Netflix is Looking Full
After a ~200% return is time to take money off the table or leave it alone? Buying at ~15x EBIT is different than owning ~27x '24eEBIT.
I bought my first shares of NFLX on April 28th, 2022 for ~$190 a share. Back then, the world wasn’t so bullish.
The words, “Our revenue growth has slowed considerably” sent investors to the exits.
At the time, the stock was down ~73% from all-time highs and traded at an EBIT multiple of ~15x. New entrants were banging at the door with billions in their pockets. This new supply would, “Kill the streaming business”.
But, the moat stood strong and the same shares today are ~$600.
Now the investors who bought in the face of uncertainty have a new question to ponder, "Is it time to take some money off the table?"
At the start of this investment, there was no optimism. Today, there's plenty. Although, it doesn’t feel like there’s too much.
Don’t get me wrong, it’s not cheap. But it doesn't scream overvalued to me either. It feels full. Should the multiple expand of another 10 points, I might get scared of heights.
But we are not there yet.
Underwriting a name at 15x EBIT differs greatly from owning a name at 27x 2024 eEBIT. (If they can hit their revenue targets of double digits and operating margins of ~24%). Topics like competitive position, TAM, and growth are much more top of mind now.
To own at these levels means I have to be comfortable with the direction of all 3. So let’s dive in.
TAM
Ted Sarandos likes to throw around $600B as the TAM for NFLX. This number includes Paid TV, Games, and Advertising.
By those standards, NFLX captures only 5% of the market, but as much as I like Ted, I am going to apply a discount. Asking a CEO for a TAM is like asking the barber if you need a haircut.
Let’s cut it in half, this might be too much but call it a margin of safety. Using this NFLX currently sits with a 5-10% market share based on both numbers. The big questions become:
Will the TAM for streaming companies be bigger in the future and can Netflix take a bigger share of the market?
Let’s address the first one.
Yes, I do think the TAM for streaming companies will expand over time.
In May of 2021, Nielsen reported that streaming-only accounted for ~26% of total TV viewing. In the most recent report, it was ~36% of total TV viewing. In under 3 years, streaming has been able to grab an extra 10 points of market share from cable and broadcast.
Will this continue? I like the odds.
From a consumption perspective, streaming is a better mouse trap for entertainment.
Will we become a streaming-only world anytime soon? No, but the introduction of ad tiers has only made it harder for legacy cable and broadcast to compete for eyeballs.
As the eyes migrate, so will the dollars. With less ad revenue C&B will have to pull back on spending only making the offer less and less attractive.
Warren Buffett said in newspapers, “It’s survival of the fattest”. In this circumstance, this sounds like it rhymes.
Competitive Positioning
The answer to the second question, “Can Netflix take more share of the TAM?”, will be a direct result of their competitive position.
When we look at the playing field right now they lead the pack in most of the key metrics and not by a small margin either.
I am not saying the other ones won’t work. This is not a winner-take-all market. But it might be winner take most and NFLX is the lead dog.
It helps they have one focus.
For Disney, Warner Brothers, or Comcast streaming is a part of the entire business. Although it’s top of mind, they can't devote 100% of their resources to it, and this comes with a cost. Please don’t ask me to put value on it, I would say go look at the numbers and they don’t lie.
Chasing someone who has reached critical mass, in a hard business, is not the premier position to be in. It also doesn't help they have been able to build a platform that enhances the long-term value of content.
As a recent example, look at what has happened with Suits.
“The example on Suits, that was the show that didn't make a lot of noise in USA. It was certainly available on Peacock and on Amazon for 2 years before it came on Netflix.
And that power that comes from that recommendation engine and that distribution platform, they can get a lot of people talking about and then the compounding benefit of everyone is talking about this show. And then everyone is using Netflix, so you got this powerful self-reinforcing cycle.
And where that comes out is for the last several years, the guy who created Suits had a spin-off show he was trying to sell everywhere in town. Everybody passed, including us and including NBC. And now they're making it. It was a huge, new interest in Suits. And I would probably argue that next year, you'll probably see a bunch of lawyer shows.” - Ted Sarandos, UBS Global TMT Conference Interview
This ability to strengthen value will make Netflix the first call for owners of IP.
To answer the question above, I would say yes, Netflix will own a bigger piece of the streaming pie over time.
As the industry continues to play out, others will reach profitability and break even. But, it will be a battle for second place. All the while, Netflix continues to focus on widening the gap.
They Still Need Growth
For the current valuation to make sense, they are going to need to continue their revenue growth. It's naive to expect the next 10 years to look like the past. But, they should be able to grow at a mature clip. They forecast mid-teens, which is reasonable to me.
The majority of their growth going forward will come from three variables:
1) Ads
The advertising tier for the service is still young but now accounts for over 40% of new signups. As it scales, the audience size and targeting will improve attracting more ad dollars.
The introduction of an ad tier pulls both levers increasing subscribers with a lower-priced offering and giving ARPU room to grow from both small price increases and more Ad spend per user.
2) Paid Sharing
The success of their password crackdowns would not have been as effective if they didn’t have the ad tier to offer at a lower price. Now, this is the normal course of business and has expanded their reach opportunity.
“At this stage, paid sharing is our normal course of business — creating a much bigger base from which we can grow and enabling us to more effectively penetrate the near term addressable market of ~500M connected TV households (excluding China and Russia), which should increase over time as broadband penetration rises.” - 4Q23 Shareholder Letter
Although you can’t beat free, $7 a month is a pretty good price-to-value trade-off if you ask me. With this effort now the company will be able to get more juice from the squeeze.
3) International Expansion
In Q1 of 2017, the international segment of Netflix only had 47.89M subscribers bringing in $5.3B in Revenue. At the end of 2023, they had ~180M subscribers bringing in ~$18.6B.
During the same period, the UCAN segment went from ~50M subs with $5B in revenue to ~80M subs doing ~$14.9B.
Netflix is not looking to be the most entertaining company in America. They seek to become the most entertaining company in the world. This has led them to build out content libraries for each local market and cater to local tastes.
This attention to local detail has shown to work.
But, with >50% of their market tapped (as defined by the ~500M connected TVs) the incremental sub-gains from here will be small.
But I am not worried.
The average ARPU in these international markets is lower than the UCAN. If they mature similarly these should trend up over time. It will take years to close the gap but it is a trend in the right direction.
When you stack all three of these (Ads, Paid Sharing, and International) it’s reasonable to believe there is still room for revenue growth. It won’t be as large but it will still be positive.
In Closing
The current multiple feels full but not crazy so I’m holding onto my shares.
When my mind begins to wander down the road of trimming or selling a quote from Chris Cerrone comes to mind about the attempt to optimize a portfolio.
“In some ways, optimizing is insatiable and I think there's a certain amount of humility that comes into play where you say, "I'm taking money out of this business that's doing really well, and I'm reallocating it over here to something that hasn't done as well, and I'm right in both of these instances” - Chris on The Business Brew
Trimming the position would be an effort to optimize and I hold it with a sense of humility.
We have a leading company with a strong position in a growing industry. With their moat under attack, they have grown revenue, subscribers, and expanded margins. They introduced a whole new offering and asked non-paying customers for money. The last three years have been some of the best execution I have ever seen.
If this isn’t a stock worth holding I don’t know what is. It has earned the right to stay in the portfolio.
As I look into the future I will be assessing the company based on the normal KPIs (Subs, Revenue, and Operating Margins). I will be paying closer attention to the international ARPU growth but I don’t expect huge gains over a short period.
Over the next year, I would like to see them execute on their guidance of revenue growth of ~13% and hit their operating margin target of 24%. If they can deliver, consider me a happy shareholder.
Disclosure: At the time of this writing I do own shares of Netflix.
Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.
Great post, thanks for sharing Michael.
I often wonder whether the goal of optimization (as referenced in the Cerrone quote) is likely to be a net positive or a net negative over the long run (see Lynch on watering the weeds). Of course, the alternative suggests an approach that seems sacrilegious to the traditional value investor, and fairly so. They are skeptical of the argument that a company has "earned the right to stay in the portfolio." Like yourself, I think that idea has merit. My conclusion is there's more than one way to play the game.
Thanks again!
Thanks for sharing, great work Michael!
Here I have mentioned your post:
https://tinyurl.com/3yvdzscx