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✨ Much Ado About Netflix - House of Cards, or Queen's Gambit at 17x PE?
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✨ Much Ado About Netflix - House of Cards, or Queen's Gambit at 17x PE?

A Business Economics Primer of Netflix and its Streaming Industry - and How Investors Have Short Memories

Aaron Pek
May 6
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✨ Much Ado About Netflix - House of Cards, or Queen's Gambit at 17x PE?
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This is a free article. Follow me on Twitter or Linkedin - or click here to read my previous Part 1 article titled “Big Tech is officially in Value (factor) Investing Territory”!

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  • NFLX’s share price has since fallen by -68% YTD, resulting in their current valuation of 17x trailing PE. This was likely due to three recent changes from the status quo: 1) negative 1Q22 subscriber growth, 2) password sharing crackdown, and 3) their pivot towards an ad-supported business model.

  • NFLX’s reporting of their Amortization of content assets reflects a true & fair view of their consumption patterns; and their outsized Commitments & Contingencies are all above board. No hanky panky going on here.

  • We’ve actually seen this story before - investors seem to have forgotten that NFLX actually experienced similar concerns during 2015, 2018 and 2019 - when their share price experienced drawdowns of -30%, -40% and -30% respectively.

  • We explore the business economics of NFLX and its Streaming sector - their entry into an ad-supported model makes a lot of sense and should be viewed as a net positive, in my view.

  • If NFLX can eventually rise up to become a media giant the likes of its predecessor Cable competitors, it can easily justify an investment today at 17x trailing PE. Keep in mind that Bill Ackman’s initial stake was acquired at around 40x PE - so new investors in NFLX today won’t have the same exposure as him.

In my previous article titled, “Big Tech Is Officially in Value (factor) Investing Territory”, I discussed how I felt that the ‘FING’ stocks (Facebook, Intel, Netflix, Google) might have fallen into value factor territory (not value investing) - after even some of the Big Tech megacaps saw their share prices crashing by -70% YTD. The tweet below demonstrates how bad the carnage was over just the past half-year alone - with some drawing parallels to 1929 Depression-era crashes:

Twitter avatar for @jasongoepfertJason Goepfert @jasongoepfert
Internal Nasdaq damage: 😒More than 45% of stocks down 50% 😢More than 22% of stocks down 75% 🤬More than 5% of stocks down 90%. The only comparisons are Oct 2000 - Oct '02 and Nov 2008 - Apr '09.
Image

April 29th 2022

1,186 Retweets3,706 Likes

One of these unfortunate casualties was Netflix (NFLX) - which has fallen by an astounding -68% YTD. At its peak, NFLX was trading at nearly $700 or 60x trailing PE - but since then, it fallen to its latest share price of around $188 or 17x trailing PE. Regardless of whether this makes it a value factor stock today, it certainly caught my attention as a value investor - especially considering that Netflix is currently the world’s dominant streaming platform. My initial screening criteria was that if the market leaders of other highly capital-intensive and commoditized industries can command 30x average PEs despite posting flat growth (e.g. FMCG, O&G, Financials), it shouldn’t be surprising to imagine NFLX one day commanding those valuations either.

As I’ve mentioned in my previous article, this is only meant to be a shallow-dive of NFLX - and is not meant to replace an exhaustive deep-dive or serve as a definitive Buy recommendation in any way. As this blog usually covers Value Investing in ASEAN stocks, I wasn’t able to justify the time investment required to do a comprehensive deep-dive into NFLX. However, curiosity got the better of me in light of its current share price, and I did end up tunelling down several rabbit holes in the course of satisfying my inner cat - so I just thought of sharing with the world what I’d found, in case someone finds value in it. In any case, this shallow-dive is already 8,000 words long - so I’m confident it will be able to find its intended audience.

Subscribe for FREE below if you enjoy this kind of content - on Value Investing Substack, the premier place for all things ASEAN stocks & value investing!

For ease of navigation, please click on the links below to jump to the respective chapters of this article:

  1. Why NFLX Fell -68% YTD

  2. Addressing the dominant bearish narratives surrounding NFLX stock today:

    1. Content Assets & Amortization

    2. Streaming Content Obligations + Commitments & Contingencies

    3. Investors Have Short Memories

  3. Understanding NFLX and its Business:

    1. The Business Economics of NFLX and its Streaming Industry

    2. NFLX’s Business Economics, Competitive Landscape and the Future of the Streaming Industry

  4. Valuation

  5. Summary

  6. Mother's Day 10% holiday discount

(The above links which jump to the relevant chapters will only work in the desktop version of Google Chrome. If you’re using a different browser, please scroll to the relevant chapters below.)

Why NFLX Fell -68% YTD

Click this image to view this chart

If you’ve been following market news recently, it would probably be no “Stranger Things” to you why Netflix’s share price cratered by -68% YTD. On the macro front, surging inflation (due largely to supply-side issues) led the US Fed to announce a 50 bps interest rate hike yesterday - this projection was telegraphed months ago and hit all Big Tech stocks hard, as the purchasing power of their long-tail returns got crushed by rapid inflation.

However, NFLX shares part of the blame as well for its calamitous fall from grace. At the idiosyncractic level, management recently announced three changes from the status quo - 1) for the first time in a decade, the company reported negative overall subscriber YoY growth (see below), perhaps resulting from: 2) their decision to start disallowing password sharing amongst subscribers. They also said that 3) they would be entertaining a shift towards a hybrid subscriber-ad business model, which would mark a significant departure from their previous subscriber-only model.

NFLX’s historical subscriber growth - click image to expand, or download the Excel file below:

Download my Excel financial model by clicking the link below:

220506 Netflix Excel
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Immediately following the news, famed investor Bill Ackman announced that he would be disposing his entire stake in NFLX - despite announcing his initial position just slightly less than three months ago. The combination of all the above served as a one-two punch in NFLX’s proverbial gut - prompting its share price to fall by -35% overnight after its latest quarterly earnings announcement in mid-April.

While I wasn’t a fan of NFLX’s rich valuation over the past two years, its latest share price reflects a valuation of roughly 17x trailing PE - which caught my attention, especially considering that it is currently the dominant global streaming platform in a New Media era where Streaming has emerged as the incumbent. I’ll share more about NFLX’s future amidst the broader context of its Streaming sector below - but to save us all some time, let’s get some of the easier questions about them out of the way right now.

Firstly, while it is true that their subscriber growth hit a speed bump last quarter, it is also plausible that this was partially contributed by their announcement they they would no longer be tolerating password sharing between users of different households. Anecdotally, I personally know plenty of friends who engage in such privacy shenanigans - and it is not difficult to imagine how this might have pushed some “lurker” subscribers who might have only had enough time to watch 1-2 episodes per month due to work over the edge (I used to be one of them) - and justify cancelling their subscriptions. It might be worth noting that such types of cancellations tend to represent large one-time drops in subscriber growth - which implies that extrapolating these cancellation rates into perpetuity might not necessarily be the correct thing to do. As Munger puts it, “invert always invert” - imagine what might happen if next quarter’s subscriber growth recovers to positive territory.

Now of course, that still doesn’t satisfactorily explain why Ackman might have sold his stake - since he is clearly far smarter than I am and would have foresaw this possibility as well. My current working theory is that his inital stake was acquired at the beginning of this year at closer to 40x trailing PE - so even if he were to average down at today’s valuation of 17x PE, his average cost basis would still be around 30x PE. And I would be inclined to agree that NFLX would be a much harder buy (pun intended) at 30x PE - probably easier to cull the position than to suffer through an endless stream of angry investor calls, financial paparazzi, and Robinhood judges (especially when an actual global monopoly is currently also on sale for 21x PE).

However, for those of you who still have yet to initiate a position in NFLX, your upside exposure wouldn’t be the same as Ackman’s - you’d be getting in at a clean 17x trailing PE - which at least on the surface, sounds like a genuinely seductive proposition.


Content Assets & Amortization

One of the dominant narratives surrounding the justification of NFLX’s recent share price nosedive is that they amortize their content assets over an excessively long period of 10 years. If you think about it, the useful life of an average show isn’t typically that long - at most, you might allow it a shelf life of 3-4 years (aside from the rare golden hit like ‘Friends’). This would make the aforementioned argument valid - as amortizing their show catalogue over 10 years would be legitimately overstating the useful life of their shows (i.e. recognized as ‘Content Assets’).

Another reason why this might be a problem is because NFLX has a huge ratio between its revenues and the amortization of its content assets. Their Amortization of content assets (FY21: $12.2B) is a significant component of their Cost of revenues (FY21: $17.3B) - and amounted to nearly 60% of their FY21 revenues ($29.7B). The implication is that if management might have understated the actual amortization of their content assets, their Net Profit figure and therefore their current 17x trailing PE valuation might very well be illusory.

Fortunately, this does not appear to be the case. In the screenshot below taken from p.45 of NFLX’s FY21 annual report, we find the recognition criteria for the amortization of their content assets. Firstly, note how they account for such amortization at the shorter of each title’s contractual window of availability, estimated period of use, OR ten years - beginning with the month of first availability. This means that they are using the shorter of the above three criteria, not 10 years by default - so if their estimated period of use is 4 years, they would be using 4 years as the full amortization period (i.e. useful life of content asset).

p.45 of NFLX’s AR21 (click image to expand)
Click image to expand (download PDFs below):
Ar21 Nflx
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Also, they are accounting for such amortization at the beginning (of) the month of first availability. What this means is that the recognition period for the amortization of a content asset (i.e. show) begins only at the point when it is released or made available to the public. To give Netflix’s management the benefit of doubt, I don’t see the rationale behind amortizing a show that has already been created (or is in the midst of being produced) but not released yet - since consumption of that content asset hasn’t even begun yet; and there is no way to reliably estimate if any impairment even exists (e.g. new show not meeting viewership expectations). Thus, I don’t really find any issue with this approach to the amortization of their content assets - and think that it does reflect a true and fair view of the actual consumption of these content assets in real-life.

On top of that, notice how they also mention in the screenshot above that “over 90% of a licensed or produced content asset is expected to be amortized within four years after its month of first availability”. This is a very direct form of accountability being provided that management is actually trying to amortize most of their content assets within 4 years after its first showing - which would align with our initial expectations above concerning the maximum shelf life of a typical show. If we wanted to nitpick, we could perhaps make the case that 4 years isn’t conservative/accelerated enough for the average show - but at least it’s not 10 years. Feel free to adjust their annual amortization amounts upwards to a more conservative level as you see fit.

Hence, based on the recognition criteria provided, it is quite unlikely that they are amortizing all of their content assets based on a useful life assumption of ten years. Even if that amortization rate of 10 years were true for their entire content library as a whole, that rate would also include the useful life of unpublished/unavailable content assets - which could reflect a true and fair view of their actual consumption, since by definition those shouldn’t even have begun amortization yet. The only nitpick I might have here is that the amortization of their content assets is performed at the group level, rather than at the individual show level - so there’s no real way to verify what that actually means from the annual reports; which might leave room for some potential hanky panky given the size of their amortization of content assets relative to their revenues.

In summary, I don’t think there is anything misleading going on with regards to the quantum of their existing amortization rate - at the very least, we can give them the benefit of the doubt under the presumption of “innocent until proven guilty”. Personally, I wouldn’t worry about it too much - especially when there is actually something else about their financials that might actually be a legitimate concern.


Streaming Content Obligations + Commitments & Contingencies

Netflix’s content spending P&L (2018-2021)

As we have discussed above, NFLX possesses an outsized level of amortization of content assets relative to its revenues - as it needs to constantly reinvest its earnings into creating new hit shows in order to maintain its competitiveness vs. other streaming players (e.g. Disney+, Peacock, HBO Max, etc). We’ll get into the reasons why in their business model discussion below - but the fact is that they’ve been spending a ton on new and original programming, as evidenced by their Cash spending on content above (i.e. additions to content assets + change in content liabilities). This amount simply reflects how much cash outflow they’ve actually spent on content, rather than their accrued expense figures (i.e. Cost of revenues) - but the difference is actual quite immaterial when considering the quantum involved.

Netflix’s content spending B/S (2018-2021)

We can also observe this pattern of rapid growth in content spending by observing their balance sheet. Notice how much the carrying values of their Total Content Assets have grown over time - despite the massive amounts of Amortization of content assets which we’ve discussed above, which is deducted from the former each year.

However, one thing that I would like to draw your attention to is their Total Content Liabilities. As the name suggests, these represent the amounts owed related to show production which haven’t been paid out in cash yet (e.g. next month’s actors’ salaries) - and is why NFLX recommends adding incremental amounts from here to the aforementioned Cash Spending on Content figure (since there is fair expectation of these future expenses being paid out). While these amounts appear to be relatively small when compared to their Total Content Assets in the chart above, they are still huge absolute numbers (FY21: $7.3B) - which might be concerning as you can basically think of them as future Total Content Assets. (both represent cash outflows)

However, perhaps an even more attention-seeking development is the line item called ‘Commitments and Contingencies’ - which as you can see from the chart above, is even larger than their Total Content Liabilities. One interesting observation that you can make about them is that they do not actually appear on NFLX’s balance sheet - but rather are disclosed in the notes, as shown below:

Amounts belonging to ‘Commitments and contingencies’ are not presented on NFLX’s balance sheet - but rather disclosed in their notes as shown below:
Amounts belonging to ‘Commitments and contingencies’ are disclosed in Note 7 of NFLX’s AR21 (p.54 - click image to expand)

This begs the question: why aren’t Commitments and Contingencies presented on the balance sheet, especially given their size? As their name implies, the reason is because these amounts only relate to contingent liabilities - which basically mean potential future cash outflows, which remain uncertain in likelihood or quantity. For instance, let’s say NFLX has determined that Season 1 of their hit Korean show Squid Game was a success, and would like to capitalize on that success with a Season 2 - this future cash spend for Season 2 would get recognized as a Content Liability on their balance sheet, as they can be reliably estimated in the present-day and are highly certain to occur.

In contrast, let’s say that NFLX hasn’t confirmed yet if it wants to pursue the Squid Game series up to Season 5 - but it wants to ensure that its key actors remain available for filming if it decides to do so sometime in the future. Hence, it would draw up a contract with the existing Squid Game actors in the present-day which obligates them to participate in a potential Season 5 at an undeterminate future date - but which also allows NFLX to cancel in case it decides not to pursue a Season 5. As the amounts involved and the likelihood of it taking place remains highly uncertain due to how far in the future a Season 5 might potentially begin filming, accounting standards recognize it as a contingent liability - since there remains a >50% chance that it may not happen. This is also why accounting standards allow such contingent liabilities to not be presented on the balance sheet and only presented in the notes - as they represent a true and fair view of cash expenses considering their low probability of occurring.

However, despite the absence of any actual hanky panky here, NFLX’s Commitments and Contingencies are still legitimately huge amounts - surpassing their actual Total Content Liabilities in magnitude. While this differential is to be expected - e.g. potentially creating Season 3-5 of Squid Game over the next 10 years, whereas only Season 2 has been confirmed so far - it’s still a large amount. For context, if we were to deduct FY21’s Commitments and contingencies of $15.8B from their Total Equity of $15.8B (coincidentally similar), NFLX would effectively have zero book value remaining.

To be clear, this is not the correct way to approach NFLX’s Commitments and contingencies. However, it never hurts to be over-conservative - and the fact remains that these off-balance sheet amounts represent some legitimately astonishing potential future content spend. It could also give us a sense of how much their future amortization of content assets might further increase - as we can see from the screenshot below, their current amortization schedule (based on existing content assets alone) already imputes a minimum Amortization of content assets of $6.0B, $3.1B and $1.9B for the upcoming three years of FY22-24 respectively:

Note 5 of NFLX’s AR21 (click image to expand)

At this point, we should be trying to forecast what the above numbers for the potential future Content Liabilities might look like going forward - but I’m aware that any attempt to do so is going to invite some serious pushback (from both directions), so I’m just going to leave this matter at this point. Fortunately for NFLX, not being able to forecast such numbers with pinpoint accuracy might not be such a big deal - as we’ve actually seen this story before.


Investors Have Short Memories

As we have discussed above, Netflix’s recent financial woes have been caused by two main things: 1) falling subscriber numbers and 2) concerns over their burgeoning Content Liabilities and Amortization of content assets. As luck would have it, we’ve actually heard this story before - three times in fact, in 2015, 2018, and 2019 respectively.

Click this image to expand NFLX’s historical share price chart (before the pandemic)

Markets may have forgotten about this by now given NFLX’s share price’s meteroic rise throughout the pandemic period of the past two years - but NFLX has actually experienced large drawdowns before. In 2015 and 2019, there were both relatively large drawdowns of -30% respectively; whereas in 2017, there was an even larger drawdown of -40%. While nowhere near the magnitude of the -68% YTD drawdown today, these drawdowns were also large enough to have shaken out the same types of investors who might have sold their positions today.

If we looked slightly deeper beneath the surface, we can make a surprising observation - the reasons behind these drawdowns were actually very similar in nature to the ones making today’s headlines! Here are some notable examples:

  • In 2015, there was this Forbes article which threw shade over their subscriber growth falling sharply below the company’s expectations due to “the company’s continued cash bleed and extremely high level of spending budgeted for future content” - amidst long-time customers being “un-grandfathered” from early cheaper plans to a more expensive tiered pricing system;

  • In 2018, this analyst called them out for their rapidly increasing Streaming Content Obligations, high Content spending, negative FCF and growing debt;

  • In 2019, this blog post noted widespread concerns at the time over their outsized Content Liabilities and hidden but growing off-balance sheet Commitments and Contingencies.

The point I’m trying to make isn’t to dismiss either their past or current financial woes - all of these concerns were certainly as legitimate as they are today. However, it’s also worth pointing out that despite the -30% drawdowns which they had experienced in the past, NFLX’s share price eventually did recover and continued to make new highs.

While this alone does not sanction buying their shares simply based on a hope and a prayer, we shouldn’t be doing the complete opposite either - i.e. prophesying visions of corporate Armageddon and extrapolating their current downward trajectory into perpetuity. Markets tend to display irrational exuberance both to the upside and to the downside - and after falling -68% YTD, it’s reasonable to begin entertaining the opposite trajectory.

In any case, I’m not trying to use the above historical share price chart to say that just because NFLX’s share price has fallen and recovered before, it is guaranteed to do the same in the future. I’m simply trying to encourage you not to do the opposite. The fact is that trying to project a company’s future share price trajectory by extrapolating from historical trends is an exercise in futility - it would be far more fruitful to obtain a deeper understanding of their business fundamentals, which will give us an organic sense for what the trajectory of their future business performance might look like.

In this vein, let us do exactly that right now - by diving into a business economics primer of Netflix, as well as the wider Streaming sector which it inhabits.


The Business Economics of NFLX and its Streaming Industry

If Kate Winslet were the average NFLX investor today, she would be clutching her pearls while screaming at Leonardo DiCaprio as he sunk beneath the icy-cold waves of the North Sea. What she might not have realized is that she was about to be saved, and would go on to live a long and happy life - which would subsequently be immortalized as legend in one of the highest-grossing films in history (after adjusting for inflation, of course).

Mark Twain’s famous saying, “History doesn’t repeat itself but it often rhymes” finds a home in the current investment thesis for NFLX. By that, I mean that you can actually catch a glimpse of what their future might look like - not by peering into a crystal ball, but by looking back into the past. And by that, I mean that we can understand Netflix’s future by observing the legacy Cable sector that preceded it - which was disrupted by none other than Netflix itself.

Let us start by looking under the hood at NFLX’s business model. For the better part of the past decade, it was relatively simply to understand - they earned revenue from monthly paying subscribers, which could then be funnelled into the production of new shows in order to gain new subscribers. As hit shows like House of Cards tend to involve large sums of upfront investment to create content with a finite useful life, NFLX’s business model resembles that of a capital-intensive industry like O&G or Utilities - where it has to invest large amounts of upfront fixed costs that depreciate/amortize over time, and need to be replenished periodically via relatively high reinvestments from retained earnings. This also contributes to high operating leverage in its business - where since variable costs are small relative to fixed costs, an increase in revenue growth is met with an exponentially higher like increase in net profit growth; and vice versa to the downside.

On top of that, the Streaming sector has since become a completely commoditized industry - in stark contrast to the incredibly moat-y Cable sector that preceded it. As the news headlines have already made us fully aware, the future of the Streaming sector rests on the quality of shows it can deliver - and since the “pipeline” which delivers the shows to the last-mile (i.e. fiber) has since been reduced to an utility, the differentiation of the legacy Cable sector no longer lies within its distribution channel (i.e. cables), but entirely rests with its shows - which makes the economics of the sector resemble a price war. This is what we in the investment industry refer to as a commoditized sector - i.e. customers have low switching costs and can easily jump to whoever can give them more for less.

Couple this with the high fixed cost/low variable cost business model as described above, and you get a similar business model as those found in the Telecommunications or Airline industry - in which competitors will slash prices to the bone up to the fixed cost breakeven point, in order to capture the marginal customer. And because competition in such commoditized business environments tends to be fierce amongst industry players, it becomes very easy to justify dipping below that fixed cost breakeven point in order to gain that marginal customer - usually with disastorous results.

Now, let’s compare that to the Streaming industry’s predecessor - the Cable sector. Prior to when Netflix disrupted the media industry, most of the USA’s television entertainment needs were served by Cable companies - which themselves had disrupted the Broadcast industry that came before them (as excellently told in the John Malone biography ‘Cable Cowboy’). The supply chain of the Media sector (prior to Streaming) could be divided into three broad categories - Producers representing the “upstream” who made the shows, Aggregators representing the “midstream” who acquired the shows and bundled them together as channels for resale, and Distributors representing the “downstream” who served as the last-mile which delivered the bundled channels to the consumer’s home. The chart below demonstrates the role each of them played within the old Media sector:

This is a chart of the Indian Media sector’s supply chain - but it accurately reflects the legacy US Media sector’s supply chain

If you’d like to learn more about the Producer-Aggregator-Distributor dynamic of the legacy Media sector’s supply chain, here are some reports which describe them better:

2017 Vod Distribution And The Role Of Aggregators (g
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Cable companies initially started off as Distributors within the wider Media sector - since they owned the cables which served as the last-mile that piped the shows into the consumer’s home. However, over time they also started to take on the role of Aggregators - who basically acquire show rights from Producers (e.g. National Geographic), bundle hundreds of such shows together (whether you watch them or not), and sell it to customers as a packaged “bundle”. This was exactly what Netflix was initially disrupting - one of the latter’s Unique Selling Points (USP) was unbundling, so that customers only paid for what they wanted to watch. The other was offering a customers a purely subscriber-based option - Netflix founder and CEO Reed Hastings was famously against showing ads on the streaming network.

You can quickly see how the bottleneck of the Media sector rests with the Aggregators - since they were turning hundreds of individual shows into one packaged “bundle” and selling the latter as their own product, they had bargaining power over the fragmented Producer industry when it came to choosing which shows they wanted to host. On top of that, since the end-consumer enjoyed the convenience of buying one large entertainment package which served all their consumption needs rather than subscribing to hundreds of individual channels (e.g. sports, sitcoms, documentaries, cartoons, etc), the Distributors were also hostage to the Aggregators when it came to choosing which shows they wanted to deliver to the end-consumer.

On top of that, the Cable companies who over a few decades had eventually evolved into Aggregators also tended to be quasi-monopolies within their respective regions - for instance, the top 3 players AT&T, Comcast and Charter (24%, 22% and 17% market share respectively) tended to stay within their own regional turfs when it came to acquiring the cable customer, whether intentional or not. Coupled with the strong-arm nature of Aggregators as described above and the sector’s highly regulated environment, this gave the Cable companies a very strong moat - as evidenced by how even Google Fiber failed to penetrate the industry after trying for a half-decade beginning in 2010.

Now, contrast that with the entirely commoditized Streaming sector as we’ve just described above. Firstly, all of the Streaming companies today have since lost their role as Distributors - since the last-mile is now represented by the Internet backbone, and that can be considered an utility. Furthermore, Netflix’s own efforts to encourage the unbundling of entertainment packages over the past decade has led to the collapse of the moat of Aggregators in the Media sector - which means that the competitive bottleneck within the industry has shifted completely into the hands of the upstream Producers. This means producing higher quality shows and offering it for less than your competitors - which transforms the Streaming sector into a purely commoditized one.

In line with this context, we can also make another observation about the competitive bottleneck of the Streaming sector. If you reflect on the shows/songs (i.e. media) that you personally consume on a regular basis, they are typically the same branded hit shows or songs played by everyone on a recurring basis. For instance, if you caught the Squid Game bug recently, you would be binging it together with your friends every week/period whenever a new episode landed - and ignore the literal thousands of other shows available on Netflix. This makes the economics of the industry very “hit-based” - i.e. 90% of people will only have time to watch maybe 2-3 shows per week, and therefore 90% of all total show viewing time will revolve around just the top 10% of “hit” shows.

Initially, Netflix actually entered into very long-term syndication rights with the incumbent major networks to bolster its own content library with hit shows - so that it could draw subscribers onto its own then-fledgling network. At the time, the incumbent networks saw Netflix as just another Distributor who might be able to help them navigate through the then-uncharted Internet distribution channel. However, once its competitors started realizing the imminent threat that Netflix posed to them, one by one they started allowing their syndication rights with the former to expire to deprive the upstart disruptor from hit shows to distribute to its audience. To its credit, Netflix saw this outcome coming from a mile away and began its venture into original programming with the debt-fuelled House of Cards in 2013 - and was just able to skate through the closing window of being deprived from its competitors’ hit shows with a sufficiently robust roster of its own hit original programming.

This is why Netflix is currently going on a content spending binge in order to produce its own original programming - it needs a large library of its own “hit” shows in order to retain its subscribers, as more and more of the legacy networks allow their syndication rights with Netflix to permanently lapse. This is also why movie studios tend to make very safe, reliable films like The Avengers - with a star-studded cast that is guaranteed to do well at the box office; rather than try and make a critical hit, but which might still end up falling flat in theaters. The economic objective is to create a “hit” show where the production investment can hopefully be reused over and over again, and will cover the production losses from all the other “non-hit” shows - e.g. Friends, which has been shown as re-runs across the world for the past 18 years despite its last episode airing in 2004.

Also, note how despite WarnerMedia owning the rights to the hit show Friends, even people halfway across the world get to see it on their local TV channels. This is due to the most lucrative form of the business - i.e. the aforementioned “syndication”, where you own the rights to a show but “rent” it out to other networks for a contracted period of time in exchange for royalties to show to their own customers on their own networks. Since the economics of the entire industry revolves around giving customers the hit shows that they want to watch, possessing ownership of a hit show and being able to rent it out to every other network out there is unimaginably profitable - especially when you consider things like re-runs which go on for 20 years after there are no more recurring costs involved.

This is the reason why Netflix is going hardcore into producing its own original programming - it is simply attempting to populate its library with its own hit shows like Friends, which will deliver a rolling stream of syndication royalties into perpetuity. In essence, there is nearly zero difference between the economics of original programming in the Streaming sector vs. during the times of its predecessor Cable industry - the goal is to create a VC-like stream of hit show unicorns which will cover the losses of all the other non-hit shows being produced. And to its credit, we’ve already seen that Netflix is capable of doing that - as evidenced by some of the hit original programming that it has already created, e.g. House of Cards, Stranger Things, Queen’s Gambit, etc.

There’s one last point we need to discuss in order to wrap up this section about Netflix’s business model. If you’ve been observant, you’ll notice that Netflix’s latest hit show Squid Game was created on a very low budget relative to its other recent hits like The Witcher. This is an excellent example of the chaotic nature of programming economics, as there is no formula set in stone for which shows will eventually end up becoming hits. This means that it is possible for a high-budget production like the $90M Marco Polo to end up being a flop; while a low-budget production like the $21M Squid Game can pull in a staggering 1.65 billion hours of total viewing time in 28 days - and ends up being estimated to be worth almost $900M.

In layman’s terms, luck plays an outsized role in the creation of a hit show via original programming. While higher content spend does increase the chance of a show becoming a hit (e.g. hiring a star-studded cast), it far from guarantees it the way throwing money at the problem might work in other industries. This is how the $15,000 production budget Paranormal Activity and $60,000 production budget The Blair Witch Project managed to surpass its contemporary peers; and why Harry Potter was rejected by 12 publishers before finally gaining acceptance by the then little-known Bloomsbury Publishing - prior to dominating the past decade of fantasy literature.


NFLX’s Business Economics, Competitive Landscape and the Future of the Streaming Industry

For a slightly outdated deep-dive into Netflix’s respective competitors in the Streaming wars, click here for an excellent article written in 2018 which might help you get up to speed with the competitive landscape of the Streaming sector:

Click this image to read this article

One of the loudest contentions against investing in NFLX today - despite it trading at 17x trailing PE today - is the argument against its relative competitiveness vs. its competitors. As we’ve explored above, the Streaming sector has since transmogrified into a totally commoditized one a la the Telecoms or Airline sectors - which means that the player with the lowest unit cost wins, as they can give customers the most value for the lowest price. And due to the nature of hit shows dominating 90% of all consumer viewership, having the largest wallet matters a lot in the production rat race for hit original programming - with individual shows involving deca-million dollar production budgets.

This is where the widespread concern about NFLX’s possible future underperformance might hold some water. As we’ve noted above, in a commoditized industry what ultimately matters is having the lowest unit costs - since that allows you to offer customers the greatest value for the lowest price - and the way to achieve that in a highly capital-intensive business is via having the greatest economies of scale. This is because creating a hit show usually involves a $100 million upfront production cost regardless of whether it attracts 1 new paid subscriber or 100 million new paid subscribers - which is the difference between a unit CAC (customer acquisition cost) of $100 million or $1. And when your variable costs are insignificant compared to your fixed costs (like with Netflix), being able to spread out your fixed costs over the maximum number of unit revenues makes a huge difference to your bottom-line.

Of course, the 8,000 pound gorilla in the room in this context is NFLX’s largest competitor - Disney+. To save us all some time, I’m going to assume you already know about Disney+ and its extremely competitive offerings (e.g. shows of comparable quality and lower subscription fee) - if you don’t know, feel free to sign up for a Disney+ subscription at just $7.99/mth (vs. Netflix’s $9.99/mth) and browse their expansive show library. Arguably, Disney+’s huge roster of entertainment intellectual property (IP) is far more robust than NFLX’s - it owns a bevy of highly recognizable brands such as Disney, Marvel, Star Wars, Pirates of the Carribean, etc - which will serve them well for the long-term in establishing its content inventory for the next generation of Media. In comparison, Netflix is really only starting to build up its own entertainment intellectual property (IP) via its original programming - you can easily see how a character like Beth Harmon from The Queen’s Gambit can’t hold a candle to Mickey Mouse in terms of brand recognition and scalability.

On top of that, one thing that Disney has over Netflix - which the latter will probably never have - is a huge array of theme parks and a matured merchandise supply chain. For a pure-play streaming service like Netflix, the only way it can really monetize its entertainment IP is via turning them into shows - and with the rare exception of a golden hit show like Friends that can be monetized over 2 decades, the shelf life of the average show usually runs its course within 3-4 years, which makes them one-hit wonders. In contrast, Disney is able to turn its entertainment IP into theme park rides, toys and sponsorship icons - which can continue to be monetized for as long as customers remember the brand. This is a surprisingly lucrative option, with Star Wars being rumored to have cumulatively earned more money via its merchandise sales than its movies since its first movie’s release in 1977. Having an ecosystem of products also allows for a multiplier effect - where the movie side of the business reinforces the toy or video game side of the business, and vice versa.

However, that’s just the revenue equation for Disney+. More crucially, having a complete ecosystem of products also allows for lower unit costs - since now you can spread around the highly capital-intensive upfront investment required to create a new hit entertainment IP like Mickey Mouse from scratch onto greater product unit volumes. Recall from our discussion above that there is a lot of uncertainty involved in the creation of a successful new IP - so ideally, you want to be able to tank as much uncertainty as possible by having a diversified product portfolio - such that you can shoehorn that IP into the maximum number of unit volumes and benefit from reduced uncertainty, owing to having a closer risk exposure to the probability distribution of the bell curve. This reduced risk also allows for greater durability and scalability of the content IP portfolio - which can justify greater levels of investment than if everything rode on the success of just one product offering.

Let us illustrate this phenomenon with an example. Let’s say that you might be able to justify a 20% higher upfront investment to create a new entertainment IP, if the chance of recouping the investment was 50% higher - which can be generated if you also you also had a toy merchandise division ready to capitalize on the success of a movie featuring that IP. In turn, that 20% higher upfront production budget might allow you to hire Robert Downey Jr. for your new Iron Man movie - whose star power might further increase the movie’s chance of becoming a blockbuster at theaters. You can see how this has very similar economics to the much bandied-about “flywheel effect” at Amazon - and is arguable why Amazon is also going all-in into video right now (e.g. its recent acquisition of MGM Studios which owns the James Bond IP).

Where Netflix falls short as compared to Disney in this regard is obvious - it is currently only a pure-play streaming service, which means that it has to justify its cost of investment for new IP creation entirely via its ability to generate incremental subscription revenues. As you can imagine, this is perhaps an order of magnitude more difficult in terms of recouping your initial investment than what I’ve just demonstrated with Disney - since the creation of hit shows involves such an outsized level of uncertainty. If we assume that the status quo maintains, it is all too likely that Netflix will eventually cede its throne to Disney - as perhaps evident by its recent share price performance.

Fortunately for NFLX shareholders, that does not seem to be the case. For one, Netflix recently announced that it would be entertaining a shift towards a hybrid ad-subscription business model - with the first ad-supported plans targeted at reducing the cost of entry for lower-income customers coming out sometime around 2025. While this definitely introduces an entirely different revenue mix to their business model, management clearly felt that the reward of doing so justified the risk before they announced it - so what do these new economics look like?

Think about how I described the economics of Netflix’s current pure-play subscription-based streaming business above - you need to create a hit show as they control 90% of all viewership time; but the creation of hit shows involves large amounts of uncertainty in terms of recouping the upfront cost of investment required. If you’re a pure-play subscription-based streaming business, the only way you can do that is by increasing your subscriber numbers or raising subscription fees - which naturally involves tradeoffs in a purely commoditized industry. As such, what ends up manifesting is a VC-like business model - where for every 100 new shows you produce, you’re banking on 1 hit show unicorn to cover the costs of the other 99 potential failures. This is clearly not ideal when it comes to competing with the likes of Disney+ - which has a clearly superior business model via greater economies of scale, as we’ve explored above.

However, what if Netflix switch to an ad-based model like the NBCUniversal-owned Peacock network is currently experimenting with? This would be almost identical to what most of us are already used to with traditional Broadcast channels - where an ad or two will be slotted in between our 30-minute or 1-hour long episodes, and corporations pay for ad slots which vary in price depending on how many viewers a particular show gets. Observe how the economics of an ad-based business is entirely different from that of a subscription-based business - the network generates revenue on a variable basis depending on how many viewers each individual show gets, rather than on a comparatively fixed basis by selling a subscription for access to a conglomerate show bundle. This makes it a lot easier to estimate the potential ability to recoup the upfront investment needed to produce a show based on the number of ads it can sell - e.g. Netflix’s salespeople could go to its various corporate ad customers (with thick ad budgets), and attempt to secure their ad dollars in advance by justifying how their new show can attract 100 gazillion eyeballs or whatever. Then, Netflix’s management can take these ad commitments and try to sell their shareholders on a greater production budget for that new show (whose chance of success has obviously already been research to death by its algorithm) - which as we’ve already mentioned above, can lead to a potential flywheel effect.

The long and short of it is that adding an ad mix into Netflix’s current business introduces a higher variable element to their business model - which currently has an extreme level of operating leverage, owing to its high capital intensity as described above. While this will certainly impact their earnings growth going forward - since it reduces operating leverage - it also dramatically reduces the risk/uncertainty involved, in terms of justifying the cost of investment for creating more hit shows via original programming. By diluting both the risk and reward in this way, it allows Netflix to justify higher production budgets for future content and therefore potentially compete head-to-head with Disney+ in terms of unit cost.

And perhaps the economics of an ad-supported tier was also apparent to Disney+ as well - since it also announced that it would be exploring ads on its own network. I’m not sure what research they are looking at which justifies the move that “some consumers actually view ad-supported streaming more favorably than ad-free streaming” - but I’m pretty sure that pot of advertiser revenue gold sitting on the sidelines was a little bit too hard to ignore (“we also had an incredible amount of advertiser demand”). Peacock is even taking it one step further - it will reportedly “begin serving ads by putting a frame around the show being watched, which is sponsored by an advertiser”.

What we can say for sure, however, is that introducing an ad-supported element into its network will help put Netflix on more even footing with Disney+ when it comes to competing with the latter’s incredible economies of scale. Unfortunately, what’s bad for consumers is usually good for companies - and the same applies for the economics of an ad-based network. And since Netflix is currently the dominant streaming platform, it has a very good chance of taking market share in the ad-based business by stealing it from existing ad-based Broadcast and Cable network competitors - as well as other ad-based Streaming network competitors like Peacock. In the same way that the entrance of Disney+ in late-2019 probably introduced uncontrolled shivering into the ranks of Netflix’s management, you can bet that the managements of existing ad-based networks are quaking in their boots from Netflix’s recent announcement to sidestep into their turf.

In fact, let us take it a step further, and consider what the Streaming sector might look like in the future - based on everything we’ve just discussed about the industry’s economics. My prediction is that since the Aggregator and Distributor roles of the Media sector have since become diminished, the competitive bottleneck of the sector will rest with the upstream Producers - who need to create quality hit shows and offer them to consumers for the lowest price in order to justify their existence. This newly commoditized element of the Streaming sector means that all industry players will strive to achieve the lowest unit costs - either via having greater economies of scale or reducing the risk of upfront capital investment, depending on their unique circumstances and tradeoffs involved. Shareholders of the sector will demand a dual mandate from their Streaming companies: 1) lower your unit costs as much as possible; and 2) create higher quality shows to attract more viewers, which will necessarily involve higher production budgets. This will in turn require the managements of Streaming companies to participate in the familiar boom-bust cycle of greed & fear that perpetuates every commoditized industry during market cycles. After multiple market cycles involving successive waves of M&A activity, the TAM of the entire sector will gradually become consolidated and end up in the hands of just 4-5 market leaders - just like in the equally commoditized Banking, Hypermarket, Commodities and Insurance sectors. Then, as history is wont to repeat itself, they will mature into oligopolies - just in time for the next generation of technology to disrupt the aging incumbents after 30-40 years.

I know I’m painting a very bleak picture, but it’s hard not to get philosophical when you’re talking about extremely long periods of time. In the meantime, it’s entirely possible that Netflix might eventually acquire the rights to Harry Potter within the next 5 years, in order to bolster its competitiveness vs. Disney+ - just as Disney acquired Marvel and Lucasfilm to bolster its content library. Doesn’t sound so “Riddikulus” anymore, doesn’t it?


Valuation

Now, after everything we’ve discussed, the question boils down to - “Can NFLX justify an investment of 17x trailing PE today?” Firstly, as we’ve seen above, it’s relatively easy to forecast their revenues and margins in the medium-term - owing to how much their net margins and earnings growth are contingent on just two line items: 1) revenues and 2) cost of revenues. And as we’ve also discussed, these will likely keep their profits depressed for awhile - as Netflix struggles to match Disney+ in terms of unit cost in the production race for hit original programming.

However, as we’ve also discussed above, it is likely that the future of Netflix lies not in its current form as a pure-play subscription-based streaming business, but with the significant addition of an ad-based business which will increase their relative competitiveness in the production race for “hit” original entertainment IP. The higher production budget enabled by their shift to an ad-subscription hybrid business model will allow them to pursue inorganic routes of expansion through M&A in order to acquire original entertainment IP - something that both Disney and Amazon have already done (Marvel and Lucasfilms by the former, and MGM Studios by the latter). It would only be natural for Netflix, being the No. 1 (or future No. 2) player in the industry, to follow suit.

In fact, I would personally view the addition of their new ad model as a net positive - for all the risk:reward benefits which I’ve described above. The fact is that total US Digital Advertising revenue in 2021 amounted to a goliath $189.3B - and being able to tap into this pool of latent energy is the financial equivalent of drinking from a bursting dam. In my view, this pivot towards an ad-supported network was inevitable - considering how lucrative the opportunity set is, and how dumb it would be to leave the advertising revenue land grab to other Streaming competitors. In capitalism consumers be damned, I suppose.

The parallel to draw here is this - can Netflix eventually become a dominant Media player the likes of Comcast or Charter in the predecessor Cable sector? My answer to that is a very affirmative “Yes”. Its current economic woes notwithstanding, Netflix is not a static phenomenon - it will constantly evolve and respond to changes in a dynamic manner, as businesses are wont to do in their fight for survival. And I think we can all agree that Netflix’s management are a smart bunch and aren’t going to be resting on their laurels going forward either. In this case, it is easy to see how Netflix might eventually end up as one of the dominant market players as the Streaming sector gradually “oligopolizes” - and if you’re a long-term investor, being able to scoop up their shares up at 17x trailing PE today might represent a steal the likes of participating in Amazon ten years ago before AWS really kicked into gear - or perhaps more relatably, buying into John Malone’s TCI Communications when they hit a spot of trouble in the 70’s. And as we’ve seen with Buffett, buying moats during times of crisis typically represents the best of investment opportunities.


Summary

Let’s recap everything we’ve discussed about NFLX so far in this 8,000 word article:

  • NFLX’s share price has since fallen by -68% YTD, resulting in their current valuation of 17x trailing PE. This was likely due to three recent changes from the status quo: 1) negative 1Q22 subscriber growth, 2) password sharing crackdown, and 3) their entry into an ad-supported business model.

  • NFLX’s reporting of their Amortization of content assets reflects a true & fair view of their consumption patterns; and their outsized Commitments & Contingencies are all above board. No hanky panky going on here.

  • We’ve actually seen this story before - investors seem to have forgotten that NFLX actually experienced similar concerns during 2015, 2018 and 2019 - when their share price experienced drawdowns of -30%, -40% and -30% respectively.

  • We explore the business economics of NFLX and its Streaming sector - their entry into an ad-supported model makes a lot of sense and should be viewed as a net positive, in my view.

  • If NFLX can eventually rise up to become a media giant the likes of its predecessor Cable competitors, it can easily justify an investment today at 17x trailing PE. Keep in mind that Bill Ackman’s initial stake was acquired at around 40x PE - so new investors in NFLX today won’t have the same exposure as him.

NFLX Links:

  1. Netflix’s main website

  2. Netflix's investor relations website

  3. Netflix’s Investor FAQ

  4. Download more resources below:

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✨ Much Ado About Netflix - House of Cards, or Queen's Gambit at 17x PE?
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Kalani Scarrott
Writes Allocators Asia May 6

the thing I can't get past Netflix, (as a user), I just don't like nor pay for their product anymore, so it gets me wondering, how many other people are in the same boat? Disney has a lot stronger IP in the streaming space, but for netflix, it's just a cost I can't justify anymore personally

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