Sunday, November 6, 2011 9 comments ++[ CLICK TO COMMENT ]++

Preliminary look at Netflix (NFLX)


Netflix (NFLX) has been in the news lately, and given its steep fall in its stock price, I thought I would take a look at it. This is an early look, focused on its business model.

For those not familiar, Netflix is a US-based distributor of television and film content. It became the dominant DVD-by-mail rental service in the US, and has been transitioning into the online streaming business.

Netflix used to be a "growth story" over the last few years, and favoured by growth and momentum investors. It rose more than 900% within just the last 3 years but has had a spectacular fall this year:


As a contrarian, I became interested given its steep fall. The stock is off given poor results and some strategic mistakes by management.


Still Not Cheap

The stock still doesn't appear cheap (trailing P/E around 20; forward P/E around 63; P/Sales close to 1.7; P/Book of 12.5). Market cap is around $4.7 billion (enterprise value around $4.6B) and I think the company is probably attractive at $3 billion (say a stock price around $55, assuming share count stays the same).

Anyone doing valuation should be really careful because Netflix is switching from a mail-order DVD business to a streaming business, which will result in signficantly different business characteristics. For instance, profit margins on streaming will be significantly lower—with DVD you buy once and rent as many times as you want; with streaming, the price paid for conent will likely factor in volume—and the competitive marketplace is radically different.

Also, Netflix is expanding rapidly into Canada, Latin America, and UK & Ireland. Consequently, figuring out owner earnings based on existing numbers is very tricky. All the earnings and FCF numbers will be depressed and the investor needs to separate out sustaining capex from growth capex.

One negative against Netflix is that their capital allocation is questionable. Management and the board bought back stock at ridiculously overvalued prices in the last few years and they probably destroyed several hundread million dollars of shareholder wealth by doing that. They also issued debt to buy back shares and this has backfired given the fall in share prices. (To be fair, if you look at a longer period spanning 4 or 5 years, they did buyback shares are much lower prices than now. But I wonder how much of this is pure luck when the company was small versus skilled capital allocation.)

In any case, I haven't really thought much about Netflix's valuation because I wanted to understand its business model first. Some bears believe the streaming model is uneconomic but I don't believe that to be the case (I addressed one bearish view in a post a while ago). If you believe the streaming model isn't going to work then there is no point investigating this company.

Who Does Netflix Compete Against?

Before investing in anything, one should figure out the competitive environment. Because online streaming of film and television content is a new delivery mechanism, the competitive environment is more complicated than it seems. There are many new entrants using all sorts of models, ranging from pay-per-view to subscription to advertising-supported free viewing. No one really knows which model is going work, or who is actually competing against whom.

I am going to spend some time quoting Netflix's views at length. I think they provide an insight into the marketplace. The following quote from the Q3'11 Top Investor Questions describes the competitive landscape (as usual any bolded text emphasis is by me):

(VOD = video on demand; MVPD = multi-channel video programming distribution)
How do you view your competitive landscape? Where might competition come from? What are your competitive advantages?

The entertainment video market is attracting a large number of participants. Those participants operate in several business models: the pay-per-view model, which is very focused on new releases and includes VOD offerings from cable companies, Redbox, Amazon and Apple; the ad supported model, which includes Hulu and YouTube; and the subscription model, which is our focus and also includes PayTV and Hulu Plus. Consumers can maintain multiple relationships within the overall market. We believe that the large market opportunity allows all of these segments to be successful.

Our largest competitor over time is likely to be an improved MVPD service offering more Internet video on-demand, and thus reducing the number of people who will be attracted by a supplementary service like Netflix. Our task is to consistently improve the quality of our service and stay two steps ahead, so that consumers will continue to enjoy Netflix

... 

More fundamentally, our primary competitive advantage is our large and growing subscriber base which gives us tremendous operating efficiencies and, which we believe, drives the following virtuous cycles:
  • More subscribers means more money to license content, which drives more subscriber growth
  • More subscribers means more word-of-mouth from subscribers to those who are not yet subscribers, which drives more subscriber growth
  • And more subscribers means we can increase R&D spend to improve our user experience, drives more subscriber growth

Essentially, Netflix focuses on subscription-based "old" (post-theaterical films and 2nd year television) content. Hence, management views its service as complementary to existing television/film delivery mechanisms but potentially competing directly with MVPD. In investors letters and other communications, management has also suggested that people aren't "cord-cutting" and relying on Netflix (i.e. dumping cable television and switching to online services). Services like Netflix are not replacements for existing communication channels.

It appears that Netflix's strategy is to become the largest player so that a larger content library can be funded, which will create a synergistic cycle. I get the feeling that if Netflix is unable to grow, it will run into serious problems. It seems to be staking its business model on first-mover advantage.

The Threat from MVPD Providers

In the Q3 Investor Letter, Netflix elaborates on the threat from MVPD (I'm having problems quoting from the PDF so I thought I would paste in a screencap; click on image if it's not clear):


The question for investors is whether Netflix can compete against these MVPD providers. For example, if a cable television company offers through the Internet its programs to its subscribers for free or for a subscription fee, can Netflix ever compete?

Some bears argue that Netflix has no chance once some of these MVPD providers establish themselves. I don't share their view. The advantage of something like Netflix is that it can offer a one-stop-shop for customers. Netflix is content-neutral and as long as it offers a large enough content library, it will be more atractive, I think. In contrast, a cable company (or whomever) will have limited, specific, content. Netflix is more like a "news portal" rather than a newspaper.

Bandwidth Throttling/Data Caps

In the long run, I believe one major threat to Netflix is the potential for bandwidth throttling by ISPs (Internet Service Providers) and/or Internet pricing based usage. Netflix has some options to tackle this threat, including increased compression of data (potentially reducing quality), but it's not clear how much this impacts customer perception.

In the Q1 2011 Investor Letter, Netflix described the bandwidth cap issue it encountered in Canada:

Below is a recent screen shot of Google’s home page in Canada [not shown here]. You can see that Rogers, a leading ISP and MVPD in Canada, intercepted the Google page, and inserted the Rogers’ data cap warning screen at its top. It stands to reason that Canadian consumers subjected to such data caps – and outrageously high overage charges of $1 or more per gigabyte – will have a less positive view of Internet use and online video in particular.

In response to these excessive $1+ per gigabyte fees, we’ve recently changed the default setting for Canadian Netflix members to an encoding that consumes only 9 gigabytes for 30 hours of viewing versus 30 -70 gigabytes for 30 hours of viewing under our standard encoding. The video quality is slightly lower but still very enjoyable.

As a side note, data caps are actually a very poor way to manage demand and limit Internet congestion. All of the costs of supplying residential broadband are for supporting the peak loads, typically Sunday nights for residential customers. Bandwidth consumed off-peak is completely free; it literally has no marginal costs. If ISPs really wanted to limit their costs and congestion, they would limit speeds at peak times. But if their goal is instead to increase revenue, then making consumers pay $1 or more per gigabyte is an excellent strategy.





...

In the U.S., AT&T recently imposed caps of 250 gigabytes on U-verse fiber Internet subscribers, and 150 gigabytes on DSL subscribers, with a charge of approximately 20c per gigabyte over those limits. We’ll study how this affects consumer attitudes about Internet video, and take appropriate steps if needed. Comcast has had 250 gigabytes caps for years without overage charges and that hasn’t been a problem for Comcast customers or for us.
In the long run, data caps and bandwidth throttling can impact the profitability of online streaming of content. Right now, at least in Canada, you are seeing the battle between the ISPs (like Rogers) and the content distributors (like Netflix). It's not clear who will profit the most from increased Internet usage.

How Will Netflix Differentiate Itself?

Some have wondered how Netflix will differentiate itself from the competitors. I believe differentiation is not a concern in the streaming business if Netflix is able to have a sufficiently large content library. You are going to end up with differentiated products in the television/film streaming business because it inherently involves exclusive content distribution. Management thoughts on the differences between the radio and video business explains this. The following graphic is from the Q3 2011 Investor letter (click on image for larger one):



I wasn't familiar with the media industry but I never knew that radio involved statutory, non-negotiable, licensing. Thinking about it, it seems so obvious—all radio stations can play the same songs—but it is 180 degrees from the television and movie business, where exclusive deals are the norm. If online streaming follows the path of television, which it appears to, then content distributors will automatically be differentiated.

Some have misunderstood the Netflix's business and assumed that every company that enters the market will provide the exact same service but this appears to be incorrect. As with television channels over the last 50 years, there is going to be quite a bit of differentiation.

The key, which is what Netflix is attempting to do, is to sign exclusive deals and carry as much content as possible. Content costs are rising but if subscribers increase as well, this can create a moat for Netflix.

Final Thoughts for Now

This post isn't very structured, on purpose; I wanted to look at the business Netflix is engaged in and tackle some of the views put forth by some. The main points I gathered from looking at Netflix's business model are:
  • Netflix isn't a replacement for cable/satellite television; it is complementary to many other content offerings
  • The main threat to Netflix will come from MVPD
  • I also think bandwith caps/throttling/price-increases will be a long-term threat and can move profits from the content distributor to the ISP
  • Video industry has evolved differently from radio industry and there will be inherent differences amongst distributors due to the exclusive contracts common in video distribution
  • Netflix's business strategy appears to focus on first-mover advantage and to build out a large content library. This is a bit risky since Netflix is signing deals with the assumption that subscribers will show up. Content-related contractual obligations (some of them off-balance-sheet) are quite large.
The stock isn't cheap but if it falls a bit more, I'll take a look at valuation.

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9 Response to Preliminary look at Netflix (NFLX)

Anonymous
November 7, 2011 at 11:37 PM

NFLX has only gone from very very overvalued to overvalued.

November 9, 2011 at 9:37 PM

Anon,

You could be right... but what would you say is fair value?

Anonymous
November 13, 2011 at 2:05 AM

fv of nflx is $50 - $60. I am very conservative value investor.

November 13, 2011 at 1:13 PM

Anon, I concur with your view. I'm thinking Netflix is attractive around $55 per share as well. If the stock market crashes, it may hit that price.

Anonymous
November 13, 2011 at 1:40 PM

Being a deep value investor, I would probably look at around $40 as entry price. But high growth (assuming it continues) company like NFLX probably is unlikely to come at such discount anytime soon. If you think it having great future than it is more of buying "High growth at reasonable price" - on which I agree $55.00 is good entry point.

November 13, 2011 at 2:29 PM

A stock like Netflix can hit $40 easily. AFter all, it was trading around that level 2 years ago and has the company's business characteristics dramatically changed in those two years to warrant almost a 2x higher value? You probably need a broad market sell-off for that to happen though.

The difficulty with Netflix is its moat or long-term future prospects. I'm not too concerned with price right now because this is the type of stock that can fall 50% in a short period without much reason. I'm spending a lot of time thinking about that and it is not easy to figure out.

I'm just a total newbie but based on my past research, Netflix resembles Expedia (EXPE). I never invested in Expedia :( but bears were arguing it had no moat whereas I believed it had a somewhat small moat. I have a similar feeling with Netflix.

Do you have any thoughts on whether Netflix can carve up a small moat--sort of like how HBO has a nice niche on cable television--that can be defended? Or did you throw this in the "too hard" pile and you haven't really given it much thought?

Anonymous
November 15, 2011 at 1:56 PM

Moat can be based on
1) brand name - Yes
2) Subscribers - Yes
3) Size of library - ?
4) Price - ?
5) Technology - NO

What else would you think?

Based on their current position, NFLX should remain as one of top 3 movie online streaming and dvd rental sites. So yes I think it has some moat.

November 16, 2011 at 8:55 PM

I prefer to look at moats based on their core characteristic than the results you listed (i.e. something like subscribers isn't a moat in and of itself, but the subscriptions may be driven by some moat).

Well, as a coincidence, The Globe & Mail quotes Morningstar's moat categorization and we have the following:

-intangible assets: brands, patents and regulatory licences;

-cost advantage: able to produce products or services at a lower price than the competition;

-switching costs: allows companies to charge customers more than they would otherwise be able because switching to a new supplier is too costly;

-network effect: the value of a company’s product or services increases as more customers are added;

-efficient scale: effectively serving a limited market, where potential competitors have little incentive to enter the market.



Right now, I would say the only suggestion of moat may be from network effect and intangible asset. The number of subscibers may seem to give Netflix a low-cost advantage but I don't believe that is the case if you treat cable/satellite television as competitors.

I believe Netflix may be able to build up a moat in intangibles by locking up content licenses. It's too early to say but if Netflix can offer an attractive price, it may be able to lock up content exclusively.

The real big question is whether Netflix can build up a moat with the network effect. This is really what makes this a $10 billion company or a $1 billion company (I'm being simplistic with the figures). I am waiting to see how this plays out. For mail-order DVDs, Netflix capitalized on network effects by offering online suggestion system/reviews/etc (kind of like Amazon in the early days with its ratings and feedback). It's not clear to me how easily this translates to streaming. I'm curious to see if Netflix can do a better job integrating social networks like Twitter or Facebook than competitors. If it can, the benefit could be huge.

Anyway, going back to your thoughts, if you do think Netflix has somewhat of a moat, it deserves a higher multiple than a typical media company or content distributor.

(For what it's worth, I'm reading the analyst report from Morningstar and they say Netflix has no moat. THey aren't always right, and I disagree with a lot of what they say, but they do think that there is no moat here).

November 16, 2011 at 8:58 PM

BTW, I have a theory that Internet service companies can develop huge moats through network effects (Ebay, Amazon, Facebook, etc) and I am trying to figure out if this is the case with Netflix-type businesses as well. This is one reason Netflix is attractive to me. There aren't too many opportunities like this; once the Internet is built out, the current leaders may end up dominating for the next 100 years--kind of like how industrial giants from the late 1800's or 1920's ended up dominating for a long time.

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