Netflix security analysis - Q2 2018


(Vladislav Kozub) #1

Disclaimer: please do not base your investment decisions on any other people’s opinions in the world except for yourself.

Hey community,

@Chris once asked whether there will be interest in some securities’ analysis and I mentioned that I could do it one day.

This time it shall be Netflix. It is a company I purchased when it was at $185 and sold at $250 thinking it is overvalued. Long story short, it got to $420 within the next 5 months making it my worst sale, but I think it was and still is extremely overvalued and would not risk getting back to it.

I will avoid subjectiveness and bias in the following analysis (until after the Conclusion) and most of the information will be presented in figures with minimal assumptions.


Overview
Netflix produces and buys licences for movies and TV series. It has achieved a mere 10,000% growth for the past 10 years. But that is sad history, let’s look at the contemporary information: on the 16th of July, Netflix has disclosed its financial results for the second quarter of 2018. We’ll figure out why the shares went down significantly in the past few days.

Results in the USA
Revenue from online streaming increased by 26% in comparison to the second quarter of 2017: from $1.5bn to $1.89bn. In April 2018, Comcast added Netflix to its subscription packages. Comcast has an audience of 50 million people.

Gross profit rose by 32% in comparison to Q2 2017, from $560m to $740m. Profit per Subscriber rose by 19%.

Netflix gross profit from paid subscribers in the US is presented below (In brackets - growth compared to the same period a year ago):

| Period  | Profit       | Subscribers   | Profit per Subscriber |
|----------------------------------------------------------------|
| Q1 2017 | $605m        |  49.4m        | $12.3                 |
| Q2 2017 | $560m        |  50.3m        | $11.1                 |
| Q3 2017 | $554m        |  51.4m        | $10.8                 |
| Q4 2017 | $561m        |  52.8m        | $10.6                 |
| Q1 2018 | $697m (+15%) |  55.0m (+11%) | $12.7 (+3%)           |
| Q2 2018 | $740m (+32%) |  55.9m (+11%) | $13.2 (+19%)          |

Results in other countries
Revenue rose by 65% in comparison to Q2 2017: from $1.16bn to $1.92bn. Since July, Netflix is testing a new Ultra subscription type in Europe: it is more expensive than others, some advantages are moved from the Premium and will be left only in the new subscription type. Discomfort for the users, income for the company, damage to the image.

Gross profit increased in comparison to the second quarter of 2017: from -$13m [loss] to $298m [profit]. In terms of profit/loss per subscriber, Netflix reached its peak of $4.3, which remains the same since the previous quarter.

The total revenue and profit grew thanks to higher subscription prices, and not due to a sharp increase in the number of actual subscribers. The company showed the result below the analysts’ forecasts and hence many investors sold their shares due to lack of confidence.

Netflix’s profit from paid subscribers in the rest of the world:

| Period  | Profit | Subscribers | Profit per Subscriber |
|--------------------------------------------------------|
| Q1 2017 | $43m   |  44.9m      | $0.9                  |
| Q2 2017 | ($13m) |  48.7m      | ($0.3)                |
| Q3 2017 | $62m   |  52.7m      | $1.2                  |
| Q4 2017 | $135m  |  57.8m      | $2.3                  |
| Q1 2018 | $272m  |  63.8m      | $4.3                  | 
| Q2 2018 | $298m  |  68.4m      | $4.3                  |

Losses
Netflix achieved a cash-flow loss of $518m. According to the Income Statement, the company profitable, but Netflix does not receive real money. The difference arises from the accounting principles for calculating the costs: Netflix pays for their licences straight away in full, but when reporting these in the Income Statements, the cost of each licence is split for the duration of the show (e.g. if a series is 10 years long and they paid $10m on day one in cash, only $1m per year will be counted as cost each year for the next 10 years).

Netflix reduced the loss by 3%, but by the end of the year, the company will spend another $2-3bn creating and acquiring new content. Moreover, the company increased its loans by 10%, up to $10.6bn - and this is additional cost going forward, especially with the Fed constantly increasing the interest rates (2% it is already, whilst we are lucky with 0.5% in the UK).

Netflix’s ratios in comparison to its direct competitors:

   | Ratio          | Netflix | Disney | Amazon |
   | -------------------------------------------|
   | EV/EBIDTA*     | 119     | 11     | 51     |
   | EV/CF**        | (199)   | 13     | 49     |
   | Debt/EBIDTA*** | 6       | 1      | 0.4    |
   | ROIC****       | N/A     | 18%    | 11%    |
   | Revenue Growth | 31%     | 4%     | 28%    |

*The less, the better (close to or less than 10 is often a severe undervaluation [$MU is exempt from that logic]).
**Same as EV/EBIDTA but considers real cash flow instead of accounting profit. Hence Netflix at the moment is making a monetary loss from their operations.
***At least how many years the company will need to repay the debts. Under 3 - usually fine. Over 5 - risky. Netflix has a very significant amount of debts and it is particularly risky in the times of the Fed raising interest rates.
****Profitability. But excluding one-off costs (ever tried to “exclude from summary” one of your Monzo transactions? This is that). 15% and over is generally fine. As Netflix only has profit on the “books”, we could not get their ROIC but there is an indication for the competitors.

Conclusion
The price of Netflix’s shares depends on investors’ expectations of the subscriptions and revenue growth. Netflix shares are for those who are ready to take risks: the company does not pay dividends, the growth depends on the expectations of large investors. The company increases loans, but not its own cash - this is bad. Also, it is severely risking to lose all Disney’s content in 2019 since Disney is getting Fox (that is 100% legit now) with their user base, which could all be moved to Hulu (honestly, what else do people watch in cinemas other than Disney’s content?).

Whilst there are most likely hard times for Netflix to follow, it still has an enormous room for growth and development. It’s only got 120m subscribers, which is 1.5% of the world’s population. Going forward (10+ years we are talking about), with current global demographics and rapid technological development, significantly more people will be exposed to streaming services and if Netflix plays its cards correctly, they can still double their net worth every 5 to 7 years and thus it still can be a good investment decision in the long run. But at the moment it does seem like there are more undervalued companies out there. Even within the same sector.


Certainly, it is hard to include everything in one post so I tried to concentrate on the latest earnings report but happy to see more points raised by the community members if I have missed something paramount.


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(Chris) #3

This is awesome and exactly the sort of thing I was hoping to start reading on here. :grinning:


(Viktor) #4

Can you unpack ROIC a bit more, @vlad? I think the ratios are super important, and if we could write definitions that are exciting to read, people would look at them more.

Also, thanks for the analysis. Some of our team have strong and opposing views on Netflix vs. Disney. :slight_smile:


#5

Very interesting piece @Vlad. I’m one of those on the team engaged in the Disney Netflix debate.

I’m a Netflix sub but not a direct shareholder, in part for the same reasons. Its moat is pretty much just brand recognition and first mover advantage and the inherent customer inertia of Saas companies. Original content is I think relatively underwhelming given the investment.


(Vladislav Kozub) #6

Thanks Viktor, of course, I could elaborate; I will make it very explicit so that it is comprehensible for as many community members as possible.

ROIC is Return on Invested Capital. The ratio is primarily based on the operating profit and capital invested (although there are many ways to calculate it). Operating profit is the company’s income from its core business, excluding one-off other income. The invested capital is the sum of all the funds invested.

The Formula:
ROIC = (Operating profit × [1 - tax rate]) / Invested capital
Tax rate = Paid tax / Profit before taxes
Investment capital = Capital + Short-term and long-term liabilities (loans and creditors)

ROIC is most useful when you’re using it to calculate the returns generated by the business operation itself, not the one-time events (hello Tax Reform!). Gains/losses from foreign currency fluctuations and other one-time events contribute to the net income listed on the bottom line, but they’re not really recurring results from business operations. Try to think of what your business “does” and only consider income related to that core business, which in our case is the streaming service.

So why does ROIC matter? A firm’s ROIC can be an excellent indicator of the size and strength of its operations. If a company is able to generate ROIC of 15-20% year after year, it has developed a great method of turning investor capital into profits.

That is a great idea for a blog post! In fact, there was a wonderful piece that mentioned ratios already. But having an extensive post using Freetrade’s language would be of a benefit to everyone.

Your correlation with my thinking on it is +1!


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(Big Boss) #7

Nice post @Vlad

Netflix is one that we constantly debate about in our investment team. We think there is no competition. We just can’t our heads around valuation.

With that said, I recommend reading their Long Term View here https://www.netflixinvestor.com/ir-overview/long-term-view/default.aspx

It is one of the best investor relations letter I’ve read.


#8

Thanks @Vlad :+1:

A few points I’ve not seen mentioned:

  • Netflix Technology, beyond their apps being better than Prime / iPlayer. They have a lot of behavioural data and personalise marketing of shows, including personalising artwork for viewers. They do personalised marketing really well…

  • Millarworld acquisition, which includes Kick Ass and Kingsmen as well as a bunch of other lesser known titles. Think they announced the first set of shows recently.


(Vladislav Kozub) #9

Agree with what you said and with what has been stated in the letter @Justin has kindly suggested.

In my understanding, investors’ decisions, whether individual or institutional, entirely depend on their own perception of each event’s significance for the security. For example, you believe Netflix Technology or Millarworld acquisition are important, and there may be many more people deeming this vital - they will not be wrong. Personally, I think the major event & risk is Disney’s streaming service development and repatriation of hundreds of its own movies and series back to ESPN/Hulu, which will inevitably lead to the leaks of Netflix subscribers, especially families with children.

Do not get me wrong, I am not against Netflix, and I believe it can have a great future. I only think that it is now too overvalued to get into it myself and have trust in it in the near future.


(Jim) #10

I use my daughter as a ‘youth’ barometer - apparently her and her friends ‘can’t find anything good on it anymore’. Wall St. beware… :smile:


(Calum McWhir) #11

I don’t have a view but have seen this echoed elsewhere:

Likely oversimplifying things but the ‘binary bet’ aspect reminds me of sentiment on $TSLA, albeit that’s turned manically bearish of late.


(Vladislav Kozub) #12

Thanks Calum, a very interesting article!

I sort of agree with the “binary bet” classification. After all, it is either Netflix dominating the market alone or (worst case scenario) sharing it with all other providers (main one being Disney).

And yet, Disney has a widely diversified sources of cash flows (both digital and brick & mortar), it can easily exists with a competition in place.

Whereas Netflix, which can only rely on a single type of service, can ultimately be buried (not to the ground, but back to, say, $100-150) if they do not manage to prove to the world they are the only option worth people’s attention.


(Alex Sherwood) #13

Netflix’s ambition is not just that you subscribe to its service but that you like it so much you don’t feel the need to pay for any of its competitors.

I don’t remember seeing this in Netflix’s long term strategic plan, which Martin shared earlier in the week :thinking:

Personally I don’t see why this has to be a winner takes all situation, as Reed Hastings keeps pointing out, HBO has grown alongside Netflix. Trying to completely ‘own’ people’s free time just seems like an unrealistic ambition to me..


#14

Maybe complete monopoly is not in their plans, but dominance is. And dominance is difficult to sustain. Netflix have the current network size and good tech, but relatively weak IP.

In other words, Netflix have an amazing distribution network, but only a lukewarm content factory. It comes down to whether you think it’s harder or easier to build content factories than distribution networks.


(Big Boss) #15

Great piece @freetrade_cal

From that article I found this 3 part write up from the former Head of Strategy for Amazon Studios. When such praise comes from a competitor, you know something’s up. Netflix wants to dominate ALL your free time, not just the time you spend watching TV! Enjoy.

Part 1 (Size of Content Spend) https://redef.com/original/netflix-misunderstandings-pt-1-netflixs-content-budget-is-bigger-than-it-seems

Part 2 (Product & Technology) https://redef.com/original/5aef99591e5d473edfd9a4c5

Part 3 (Risking it all…) https://redef.com/original/5b400a2779328f4711d5675e?curator=MediaREDEF


(Luke Bebbington) #16

My 2 cents. Being from down under (NZ) I grew up unable to watch certain tv shows and movies because they were physically not available. I was willing to pay!! Companies were so focused on their own country they missed the global opportunity.

Netflix is one of the first companies that destroyed this old school model in the entertainment space and still seems to be the only one to truely understand it. I can access Netflix in almost every country whereas with competitors like Amazon prime you can’t.

Hint hint Freetrade.


(Alex Sherwood) #17

Haha if only international expansion was as easy as relaxing your copywrite restrictions :wink:

But going back to your previous point about Netflix being properly global & Toby’s comment about content output, it’s also worth remembering that Netflix is investing in producing shows for local markets across the world e.g. Germany, Turkey & India so we may not be seeing all the content that they’re producing or how successful it’s been. Hopefully New Zealand’s next on the list :grin:


(Luke Bebbington) #18

If only…:upside_down_face:


(Viktor) #19

I’d think the New Zealand is too small to justify investing in producing local content, but HBO did it for e.g. the Hungarian market, so nothing is impossible. :new_zealand:


(Viktor) #20

Interesting, but not surprising view from a competitor. :wink:

From the Long-Term View (thanks for this, @Justin):

Because the entertainment market is so broad, multiple firms can be successful. For example, ABC and NBC have historically competed for viewers, attention and content but have also successfully co-existed for many decades. Similarly, in the internet TV world, HBO is now growing faster than in years past, while our business is also expanding. Many people will subscribe to both HBO and Netflix since we have different exclusive content. The transition to internet entertainment, with its greater consumer satisfaction, will mean growth for many internet TV services.

By the way, I love their view on competition:

We compete for a share of members’ time and spending for relaxation and stimulation, against linear networks, pay-per-view content, DVD watching, other internet networks, video gaming, web browsing, magazine reading, video piracy, and much more. Over the coming years, most of these forms of entertainment will improve.


#21

Great finds @Justin. However, I totally disagree with the writer’s contention that no-one else is playing the game of monopolising all leisure time (classic strategist approach = grand, highly questionable ‘everything is different’ premise).

Disney are buying up all the world’s favourite IP (including merchandise and game licences).

The Amazon competition alone is any tech business’s worst nightmare. Plus they own Twitch.

YouTube has more eyeballs, with people shouting at video games and sharing makeover tips.

They compare Netflix to the social platforms. But actually platform companies, especially ones without social aspects and often conservative advertising revenue, can be pretty shaky.

Tbh I’m a Netflix fan and could definitely be missing a great buy here. But I just don’t get treating it as one of the absolute elite tech companies. Seems uniquely vulnerable to me.