Sit Back And Relax: How Netflix Captured The Streaming World In The Palm Of Its Hand

13 mins

Sit Back And Relax: How Netflix Captured The Streaming World In The Palm Of Its Hand

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How Netflix became Netflix

165 million: that’s how many hours are spent watching Netflix every day. Since launching its streaming service in 2007, Netflix has held the gaze of 139 million subscribers with prestige TV, Oscar-winning movies, and 4K fireplace videos you never knew you needed.

Netflix’s rise to fame has been a fairytale story for investors: its stock’s delivered a 300x return since the company went public in 2002. Yep, you read that right: Netflix is actually a bit of a veteran, though it’s admittedly only become the powerhouse you know it as in the last few years. In fact, it’s been around since 1997, when founders Reed Hastings and Marc Randolph decided to start a DVD rental company – even though only 2% of the US population had DVD players at the time.

That first big gamble worked and true to form, the company’s made one successful bet after another. It managed to usurp one-time giant Blockbuster along the way (though that was as much Carl Icahn’s fault as anyone’s), and by 2007 the company was big enough – and internet fast enough – to start online streaming in earnest...

V1 of Netflix's streaming site
V1 of Netflix's streaming site

That website might not look like much now, but it was revolutionary at the time. So much so that by 2011, Netflix was the single biggest source of North American internet traffic. And all the while, the company was collecting heaps of data on its viewers – learning that, say, the people who liked an obscure British political thriller would also quite like to watch an American version directed by David Fincher...

But all is not rosy for the red giant: declining subscriber numbers, a lot of new competition, and a shedload of debt mean Netflix is at something of a crossroads. So the question on every investor’s lips is will it continue to steal the spotlight, or are the credits about to roll?

That’s a question we’ll try to answer in this Pack. We’ve tuned into confidential analyst reports from the experts, screened the company’s financial statements, and put it all together for you to binge. You’ll be a Netflix pro in no time – and not just because you’re all caught up on every episode of Orange is the New Black.

The takeaway: Bold bets and smart decisions turned Netflix into the titan it is today.

How Netflix makes money

On the face of it, Netflix has a simple business model: users pay for subscriptions, Netflix pays for content, and it makes money from the difference between the two. But things get interesting (and a little concerning) when you dive into the numbers. There are a few metrics investors care about in particular, so let’s run through those – starting with Netflix’s income.

In 2018, the media giant brought in $16 billion almost entirely from subscription revenue. Its average revenue per user (ARPU) in July 2019 was $11.40 a month in the US and $9.43 a month internationally (subscriptions are cheaper in some countries), making for a worldwide ARPU of $10.75. That’s about $2 more than in 2016, thanks to price hikes and tiered pricing.

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Netflix has big costs, mind you. It’s got a very complicated technical infrastructure to maintain – which reportedly involves millions of dollars in payments to competitor Amazon in exchange for the use of their servers – and a lot of debt to pay (more on that later). And that’s not even mentioning all the costs that come with licensing and producing content.

Still, profit has been looking pretty good of late. In 2018, Netflix spent an average of $83 on marketing to acquire each customer (though in the US, this was a whopping $180). But according to the Financial Times, when you take into account customers canceling their subscriptions, the average subscriber’s total lifetime value to Netflix is just shy of $150. So overall, Netflix earns more from subscribers than it spends to get them, making it a healthy business. As such, it tends to stream a healthy profit: $1.2 billion in 2018, to be precise.

But that number doesn’t show the full picture. Thanks to some accounting quirks, Netflix’s reported profit or loss on paper doesn’t include all its programming costs. Those costs – which often have to be paid entirely upfront – are split over multiple years in its financials. So rather than focusing on profits or losses, the media giant and its investors look at “free cash flow” instead – that is, how much cash the company brings in each year.

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Turns out, Netflix has had a negative cash flow every year since 2012 – the year it started producing original content. And it’s losing more each year, with an expected negative cash flow of $3.5 billion in 2019. Netflix says this spending is an investment in its future: in other words, the content it’s paying for today should bring in more subscribers a couple of years from now. In that case, revenue would increase and cash flow would turn positive. That’s why Netflix’s investors are so concerned with growth – and why “paid net membership additions” is a key metric.

But even if Netflix stops burning cash, it’s not in the clear. The company owes $36 billion to various parties: $19 billion in “streaming obligations” (like an agreement with a studio to pay licensing fees for the next five years) and a whopping $15 billion in debt. That debt is what keeps Netflix’s projectors turning: the company borrows cheap money, spends it all on content production, and hopes it’ll eventually have enough subscribers to pay back the cash – and pocket some itself. If it doesn’t, it could always refinance – but that would potentially increase its $420 million annual interest bill.

Essentially, Netflix has to figure out how to make more money in any given year than it spends, while paying back a veritable boxset of loans. Well, at least things aren’t about to get any more complicated for the streaming giant. Wait – they are?

The takeaway: Although Netflix makes a profit, it also keeps burning through cash – which can only go on for so long.

“Netflix’s valuation is unwarranted”

For the past decade, Netflix has had it pretty easy. Sure, other streaming services like Hulu and Amazon Prime have cropped up, but Netflix has held steady at number one (there’s a reason it’s “Netflix and chill”). As legacy media companies hummed and hawed, terrified of destroying their core TV businesses but desperate to get in on the online future, Netflix managed to achieve streaming dominance.

But next season might follow a different plotline. Over the coming 12 months, a host of new streaming services from deep-pocketed companies will appear. In 2020, AT&T (which bought Time Warner in 2018) will be launching HBO Max: HBO content supplemented with shows from CNN, Cartoon Network, and the BBC. And in November 2019, Disney will launch Disney+, a playground of Marvel, Pixar, Star Wars, and animated content. Disney’s also recently taken control of Hulu – and it’s offering a Disney+, Hulu, and ESPN+ package for the same price as Netflix. Oh, and Apple’s decided to spend $6 billion on its own new streaming service, which will come with all new Apple products.

All that competition on the way has some investors very worried: between January and September 2019, Netflix’s stock gained absolutely nada compared to the wider market’s 22%. Laura Martin, managing director of investment bank Needham & Company put it bluntly:

“We project Disney will win – and Netflix lose.”

– Needham & Company

Wealth manager Wedbush Securities feels similarly, arguing the increased competition will make it difficult for Netflix to grow its US user base. But Wedbush goes one step further in its prediction: the firm thinks the stock – which was trading at around $300 in September 2019 – is only worth $188. According to Wedbush, investors typically expect the cash a company generates (i.e. free cash flow) to represent 5% of the eventual stock price – which means Netflix needs a free cash flow of $6.5 billion to be worth the $130 billion it is today. But Wedbush doesn’t think any positive cash flow is in Netflix’s near future:

“Netflix’s valuation is unwarranted.”

– Wedbush Securities

Broker Aegis Capital isn’t quite as skeptical, taking a neutral view on Netflix’s stock while recognizing its valuation problem. Netflix is valued at 40 times its profit, compared to Amazon’s 17 times and Facebook’s 11 times. That wouldn’t be unexpected for a fast-growing startup – Stranger Things have happened after all – but Netflix isn’t a fast-growing startup any more: many argue Netflix has reached user “saturation” Stateside (the company actually lost US subscribers in the second quarter of 2019).

Despite all of the above, the vast majority of analysts still consider Netflix’s stock worth buying – and some think its price could go as high as $515. Onto the next session to find out 13 Reasons Why. Well, a few anyway.

The takeaway: Increased competition and pricey stock have some investors chilling on Netflix.

The bullish case for Netflix

Of the 39 analysts that rate whether to buy, sell or hold Netflix’s stock, as many as 26 say buy (more than the 48% average). While it’s best not to take their word as gospel (analysts are incentivized to be nice, after all), there are very real reasons Netflix could deliver blockbuster returns for its investors.

Mickey ain’t nothing but a mouse. A lot of analysts are skeptical of the threat posed by Disney. Investment bank JPMorgan doesn’t expect Disney+ to have a big impact on Netflix’s subscribers, while RBC thinks Netflix’s scale and massive content library will enable it to “remain a leader in the space”. Fellow bank SunTrust Robinson Humphrey ran a survey to quantify Disney’s impact: according to the results, only 8% of Netflix subscribers anticipate leaving for Disney.

Who needs friends? There was a lot of hoopla when Netflix lost audience-pleasers Friends and The Office to its competitors, generally referencing a survey that rated them the most viewed shows on the platform. But as Netflix doesn’t release viewing data, that survey might be completely off base. RBC’s own survey found that Netflix original Stranger Things was its most popular show. And according to Netflix, no single show matters that much anyway:

“We don’t have material viewing concentration as even our largest titles (that are watched by millions of members) account for only a low single digit percentage of streaming hours.”

– Netflix

A penny saved is a penny earned. When Netflix loses content like that, it sheds the expense too – freeing up cash to spend on original content. And as the streaming giant has to pay a 30-50% markup when it licenses other company’s shows, that’s not exactly pocket change. On top of that, Netflix’s original content gives it a competitive advantage: if it can offer better original shows than Disney, customers should follow. And it can then sell those shows to TV networks for syndication, as an extra little earner.

Pay to win. Remember we said Netflix is spending now to bring in subscribers later? That strategy might just be working. According to Goldman Sachs, “the correlation between content spend and subscriber net adds actually ticked up modestly” in the second quarter of 2019. In other words, Netflix is gaining more subscribers for every dollar it spends on content. And since content costs are “relatively fixed”, JPMorgan notes, each additional subscriber has a “disproportionately larger impact on profit”. Deutsche Bank thinks content costs could actually decrease as the company gets better at picking hits (it’s already got pretty good at canceling shows when they stop bringing in subscribers).

“There is significant room to improve the efficiency of Netflix's content budget.”

– Deutsche Bank

Bollywood billions. As of July 2019, Netflix had 90 million international subscribers – a worldwide dominance rivaled only by Amazon (whose exact subscriber numbers remain a mystery). Netflix is now doubling down on its lead: it’s offering a cheaper, mobile-only subscription in India that could bring in millions of new subscribers. A focus on dubbing content could expand the pool of potential Netflixers, as could internationally-produced originals that it hopes will resonate more with non-US users. And as broadband availability increases, so will Netflix’s growth.

So now you know what makes Netflix both an investment worth watching, and one worth turning off from. But should you invest? There are big questions to consider before you do, which we’ll cover next.

The takeaway: Netflix’s challenges may be smaller than they seem – and there’s a lot of bandwidth for growth.

Should you invest?

Only you can decide if you want to invest in Netflix. Fortunately, it’s a popular consumer-facing business you probably use yourself, which means you’ll be in a better position to assess the company than most others (in short, when all your friends start canceling their subscriptions, it might be time to sell…). But as with any company you plan to invest in, there are some questions you’ll want to ask yourself first (and some numbers in Netflix’s earnings statements to keep an eye on)

Is the competition a threat? Ask yourself if Disney, AT&T, Amazon, and Apple actually pose a threat, or if consumers will stick with Netflix – and potentially take out extra subscriptions should other services beckon. A 2018 study found that 36% of US households already subscribe to more than one streaming service. You’ll want to consider if that number will increase as the options do, or if a potential recession will make people cut down on their spending: keep an eye on net subscriber additions, particularly domestically (i.e. the US, where competition is fiercest).

Will Netflix stop burning cash? Some analysts think Netflix is destined to keep spending. But UniCredit said 2020 “could be an inflection point for free cash flow and leverage, with both moving in a positive direction.” At some point, Netflix has to start making money to be worth its salt – you just want to work out if it’s actually able to. Watching whether its free cash flow deficit keeps growing or starts to shrink will give you an indication of the direction things are heading.

How much more can the company grow? JP Morgan expects Netflix to have 217 million subscribers in 2021, while Credit Suisse thinks 225 million is achievable – even at a higher ARPU than today. That’s 60% more viewers than it has currently, paying a lot more in subscription fees. Follow its international subscriber additions and ARPU to see if this is achievable. Credit Suisse says that Netflix has “pricing power” in the US – i.e. when it raises prices, it doesn’t lose too many subscribers. You’ll want to assess whether that can continue.

What’s a fair price? Truth is, even bullish investors can’t agree on a price for Netflix’s stock. Here’s a chart showing what various firms thought it was worth as of September 2019:

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It’s up to you to decide where you stand, but now you have the knowledge and tools to make an informed one. And if there’s anything else you want to know, just ask. We’ll pick the best questions and answer them in the coming weeks – just let us get through a few episodes of Big Mouth first… 🙄

In this Guide, you’ve learned:

🔹 Netflix’s early bet on online streaming and original content turned it into a global giant

🔹 Although it has 139 million subscribers, Netflix is spending so much on content that it has a “negative cash flow”

🔹 Some investors are worried about the road ahead, and think the company is overvalued

🔹 But others think it’ll stay top dog as international growth turns its cash flow positive

🔹 As of September 2019, analysts thought Netflix’s stock could hit $417 – 44% higher than its actual trading price.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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