As with any article which discusses stock-picking, I want to give my overall investing disclaimer. So, here it is…
Streaming is one of my favorite long-term trends to follow for a number of reasons. It’s a significant trend that is impacting not just the obvious areas such as television and movies, but it’s even bigger than this. It’s impacting behavior. It’s impacting how we spend our time. It’s impacting how we interact with others.
Like Apple’s iPhone altered the landscape not just for mobile phones, but for how we consume content, how we take photos, how we surf the internet, how we communicate with others, and more, I believe streaming is having a similar widespread affect on our world.
Similar to how the rise of mobile has been one of the most important trends of the 21st century, I believe streaming is one of the most important trends and its effects will be widespread.
Why I’m extremely bullish on Netflix (NFLX)
Netflix is one of my favorite companies to both follow as a business and as an investment. I’ve been long NFLX since mid 2016 and plan to own the stock for years.
Streaming is a massive trend upending a number of industries, and Netflix is the tip of the spear of this trend.
The streaming landscape
The percentage of the U.S. population spending time on streaming platforms has been growing for years. A combination of an increase in our “on demand” expectations, a secular decline in traditional cable, and overall better product have fueled this growth.
For years, Netflix has been the clear leader when it comes to streaming entertainment into the home. While it started with licensed content from other studios and content owners, Netflix was years ahead of competition in an aggressive shift towards original content.
To understand the landscape, we need to first better understand how we arrived at this current moment.
Netflix grew its brand and its subscriber base off the backs of other studios. This happened by Netflix offering studios cash in exchange for letting Netflix license its content and allow Netflix users to stream shows like Walking Dead, Breaking Bad, and more. The studios viewed this as just another way to monetize content that they already paid for, so why not? Of course, they drastically underestimated that they’re essentially helping build a monster that would directly compete with them in the future.
Fast forward to today and the studios are now aware of their current predicament. They of course would love to further monetize their content, but do they dare continue to help fuel Netflix’s growth? For most companies, they’re in a no-win situation, and they need the cash. Only companies like Disney are strong enough to truly break away of the Netflix ecosystem (more on Disney later).
That doesn’t mean the other studios and networks aren’t trying to build up their own streaming platform. HBO is another example of a strong company with strong enough owned brands like Game of Thrones to be able to go direct to consumer. But for networks like CBS, AMC and others, the future is quite uncertain.
Consumers are probably willing to pay for a handful of streaming services (many already do), and perhaps up to 4 or 5. But it’s not likely that consumers will be steadily paying monthly fees to ten different streaming platforms.
Other networks are also at a disadvantage in the sense that they have to consider the cannibalization of other revenue streams (namely carriage fees from traditional cable) while they attempt to pivot to the on-demand streaming world. While companies such as Disney have made impressive moves toward this next era of their businesses, even Disney has made half-commitments to the future world of streaming as they attempt to maintain valuable cash flows from the previous era. This is prudent, but also a concern that doesn’t exist over at Netflix.
Many analysts look at the future of streaming as a fight to get into the elite tier of streaming platforms. The head of HBO put it this way in mid-2018:
A broad theme that I believe is occurring in the industry is there aren’t going to be an unlimited number of platforms that have direct-to-consumer relationships. There will be a select number of platforms that have direct-to-consumer relationships. It’s not going to be 10, it probably won’t be two. Now, is it going to be eight, six or four? I don’t know, but if it’s four we need to be one of the four. If it’s six, we need to be one of the six.
He’s not the only media executive to comment on what they view as a basket of streaming platforms that nearly all consumers will eventually subscribe to. And there’s typically a very common assumption that underlines all of these comments. Netflix is already in.
And that’s why I believe Disney’s commitment to streaming and the idea that this is a major risk for Netflix is severely overblown. Netflix executives, for years, has mentioned that with the rise of additional entrants like Disney, it can actually help Netflix. Why? Because as additional streaming platforms get better, it will accelerate the trend of consumers moving out of traditional cable and into streaming. And Netflix will always be in the elite tier of streaming providers.
Lastly, I enjoy Netflix’s summation of the landscape and the opportunity from its “Long-Term View” page on its Investor Relations website:
Changes of this magnitude are rare. Radio was the dominant home entertainment media for nearly 50 years until linear TV took over in the 1950’s and 1960’s. Linear video in the home was a huge advance over radio, and very large firms emerged to meet consumer desires over the last 60 years. The new era of internet entertainment, which began about a decade ago, is likely to be very big and enduring also, given the flexibility and ubiquity of the internet around the world. We hope to continue being one of the leading firms of the internet entertainment era.
Eventually, as linear TV viewing falls in viewing and value, the spectrum it now uses on cable, fiber, and over-the-air will be reallocated to expand internet data transmission. Satellite TV subscribers will be fewer and more rural. In a few decades, linear TV will be the fixed-line telephone: a relic.
These statements from Netflix give us clear insight into the long-term view of this company. Like companies like Amazon, Netflix is investing in the long game. Keep this in mind as we delve further into the Netflix strategy.
Netflix foresaw and has managed the shifting media landscape extremely well. The company was already well underway in its investment into original content before the other studios caught on and began to signal that they will consider pulling their content from Netflix.
By the time all Disney content has been pulled from Netflix, Netflix will already have launched countless family and children focused shows. I won’t go into all the details of the various programming being launched, but it’s substantial. A few notable deals recently are: Netflix recently acquired the rights for C.S. Lewis’s Narnia franchise and also the rights for Roald Dahl’s works.
Netflix has doubled and tripled down on its first mover advantage in this space. Management understands the immense value that can be gained by being the leader in global streaming amidst the multi-decade, secular shift that is occurring.
As of writing, Netflix is approaching 140 million paying subscribers which provides a growing pipeline of capital that is being reinvested into more content and more growth. Netflix clearly understands the objective of the current phase it finds itself in. The objective is global customer acquisition.
Not only is Netflix reinvesting all revenue into growth, it’s also tapping the debt markets to pursue growth. While this is cause for consternation among some investors (Netflix remains cash flow negative), my position is that they are executing their strategy masterfully.
The resulting position of Netflix is one of dominance. They can easily pay more for top talent and top content globally because they are able to amortize it across 135 million subscribers. Compare that to HBO, Disney, Apple, and other platforms that seek to grow their streaming platform. No other streaming provider is as singularly focused and in such a dominant position to continue to execute growth.
And that includes Amazon. While Amazon obviously has resources to do just about anything, they have a different objective compared to Netflix. Amazon’s goal is to push individuals into Amazon Prime, and a handful of flagship streaming properties is useful for getting new people into the service.
Netflix is seeking to become the default entertainment choice for as many people globally as possible. When it comes down to the choice of whether to find something on Netflix or watching traditional cable or browsing Instagram or going to the movies or playing outside or going to sleep, Netflix wants to win that decision moment. And more and more, Netflix is winning that moment.
With any investment, it’s important to objectively analyze the risks. Let’s look at the possible risks with investing in Netflix (NFLX):
Debt / Cash flow risk
Netflix bears will be quick to note the $8+ billion in debt on the balance sheet. While worth watching, my position is that debt levels are acceptable and management is on top of the debt servicing. Payments toward interest are quite low with respect to revenue and operating profit. Even with a potential rise in interest rates for issuing new debt in the future (current debt has rates locked in through 2021-2028), the changes in debt servicing are pretty nominal. The risk here is a larger, macro-level disruption to the corporate debt markets. Some analysts have sounded the alarms with regards to levels of debt overall in the market. For years, corporations have tapped the debt markets to pretty high levels due to low interest rates. General Electric (GE) recently made news as it pursues asset sales to lower leverage levels. If this were to become a larger trend across the large cap companies in America, the debt markets would be rattled.
So, what to watch? As a Netflix investor, the negative free cash flow (FCF) number is a key one. Management has indicated that for 2018, FCF will be close to -$3 billion. They’ve also indicated that for 2019, it should be about the same. Investors, including me, would like to see that number narrow in 2020 as it starts to move towards a break-even cash flow scenario. Should that occur, and subscriber growth is still quite substantial, you’ll see this stock skyrocket.
To me, this is the risk mentioned most with regards to Netflix that is the most irrelevant. For reasons cited above, I don’t view competition as a major risk to Netflix.
The Netflix story still boils down to growth.
One of my favorite charts provided in the October 2018 quarterly release from Netflix is as follows:
Bullish investors are looking for Netflix to achieve paid subscriber growth into the 200-250 million subscriber range in the next few years. Should subscriber growth rate slow dramatically and Netflix struggle to hit these targets, the stock would definitely be impacted.
The future value
For the investment to make sense, we should anticipate tremendous value being delivered in the future. The opportunity as an investor in Netflix is as follows:
- Achieving paid subscriptions in the 200-250 million range in the next 3-4 years.
- The market’s response as Netflix achieves positive free cash flow in 3-4 years. Note: The market will respond well before actually achieving positive FCF. As FCF stops widening and begins to narrow toward the break event point, the stock will rally.
- An upgrade out of junk status for its debt issuances.
- The further build out of its moat with regards to content. As Netflix’s dominance cements in the streaming landscape, others will exit the arena.
- The secular trend of household entertainment continually moving into streaming as outlined above.
- Tremendous pricing power. We haven’t touched on this enough, but Netflix has kept prices low in the name of subscriber growth. In the future, especially domestically, there is tremendous pricing power.
- In 7-10 years, Netflix could have utility-like cash flows. Think of the 1990s through 2000s where traditional cable was essentially a utility for households.
Here are a few scenarios to consider:
For simplicity sake, we won’t consider interest expense which is obviously an important consideration in the next couple years.
200 million subscribers, $10/mo average revenue per user (ARPU)
This clean example would result in $24 billion in annual revenue. Take out $8 billion in content costs and $4 billion in other administrative and marketing costs, and you’ve got $12 billion in profit. That’s $27.5 earnings per share. Slap on a 25 multiple, and that’s a stock price of $687.
225 million subscribers, $10/mo average revenue per user (ARPU)
This example would result in $27 billion in annual revenue. Take out $8 billion in content costs and $4 billion in other administrative and marketing costs, and you’ve got $15 billion in profit. That’s $34.40 earnings per share. Slap on a 25 multiple, and that’s a stock price of $860.
250 million subscribers, $10/mo average revenue per user (ARPU)
This example would result in $30 billion in annual revenue. Take out $8 billion in content costs and $4 billion in other administrative and marketing costs, and you’ve got $15 billion in profit. That’s $41.28 earnings per share. Slap on a 25 multiple, and that’s a stock price of $1,032.
These are rough examples, obviously, but they point to the potential massive cash flows in the future for Netflix. It is the size of the opportunity in the future that justifies management’s current (and correct, in my opinion) aggressive move to dominant this category.
This article is already lengthy enough, but I’m also very bullish on Disney (DIS), but for different reasons. First, I really like how they have pivoted in the last year into the new era of streaming. Second, company-wide, it’s a very strong company. The upside is lower compared to Netflix, just because Disney is a more mature company, but it’s a stock I seek to add to my portfolio when buying opportunities arise. I’ll plan to write a more lengthy piece on why I am bullish on Disney soon.