3B in content spending could support 55m paying US subscribers in 2017. In 2015, in the U.S., Netflix spent ~$2.4B on content with 44m subscribers, or $54/sub. $3B for 55m subscribers would keep the ratio consistent at $54/sub. It is worth comparing this to HBO, which has ~30mm US subscribers, and 90mm international subscribers. HBO spends $2B per year on content to support the entire subscriber base of 130mm.

            From 2013-2015, Netflix spent between 8.5%-9.5% of revenue on technology and development. This expense is mainly operating expense related to managing a global streaming service. Netflix employs data scientists, engineers, software designers and programmers. Some of the growth of this expense over the last few years has been to support the international expansion. I assume $650mm in technology and development would be needed to support the US streaming business, which is an expense ratio of 10%.  

            As a subscription video service reaches scale in a market, the marketing expense as a percentage of sales comes down, as long as churn is under control, which for Netflix appears to be the case. Rather than spend variable marketing money to acquire new subs, Netflix’s growing body of original content can serve as the marketing expense. This is borne out in Netflix’s domestic marketing expense as a percentage of domestic revenue from 2013-2015 (9.6%; 8.5%; 7.5%). My estimate of $380mm in marketing expense represents 5.7% of E2017 US streaming revenue. 

            I attribute half of total estimated 2017 SG&A to the US business. I attribute all of the DVD business contribution profit to the US because it is entirely a US business.

            Notably, I think my estimate on $2.5B in U.S streaming EBIT would be low because at 55mm US subscribers, Netflix will have a large budget for original content, giving it full rights over many shows, which creates high-margin licensing opportunities around the world, a hedge against failure in international markets. HBO spends about $1B per year on original content that supports a large stream of licensing revenue. HBO has been making its own content for a long-time, therefore it has a deeper owned library to license. But as the demand for high-production value US produced television programming increases around the world, the per hour license fee for desirable original programming will go up. If Netflix spent about $1.5B of its US content budget on original content, it would secure global rights for programming that it could license globally at high incremental margin.   

            Obviously Netflix is not going to do this if it believes it can monetize these rights through its own branded distribution. But a large part of the bear argument is that Netflix won’t be able to do this in international markets. Therefore, if the bears are right that Netflix’s international expansion in markets like Japan, South Korea and India will fail or fall short of expectations, it can still participate in the growth of pay-television and streaming in those markets by licensing its owned original content into the markets to the competitors that are winning in those markets. These license fees would not need to be supported by an investment in operating expense in streaming capabilities, or variable content costs, in markets in which Netflix is only licensing content. HBO has been doing this for many years in different forms. HBO is effectively a US subscription video business, and international content licensing business. The US subscription business drives the international licensing business. The international licensing business will continue to grow as pay-television grows around the world.   

            Is it realistic to value the Netflix US business separate from the international business? I think it is, especially if the US business has 55m subscribers and is profitable and has its own set of rights. Netflix does not need to invest in tangible assets to expand in new markets. There are no factories, operating leases, or inventory. The two variable investments are 1) people to support the international growth; and 2) content streaming rights to build a library in new markets. If Netflix licensed content streaming rights in a country, but then concluded that it did not see a path to monetize these rights through the acquisition of a profitable subscriber base in that country, then it should be able to sub-license the rights to one of the competitors that is operating one of the competing streaming service that is beating it, or sell the existing subscriber base in the entire market.In the U.S., EPIX has the Pay-1 movie rights to Lionsgate, Paramount, and MGM films. EPIX sublicenses these rights to both Amazon and Hulu, earning high-margin licensing revenue (but sacrificing the value associated with exclusivity). Barring something in the agreement preventing it, Netflix would be able to do the same thing.

            There is nothing inherent in Netflix’s business model that demands success in international markets in order for the business to sustain itself now that it has established a dominant scale position in the US, and growing dominance in key international markets, such as Latin America, UK, Australia and the Nordics. For much of 2015, there was something inherent in the expectations for success in international markets when the Company was being valued near $60B. At $38B, the expectations are much lower, yet the US business is growing more valuable.  

            I think some bears lack perspective on the risk/reward associated with Netflix’s international expansion. On January 6, 2016, Netflix announced it was available in every country in the world, excluding China and a few bad actors. This opened up an addressable market of probably 500mm homes. How many consumer product companies could address a market of this size, without making large investments in plants, factories, inventory and distribution? Netflix has tremendous efficiencies, and low variable capital investment, because it is able to distribute its primary product, a growing library of original content, at no variable cost. It is also able to license local and regional content rights, on a market-by-market basis, as it makes sense. Because there is very little incremental fixed capital investment, and the variable cost of distribution of the product is negligible, I don’t think there is much operational or financial risk associated with trying to expand everywhere. On the other hand, the increase in business value that will come from success is meaningful because the market is big and growing.   

            I believe that the international business will end up being larger, and probably more profitable, than the US business. The increasing popularity of U.S. produced television shows and movies in international markets around the world shows there is a strong, growing demand for high-value English-language video content. U.S. produced movies and shows have the biggest stars and the highest production value, and thus should continue to attract international viewers willing to pay for the content. Netflix is uniquely positioned to be the biggest producer and distributor of high-value English language content because it has established scale in the major English-speaking markets, namely the US, UK, Canada, and Australia.    

            As Netflix builds scale in other markets, it can expand its content offering to meet local tastes. Its budget, brand, and global distribution should allow it to create and license Bollywood content in India, Nollywood in Nigeria, and Anime in Japan. Netflix is already producing original productions Italy, Mexico, France, Brazil, Singapore and Japan. There are no other streaming services that are positioned to produce and distribute local original programming on this scale. On the other hand, it is going to be difficult for regional competitors to produce the type of original shows that Netflix is producing because they do not have the scale, global platform, or content budget.

            In every market that Netflix has entered, the bear argument has basically been the same: the content library is too small; the regional competitor too dominant; and the local content preferences are too particular. Still, Netflix has been able to do well by getting in early, learning the marketing, and improving the service and content. HBO has 2 international subscribers for every US sub. There is no reason why Netflix should not eventually have the same ratio.    

Competition

 Even if a bear accepted my separation of the US value from the International Value, he would dispute my US streaming business value because he would argue that competition is going to siphon away current subscribers, raise the variable cost of customer acquisition, and drive up content costs above a level that can be absorbed through consistent price increases because the market will be full of substitutes. For a long time, Netflix was blessed to be the only real streaming offering in the US. This allowed the Company to avoid competitive bidding situations on streaming rights, thereby getting the rights at a discount. It also was the only service that allowed on-demand and binge viewing of old television shows, for which there was a clearly a latent pent-up demand. Big media companies and distributors have finally caught-on and are going to be increasingly unwilling to license to Netflix and will focus on their own services (i.e. Hulu). Amazon is an unwelcome competitive threat because of its size and willingness to subsidize its video business with its retail business. Dish, Apple, Verizon, AT&T, and Comcast, have entered, or will enter the streaming market with new video bundles. The barriers to entry in streaming are low; the switching costs are low; the competition is getting more intense. This backdrop should translate to a low multiple for Netflix’s US business because it will not be defensible.

            There are a few responses. First, people are likely to subscribe to multiple services because the services are not substitutes for each other if they have different content. 100mm US households are used to getting 300 channels. There is a large group of consumers in the US who will want choice and will subscribe to many video services in order to have more choice and more access to programing. This appears to be happening because HBO, Hulu, Netflix, Starz, and Amazon Prime Video are all growing. Jeff Bezos and Reed Hastings have both publicly stated that they don’t think they compete with each other on demand side because will subscriber to multiple services, but the media and many analysts still frame it as a zero-sum-game even though the evidence to date does not support that narrative.   

            Second, smaller bundles are likely to be good for Netflix. Most of the smaller bundles are merely repurposing existing content through bundling of smaller channel packages. The more that you allow the customer to deconstruct the bundle and effectively build their own internet-delivered bundle, the more money they save from the big bundle and the more money they have to spend on other services like Netflix.  

            Third, Netflix has built up an offering of exclusive original programming that stands on its own and gives people are reason to subscribe outside of network library product. This year, Netflix led all networks in Golden Globe nominations, a data point that speaks to the increasing quality of the programming. HBO has sustained roughly 30mm subscribers in the US for a long-time on the back of its original content and movie selection. Netflix has more original content, more movies, is cheaper, and is available on more devices. It seems logical that Netflix can sustain a larger U.S. subscriber base.

            Where competition is likely to be felt is the supply-side; there will be more bidders for streaming rights and the cost of these rights will rise in a competitive market. But I don’t believe that rising content costs are going to negatively impact Netflix’s margins in they way bears predict. Rising content costs may actually improve Netflix competitive position.

            Netflix already has a large portfolio of desirable pay-1 movie rights locked up for years in the US, Canada, and parts of Europe. This includes all of the Disney brands (Marvel; Lucas; Pixar; Disney Animation) in the US beginning in the fall. Some of these obligations show up in the off-balance sheet liabilities that bears argue add risk to Netflix’s balance sheet. But securing these films is a strategic advantage because it gives Netflix a pipeline of desirable content with visibility into cost. If you believe there will be a sustainable demand for Disney movies in the US entertainment market for years to come, Netflix was smart to secure these rights and the off-balance sheet liability associated with is not a high-risk obligation.   

            For some of the old television shows, there will be more bidders, which will drive up the price on the desirable shows. Hulu apparently bid aggressively for Seinfeld. But looking ahead a few years, I don’t believe that old television programming is going to meaningfully differentiate a streaming service; it will be the original content. Netflix has an advantage in the creation of original content because its data allows it to size the budget in accordance with the estimated audience and viewing hours. Netflix’s scale, it will spend $6B on content next year, also should allow to it to create some of the highest production value shows on television, which have a better chance of finding a global audience. The scale + the data create large advantages in creating and financing programming. As the industry is currently structured, it will be difficult for any competitor to compete on either variable. It will be also be difficult for a competitor to grow its content budget unless it grows it subscriber base, which generally is a result of more content spending. This negative feedback loop is part of the reason that the industry probably will consolidate. Otherwise, competitors will need to make large investments in content to acquire subscribers ahead of profit growth. I am skeptical any of the publicly traded media companies will have the appetite for this. Amazon will do this, but as stated earlier, I don’t think they are substitutes. The global market should be big enough for both to do well.

            Lastly, it is worth emphasizing how far ahead of competitors Netflix is internationally. Netflix should end Q2 2016 with close to 40mm international subscribers. Hulu, FX, Showtime, Starz have none. HBO has 90mm, but these are all linear video subscribers and the packaging and distribution of HBO is fragmented across markets. HBO also does not have a direct relationship with its international subscribers in any market (except maybe the Nordics). Amazon is only available in a handful of countries internationally and is far behind Netflix in the strategically valuable Latin American market, as well major English language markets. It took Netflix between five and seven years to build scale in these markets.  

            Over time, Netflix’s global scale will become an increasingly powerful advantage. Having the most scale will give content creators the biggest platform to monetize their IP, which will attract the best talent and highest value content. One of the reasons that Activision Blizzard is premiering its highly anticipated first Skylanders television show for kids on Netflix is because of Netflix’s reach.

            A larger subscriber base will also provide more data, which should improve the recommendation engine and lead to better personalization.

            Global scale also allows Netflix to create and distribute content internationally in a way that has never been done. Original Japanese anime can be created in Japan and can be efficiently distributed to anime lovers outside of Japan. Bollywood can be exported to fans outside of India. Netflix’s capability to finance and distribute content from all over the world to all over the world should expand access to great storytelling and elevate the quality of content produced on the service.  

Potential Catalysts

There are three potential catalysts for the stock.

1) US price hike does not cause churn. In 2016, Netflix is raising the price of its standard plan to $9.99 from $7.99. This increase will impact about 20mm members. Some analysts are concerned that price hike will cause elevated churn. If the retention or net subscriber growth turns out to be better than expected, people may get more comfortable with the pricing power.

2) Disney Movies in the US-It is difficult to overstate what a huge advantage the Disney deal could provide for Netflix’s US business. Beginning the fall, Netflix will become the exclusive home for Pixar, Marvel, Disney Animation and Lucasfilm movies in the Pay-1 window in the United States. Netflix did this deal in 2012, before anyone, probably including Netflix or Disney, could have envisioned how dominant Disney’s studio and brands would become. The Jungle Book, Finding Dory, Zootopia, Star Wars Rogue 1, and all of the new Marvel superhero films will be exclusively available to Netflix subscribers in the US. Because kids will watch films repeatedly, and Disney is really the only studio with marketable brands and franchises that parents know and trust, the Disney deal could help Netflix become the dominant SVOD service for US families.

3) China-Netflix has not yet launched in China. The Chinese market is extremely complicated to enter and there is no guarantee that Netflix will be able to enter China, or earn real money in China (they probably have to get a partner). Still, if Netflix can get into China and scale a profitable business there, it could end up being one of Netflix’s largest markets due to its sheer size and the growing demand for content. Because I don’t think any success in China is being priced into the stock, there is potentially a free valuable call on Netflix figuring China out.   

Catalyst

1) US price hikes does cause lower churn than expected

2) Disney pay-1 movies in US are well-received 

3) Entrance in China