Evaluation of Netflix's Financials
I took a look at some of the qualitative aspects Netflix (NFLX) in prior posts (here and here) and it's time we look at the financials. I think any success or failure with Netflix's stock will still come down to its business model and competitive dynamics but, nevertheless, the financials provide a valuation guide for an entry point.
The stock has run up so much this month that its valuation isn't attractive right now. Most of the shareholders of Netflix—or at least those represent a big chunk of the volume—appear to be growth investors or momentum traders, so you will see more volatility in this stock than a typical company.
As I have mentioned before, Netflix is going through a major transformation, from a DVD-by-mail business to an online streaming business, so its financials prior to 2010 aren't reflective of its future. Furthermore, the company has grown so rapidly within an year that focusing on a few quarters is more insightful. I decided to look at quarterly numbers, which typically isn't a good idea with most companies.
(I had good feedback on my prior post so feel free to leave your comments, challenge my views, and point out any mistakes.)
Income & Expenses
I have been researching Netflix for a few months now, and was mostly using its 3Q 2011 financial statements. The company is to annouce fourth quarter results next week so one may want to use that for their analysis. The soon-to-be-released 4Q will likely provide better visibility into customer defections (from the price increase annouced several months ago) and the cost of the international expansion into Latin America, Britain, and Ireland.
I thought I would start off with a chart of revenue, net income, operating income and key expense categories. Do note that all the charts below show quarterly periods, and they are from the 3Q 2011 financial statements. As usual, click on the chart for a bigger figure.
The line that stands out from the chart is the teal line—revenue—which has risen significantly in two and a half years. In March 2009, Netflix's revenue was $394 million, whereas by September of 2011 it has risen to $822 million. No wonder growth investors drove this stock to some ridiculous valuation. (Note that these are quarterly figures.)
The revenue numbers include streaming plus DVD-by-mail subscribers, but as you will see later, most of Netflix's customers are streaming right now. Some skeptics believe online streaming is a failure but, so far, Netflix has done extremely well.
Interestingly, even with the big consumer backlash over the price increase in 2011, revenue has continuously gone up. However, net income and operating income (bar charts) have declined in the latest period. Some of the decline is due to international expansion costs, but most of it is likely due to customer defections.
It remains to be seen if those customer who leave Netflix ever come back. Netflix said something like 1/3 of customers who leave, come back, but it remains to be seen if that rate goes up. Netflix already has very high churn for a retailer (historically around 4%, with latest quarter around 6.3%) so it needs this number to go down in the very long-run to increase profit.
A key line on this chart is the content expenses (listed as subscription expenses). This has risen from $217M to $472m, and many bears argue is indicative of a flawed business model. It's too early to say for sure, but I don't think the content costs are as big of a concern as some believe. Yes, costs have gone up significantly (almost doubled within 3 years) but it is growing in line with revenue.
It is important to keep in mind that, more so than many other business types, Netflix's bottom line depends a lot on how costs are amortized. Since we are dealing with a new industry—online video streaming—the way management is amortizing content costs may or may not be reflective of reality. The contracts Netflix enters into with content providers is complex and generally not disclosed on the financial statements or in any public filings or presentations. For instance, how content costs can escalate, or if there is a limit to number of customers that can stream at any point in time, or if they are indexed to some other variable (DVD sales, awards received, etc), and so forth, is unclear to me. This appears to be the norm in the movie and television industry, and I don't really have a good understanding of what the content costs actually represent. In fact, even industry insiders have a hard time understanding these deals.
To see the complexity I am referring to, consider how, in mid-2011 or thereabouts, Netflix lost access to Sony content because its content licensor, Starz, hit some subscriber viewing threshold. I'm not sure how that is comprehended in the financial statements. Does the content get written down to zero when the threshold was hit? Or does it appear as Netflix continually paying for something that it doesn't have anymore? I'm not sure.
So, one should be careful with short-term income figures. Cash flow, as usual, is a better measure but even that is confusing, because Netflix tends to sign 2 or 3 year contracts and can make big lump-sum payments (on another note, these contract obligations are off-balance-sheet so one should pay attention to them as well.) In the long run, none of these issues matter since what the company pays in total is what will drive shareholder returns.
The rapidly-increasing subscription costs also indicates how Netflix has little economies of scale and isn't as leveraged to fixed assets as in the past. Yet, as I have suggested in the past—admittedly a controversial view probably not shared by anyone else—the rising content costs are actually a barrier to entry. It's weird to think of rising costs as being a barrier for competitors but it is in this case—particularly if valuable content is exclusive. Netflix will spend around $1.7 billion on content in 2012 and, as long as revenue is sufficient to cover that cost with decent margin, there are very few other competitors who will spend anything like that on content. The giant in online television with over 700 million customers, YouTube, has only announced deals totalling around $100 million(!) so far. I don't remember the figure for Hulu Plus but I believe it spends as much as Netflix does. In the long run, YouTube and Hulu Plus (and others like them) will likely spend way more on content since they are mass-market, advertising-supported, networks.
The fulfillment expense (related to DVD-by-mail business) and marketing expenses have risen quite a bit in percentage terms, but, they are not too important in dollar terms. I don't think it's worth paying attention to these figures but if one thinks Netflix is suffering, the marketing expenses line may be a proxy on how badly Netflix wants to attract customers. I suspect marketing expenses will also rise now that Netflix is entering new overseas markets. I'm also curious how Netflix intends to promote its original content (such as House of Cards and Arrested Development) with access to the first window — are we going to see heavy marketing spend for these original shows? Overall, like in most businesses, you want these expenses to remain constant as a percentage of sales.
Cash Flow, You Say?
The trend in the modern era with fundamental investors (such as value investors) is to rely more on cash flow than on net income. Everyone, including me, still looks at the income figures but cash flow is the cleanest measure. There are several reasons for this but the main one is that it represents reality—income statement has non-cash items like depreciation, which may or may not represent the truth—and is harder for management to (legally) manipulate the numbers (income statement is vulnerable to different revenue recognition techniques, subjective use of mark-to-market gains and losses, deferred taxes, etc).
The following quarterly chart plots net income, along with operating cash flow and free cash flow. I also threw in my guess of owner earnings. I'm computing FCF (which generally is operating cash flow minus capex) as operating cash flow minus content acquisition costs minus property & equipment.
As value investors would know, owner earnings is Warren Buffett's most important income measure and it is similar to FCF: operating cash flow minus sustaining capex (it excludes growth capex since that is not reflective of the long-term). For owner earnings, I'm taking 33% of property and equipment spending to represent maintenance capex. Admittedly, 33% is arbitrary and I decided to use that because I believe most of Netflix's plant & equipment spending is growth capex; Netflix will not spend as much if it doesn't grow. So, my owner earnings formula is operating cash flow minus content acquisition costs minus 33% of property & equipment.
Do note that these are quarterly periods and there may be seasonality in Netflix's business.
The negative impact of the customer defection due to the price increase, identified on the sales and expenses chart earlier, is more obvious here. All the income and cash flow metrics peaked in the March 2011 period and has been declining ever since. No wonder many think Reed Hastings is one of the worst CEOs in America. This is a disturbing trend for Netflix so it remains to be seen if they will start increasing soon.
My guess is that FCF probably won't increase materially until 3Q 2012. I think we will see the end of customer defections but the international expansion costs should start hitting the company soon. Netflix has said that it may take as long as 2 years for their expansion areas to turn a profit—this is consistent with most start-ups and new businesses—so the numbers may look weak for a while longer. If the stock market sells off Netflix on weak earnings (including the possibility of an annual loss), it may be an opportunity to buy shares (depending on the price, of course).
A Look at Margins
The following table summarizes some key figures I computed from the figures shown in the previous charts.
The top part of the table shows quarter-over-quarter change, while the bottom part shows margins (as a percent of sales). The quarterly change is almost useless since the time interval is too short and there are too many moving parts (customer defections, shift to streaming, seasonable effects, etc). The margins are more important.
The main thing to observe in the top section is how subscription expenses, which are key, moves relative to revenue. Netflix has historically kept content costs in check.
The bottom part re-emphasizes how Netflix has good management of content costs. The bears keep arguing that content costs are growing out of control, but they seem to be managed well. If you look at gross profit, it has remained between 34% and 39% over the last two and a half years. So, even though Netflix spends almost a billion on content now (estimated to be as much as $1.7B in 2012), its gross margin is fairly stable.
The question is what happens when revenue stops growing, or, indeed, falls due to some setbacks. Can Netflix rein in content spending growth if revenue doesn't grow as fast? That remains to be seen but so far, the company is manging its skyrocketing content costs quite well.
Net margin was hovering around 7% about two years ago and is around 8% now. So, this is another data point to indicate that, even in light of rising content costs, profitability is fairly stable. Over time, as the business matures, Netflix needs to raise its net margin. It would be good if the company can raise its net profit margin above 10%. If profit margin hits 10% and stays there, it may indicate that Netflix has a moat (I think the best check for a moat is persistently-high ROE but Netflix's ROE is difficult to interpret because its asset base is very low (i.e. Netflix has ROE around 55% but I'm not sure if that's high or not for a company like this)).
Overall, I don't see anything dangerous in the margins or quarterly changes in key metrics. The numbers will likely deteriorate over the next few quarters but the streaming-focused business is managed similarly to the past.
Customer Revenue and Acquisition Costs
This section needs a post on its own so I'm going to keep it somewhat short.
Since Netflix is a fast-growth business with a business model change, it is important to think about how the company may look in the future. As I have mentioned several times, the company is going to be nothing like its past self.
I think it's important to understand two elements of Netflix's business: subscriber count and cost of subscription. The following chart plots total number of subscribers (yellow bars), and the revenue per subscriber (teal) and subscriber acquisition cost (red).
I have also indicated Netflix's 3Q 2011 subscriber figures in the green box.
As indicated in the green box, Netflix had a total subscriber count of around 22.8 million. In terms of subscriptions, this amounted to 21.4 million streaming subscribers and 13.9 million of DVD-by-mail subscribers. It was difficult in the past to separate streaming from DVD-by-mail, but now that the two services have been unbundled, the figures are more clear. Do note that many subscribers have both streaming and DVD-by-mail subscriptions (that's why the subscription number is higher than the subscriber count).
You can see why Reed Hastings has bet big on streaming. Not only does it support his thesis for the future (read my prior posts), he is actually seeing more uptake for streaming subscriptions than DVD-by-mail subscriptions. So it was great strategic move!
By looking at the yellow bars, you can also see the negative impact of the price hike instituted by Netflix. Subscribers totalled 23,263 thousand in the June quarter, while they fell to 22,843 thousand in the latest, September, quarter. I think the separation of DVD and streaming business was necessary and the price hike was warranted. Although skeptics think it was a dumb move, I think it was actually a very good tactic. (On a side note, Netflix is already very cheap so if people leave for a small price hike, those may not be very profitable customers in any case.)
For long term investors, the most important lines are the teal and red ones.
The red line shows subscriber acquisition cost. This may surprise some but subscriber acquisition was more costly two years ago, in the DVD-by-mail business, than now! In March 2009, each subscriber cost around $25.79 whereas the cost is $15.25 in the latest quarter. The acquisition cost actually hit a low of $10.87 in the December 2010 quarter but it has risen over the last year. This is probably due to higher content costs.
Some investors, including one I pointed out in a post earlier in the year, forget that the subscriber acquisition cost is a lifetime cost! This is why acquisition cost is higher than revenue. Depending on the churn rate, the company can tolerate a fairly high acquisition cost.
The declining subscriber acquisition cost is bullish for Netflix; however, Netflix is earning less from each customer now than they were two years ago. In the March 2009 quarter, Netflix's average monthly revenue for paid subscribers was $13.63. In the September 2011 quarter, Netflix was earning $11.56 per month per paid subscriber. This is a bearish trend but not too surprising if you sit back and think about it.
Although it doesn't sound good, Netflix's revenue per customer will fall as streaming takes off. This is due to the fact that streaming only costs $7.99 per month whereas there were several DVD-by-mail subscriptions and many of them cost more.
Declining revenue per customer is often not a good thing but it does have some major positives in some scenarios. In particular, declining costs generally expands the market size! Most technology companies are built for deflationary environments and tend to get richer as prices fall! Most industries, however, suffer as prices fall—think about how few commodity businesses become richer as prices fall, or how few retailers increase profits as prices fall.
Declining subscription revenue is bad for the video industry—think how many cable or satellite companies will survive if cable bills fell—so it remains to be seen if Netflix is better off with a lowly-priced subscription offer or not. Content costs will not decline much so it remains to be seen if Netflix can maintain a successful business model with $7.99/month revenue.
If I get some time and feel like it—the higher this stock goes, the less incentivized I am :(—I will take a look at the market potential for Netflix and its performance under different scenarios. In particular, I hope to look at what the potential of Netflix is vis a vis household viewership of television; and how much content spending can be afforded by Netflix.
What Is Netflix Worth?
Most important question for investors: what's the valuation?
I am a fan of using P/E or P/FCF multiples so let's use that method.
From the cash flow chart above, the Trailing-12-month (TTM) figures for net income and owner earnings are $238M and $236M, respectively. Let's round this to $235M.
I think Netflix's earnings will be higher in real terms in the future than now. But, let's be conservative and assume it stays where it is right now. (I might do a future post with scenario analysis with a more realistic expectation.)
If we apply a P/E multiple of 15, we are looking at a company that is worth $3.53 billion.
(P/E of 15, as most of you probably know, is the long-term market multiple. Given how interest rates are low right now, the P/E ratio can be higher right now. Also, if you were a growth investor, you would attach a higher multiple, but I'm not one and have no confidence in high future growth.)
Netflix presently has a market cap of around $5 billion, at a share price around $95. This means that the company is near fair value at a share price around $66. (I'm not sure if the share count in my calculation is correct, since there was a roughly 10% dilution late last year, but assume these are rough numbers for now.)
If you want a margin of safety and use a P/E of around 12, the company is worth $2.8 billion and the shares should be bought around $53.
In late December, the shares dropped to $62.37 so it wouldn't surprise me if it hits $50ish sometime this year. If the stock market crashes and/or Netflix starts posting losses, it can reach an attractive valuation.
A stock price in the $50s is extremely attractive if you believe Netflix will continue to grow at above-market rates. You need to do a business analysis and make a judgement call.
Last Word For Now
To sum up, Netflix is going through major changes to its business model but management has successfully kept its eye on the financial metrics. Content costs have risen significantly over the last two and a half years, but they are in line with revenue.
There are more streaming customers than DVD-by-mail customers (although many have both) and the trend is unlikely to stop. Netflix's revenue per subscriber will likely fall, and approach its streaming offer of $7.99/month. It's not clear if falling costs in the media business increases wealth for shareholders.
Netflix has trailing owner earnings (and net income) of around $235 million. Based on my estimation, this means Netflix is worth around $3.53 billion, and I would buy it at around $2.8 billion (share price of approximately $53). Share price needs to fall around 50% to hit my figures so that probably isn't going to happen without some major calamity in the markets.
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