Netflix Business Model and value
Video entertainment from your home couch has taken a complete metamorphosis over the last 2 decades. From the days of Blockbuster which was the brick and motor business model the Netflix transformation led to Mail-in delivery of DVD to home which sounds like the E-commerce model and following this the technology transformation of streaming services of movies and TV shows (since 2007). What is interesting to note is that their Mail-in DVD business still generates free cash and aids their growth capital requirements still. But the number of subscribers of DVD service is declining day by day.
In the last 5 years Netflix had ventured into producing their indigenous contents to vow their subscribers. The advent of original content strategy has helped Netflix add subscribers at scorching pace. Global streaming membership as of Dec 2017 has touched 117 MN (63 MN International and 54 Mn domestic) and average monthly realization of $9.43 per member. They added 23 MN paid subscribers in 2017 alone. Growth focus is driving to more Originals content to reduce the dependency on studios price hikes and regulate original content cost with better control. This can be substantiated with their introduction of 18 new television series and 12 new seasons of existing series.
In addition they acquire licensed content from third party suppliers. Netflix has built its own global content delivery network called ‘Open Connect’ to enable streaming of high volume of content over internet. They also architected their software and systems to utilize storage capabilities provided by Amazon Webservices or AWS cloud computing services. Netflix has spent $9.8 bn to acquire content out of which 2/3rd was spent on originals. This clearly indicates the way forward that Netflix will be creating localized contents even in international markets which could be a big revenue driver in future if they are able to understand the local audience content palates well.
We should also consider the intensive competitive models that has evolved including Youtube, Amazon Prime and Hulu. Competitors like Disney plan to launch their own streaming services, which would likely pull content, and potentially viewers, from Netflix. Each of these competitors use discrete business models to grow their subscribers. Netflix competes against Multi Video programming distributors, internet based content providers including pirated contents, only consolation factor being subscribers can subscribe to multiple entertainment sources simultaneously.
Balance sheet cash, asset and debt positions:
Netflix holds $2.8 Bn cash as of Dec 2017. Their debt stands at $6.4 Bn which is significantly higher to service considering their negative cash flow and inherent risk of fixed cost based content acquisition and production. But consoling factor is that their cash in hand could service required working capital needs.
Total content assets are valued at $14.6 bn but what I fail to understand the content being qualified as long term assets. Their content valuation could depreciate or appreciate based on the underlying success stories these contents exhibited. Asset valuation is marked to acquisition cost and could be disparaging in non-accounting terms.
Revenues, Cost of services and Cash flow:
Netflix closed the year 2017 with revenues of $11.7 Bn. Their operating income more than doubled to $0.84 Bn and Net income at $0.6 Bn. Revenues has grown by 32% which is significant for the company`s size. While domestic revenues has grown by 21% YoY, International revenue has grown by a staggering 58% YoY. Total profits almost tripled from last year.
Operating margin has increased by 75% to 7% in 2017. The increase in operating income is due primarily to increased revenues partially offset by increased content expenses as they continue to acquire, license and produce content, including more Netflix originals. For the Domestic and International streaming segments, amortization of the streaming content assets makes up the vast majority of cost of revenues. They obtain multi-territory or global rights for their streaming content and allocate these rights between Domestic and International streaming segments based on estimated fair market value. Expenses associated with the acquisition, licensing and production of streaming content, streaming delivery costs and other operations costs make up the remainder of cost of revenues.
One thing noticeable is that if the company can regulate their content cost or cost of servicing existing subscribers which is inherent fixed cost in nature of their business, any growth in revenues can provide uptick to bottomline due to the operating leverage kicking off. It can also play in the downside spiral if the revenue growth don’t outpace content and marketing costs commensurately. This can really impact their ability to service the debts and content acquisition costs.
As an Investment candidate:
Netflix has surpassed all the Tech giants in US in terms of investment returns. Financial website How Much, take a look at some popular stocks in 2007 to find out how much a $1,000 investment in each would be worth now. It estimates a $1,000 investment in Netflix in 2007 would be worth $100,000 as of October 31 of this year, or more than 100 times as much. That’s a 100 bagger!
I could have invested in 2013 and still made huge returns and I was always apprehensive about the potential of Netflix growth. See their 5 year cumulative return on investment. It’s been a 15 bagger since then.
Where I really failed in Netflix analysis was to prophesize is their international growth since 2010. Netflix today has more international subscribers than domestic subscribers. The increase in international revenue was due to 43% growth in paid international subscribers and 11% price hike in monthly revenue per paying membership.
Am unable to value this company other than simply looking at prices as a multiple of revenue or earnings. Both multiples are steep and a simple Price to Earnings on a trailing basis is 220 times. How do we value their assets other than the Originals produced which holds the IP, Copyrights etc. The exclusivity on licensed content and its corresponding value is debatable when other competitors can host same or similar contents. Current valuation of $154 Bn could be justified if we can absorb 2 years of similar revenue growth. One can read professor Ashwath Damodaran`s blogspot to understand how he has done the valuations based on subscribers per se. Nevertheless, I will pile this on “Too difficult to prognosticate profitable growth” bucket, if I have to take a decision about investing in Netflix especially considering most of the international growth is already behind.