NETFLIX stock analysis

Hey everyone! This post is going to breakdown Netflix. I am going to provide a detailed overview of the company and then find out if it meets our four investment principles (Circle of Competence, Competent Management, MOAT & Margin of Safety). This is a very long post because I want to explain my rationale. This analysis is going to be broken down into four sections:

1. History/Overview of the Company
2. Qualitative Analysis
3. Quantitative Analysis
4. Buy Price

History of Netflix:

Netflix launched in 1998 as an online movie rental service. When Netflix began, they offered a subscription package allowing members to rent as many movies as they want for $19.95. The deal was that Netflix subscribers can keep DVDs, up to three at any one time, for as long as they wish. At the time, Netflix's largest competitor was Blockbuster, and funny enough, Netflix offered to sell their business to Blockbuster in 2000 and Blockbuster rejected the deal.This turned out to be a huge mistake for Blockbuster because Netflix forced Blockbuster into bankruptcy. How did Netflix go from offering their business to stealing consumers away from Blockbuster? There are four reasons which I will break down but the overarching answer is that Netflix just offered far more favourable options to consumers at a much lower cost. Let me explain.
Better deals: Subscribers can order a movie online with next-day delivery. Netflix subscribers were able to hold on their DVD as long as they needed without late fees. When it's time to return a movie, a subscriber puts it back into the postage-paid mailers that came with and drops it into a mailbox with no shipping fees.
Forward thinking: Netflix was investing in technology and consumers really liked the personalised recommendations by their software (Netflix recommends titles based on user's previous choices). Brick and Mortar stores like Blockbuster relied on store clerks who knew nothing about their customers' movie tastes.
Lower operating costs = better value for consumers: In 2004, Netflix's logistics systems included only 30 distribution centres throughout the United States. A typical Brick and Mortar store like Blockbuster would take more than 500 video stores to serve the Los Angeles area, while Netflix served the same market with only one warehouse. Because of lower operating costs, Netflix were able to pass on those cost advantages to consumers, offering subscription rental around 50% cheaper than same-store subscription rental.
Online streaming: Netflix invested in online streaming since they recognised that video-on-demand was gaining popularity. Blockbuster filed for bankruptcy in 2010.
Overview:

Netflix is one of the world’s leading entertainment services with approximately 238 million paid memberships in over 190 countries enjoying TV series, films and games across a wide variety of genres and languages. Netflix is available virtually everywhere except in China and Russia. Members can play, pause, and resume to watch as much as they want, anytime, anywhere, and can change their plans at any time.While consumers may maintain simultaneous relationships with multiple entertainment sources, we strive for consumers to choose us in their moments of free time. We have often referred to this choice as our objective of “winning moments of truth”. In attempting to win these moments of truth with our members, we seek to continually improve our service, including both our technology and our content offerings.
Qualitative Analysis:

Reed Hastings is currently Chairman of the Board and is the founder of Netflix. Reed Hastings has a history of purchasing Netflix shares indirectly and has a good compensation structure.

There is no doubt that Netflix has a lot of competitors. They compete against linear TV such as broadcast and cable television and other video streaming services such as Amazon Prime, Apple TV, Disney/Hulu, Youtube, HBO. However, Netflix does hold competitive advantages:

• Linear: Netflix is much more flexible over linear TV. Netflix is not competing for scarce time-slots whereas linear TV present programs only at particular time. Netflix is on demand, whenever someone wants to watch a show.
• Netflix produces their own content with their own studio and this is becoming a major source of Netflix: There is an argument that states Apple and Amazon does the same. Firstly Apple TV is operating at a loss in that segment and is relying on its more profitable lines to make up for that segment. Amazon Prime recently started operating at a profit however there are a few things worth noting.

1. Amazon Prime memberships are available in only 27 countries, whereas Netflix is available in over 190 countries. Furthermore, Amazon is very diversified so they have a limited focus, whereas Netflix's only focus is providing entertainment to consumers.

2. Netflix has a successful track record of producing local stories to reflect the different tastes in different countries and made them available and popular worldwide. Think of Netflix originals such as Money Heist (Spain), Squid Game (South Korea), Alice In wonderland (Tokyo, Japan). Without Netflix, a lot of international series and movies would have never achieved global penetration.

3. Netflix original films bypasses the Cinemas and Netflix gets original access: This also makes Netflix a competitor to theatres, except that theatres have limited seats and time slots, Netflix does not.

4. Furthermore, Netflix licenses from other studios in the first pay TV window (the “pay one” window). This means Netflix gets first access after theatrical release of licensed content. Pay-one movies debut very well after theatrical release with a lot of viewership and Netflix has the ability to carry the film for 18-24 months. The result: Netflix has more viewing time than their competitors.

Quantitative Analysis:

Although Netflix has a bigger market share compared to other streaming platforms (some countries Youtube has the lead), Netflix market share is just under 10% so there is still significant room to grow.
Revenue + Operating Income/Margin Growth

Paid Memberships (In 000's)

Free Cash Flow (In 000's)

Free Cash Flow Growth Rate

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This is where it is important to pay attention when it comes down to valuing Netflix. At first glance, it looks like membership growth is decelerating from 20% growth to under 10%. However, there are a couple things to consider.

• Last year, Netflix stock price plummeted due to losing memberships in Q1 and Q2. When Netflix reported losing -0.2 million subscribers in Q1, this was because they withdrew there services from Russia that resulted in a -0.7million impact on paid net adds; therefore, excluding this impact, paid net add would have been +0.5m.
• At the time, Netflix just announced paid sharing and there was a lot of initial negative reaction with consumers deleting their Netflix accounts. However, this turned out to be temporary and Netflix subscriber growth quickly improved after that. (One thing to keep in mind is this: 20 years ago, people were paying $5 for a single new rental DVD release, and around $60 for cable. Back then, the general cost of goods and services aren't anywhere like it is today due to inflation. People will always pay for entertainment, so Netflix paid sharing impact on subscriber growth was always going to temporary.
• Netflix has entered into the advertising business and so far it is proving to be successful. Consumers are benefitting because of lower price points, Netflix is benefiting because of increased subscriber growth and the advertising segment has better margins.
  How did I calculate Free Cash Flow?

Netflix pays a substantial amount each year for content and it is hard to determine what portion of that content spend is considered maintenance capital expenditure and what portion is considered growth capital expenditure. To make this process easy, I have calculated free cash flow by taking:

• Cash Flow from operations + Additions to Content Assets – Amortization of content Assets – Purchases of Property & Equipment = Free Cash Flow.
  I also believe that this is a conservative estimate of Free Cash Flow because amortisation is on an accelerated basis. Over 90% of a licensed or produced content asset is amortised within 4 years after it first becomes available. There are tax laws preventing management from speeding up depreciation of tangible property but since intangible assets such as content is extremely difficult to measure, management can speed up the amortization process. Management is incentivised to do this because a higher amortization expense (which is a non-cash expense) reduces the amount of taxes Netflix has to pay!

BUY PRICE:

If you made it this far in the post then congratulations. My buy price ranges from $182 to around $250. I have used the discount cash flow calculator using the current year free cash flow (2022). The former assumes a growth rate of 15% with a 15% discount rate. The latter assumes a growth rate of 10% with a 10% discount rate. I missed out on a bargain last year but I only began looking into Netflix a few weeks ago.
I'll end this analysis with this quote.
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“The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd”. – Warren Buffett

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