Netflix Inc.

Fundamentals

Written by Ophir Gottlieb, 12-08-2015
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PREFACE
While owning Netflix stock now is owning an investment in a different company than just a few months ago, there are two secrets that Wall Street simply doesn't have vocabulary to understand, and friends, they are everything.

STORY
Netflix stock is near all-time highs and its market cap has pushed it above the old school players, like Time Warner. It's price to sales ratio is now higher than it has ever been in its existence. Here's the price to sales chart over time.



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Netflix is realizing immense international growth. Here's the absurd and beautiful revenue chart through time.



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Netflix, perhaps shrewdly, is moving away from its core competency; and the truth is, that may be its only choice. Netflix is quickly losing pricing power over pure redistribution as Amazon and Apple TV step into the mix.

Netflix became a colossal success because it broke all of technology as a distributor, forever changing the way we watch TV and movies. But, Netflix is now relying more on original (exclusive) content than it used to as it has been dropping a substantial amount of other content. That allows for a new revenue source on the one hand (syndication of original content), but also means a totally new business line.

Let's turn to a chart of revenue per employee for all mega cap technology companies.



It's stunning, but no other technology company on planet earth of this size generates as much revenue per employee as NFLX. Perhaps equally amazing is that Apple, with over 100,000 employees is number two in this chart.

Even more absurd is the trend for Netflix. Revenue per employee has increased 4-fold.



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The move away from redistribution and toward content creation is an enormous pivot: "Today about ten percent of the content available on Netflix is either licensed or created by the company. It plans to increase that number to fifty percent" (Source: https://www.scottfearon.com).

Even though NFLX has done exceptionally well in this new realm, we simply must ask ourselves if the company's story is as compelling if it's an original content creator, rather than a technology disruptor through distribution. It's a fair question and one all shareholders should be asking themselves.

Netflix growth in the US has stagnated a bit. The firm now has over 45 million domestic subscribers and has given a wide ranging 60-90 million long-term goal. If we see subscriber growth slow to the point where the low end looks more like the number, the stock could fall massively. But that's a big "if."

In any case, the growth is coming from international expansion and that is costing the firm a boat load of money in the near-term. Here's a chart of cash from operations.



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We note that the measure has not only been in decline, but it has now gone substantially negative.

But NFLX works on a subscription based business, and if it can grow at the rates it has been reporting, this cash burn is not only sensible, it's absolutely value creating. Let's not lose the forest for the trees here, that cash burn today is a tiny fraction of the subscription fees Netflix will deliver from these regions. The Motley Fool reports:


The article goes on to read that "if Netflix shut down all of its international operations tomorrow, the savings would boost its annual EPS by $0.50 or more. That would roughly triple its EPS." But there's more.

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SECRET #1
Netflix has a price increase that has already gone into effect for new subscribers but was delayed for subscribers that were already on board. That delay is now over, and people that were paying $7.99 a month are about to go up to $9.99 a month.

We've all seen the data that suggests the vast majority of US subscribers are planning to stick with Netflix regardless of the price increase. The net impact is that tens of millions of users will now be driving an additional $500 million in earnings.

Yes. I wrote earnings, not revenue. You see the incremental revenue will go straight to the bottom line, as there is no cost associated with the revenue increase. And does $500 million matter to earnings? YES!

In the last year Netflix has reported $163 million in net income (after tax earnings). So that $500 million to the bottom line is enormous. Here's the net income (TTM) chart through time.



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With 427 million shares outstanding, that's more than $1 in pre-tax EPS for a company that reported just $0.38 in adjusted EPS over the last year.

SECRET #2
As stated above, Netflix is in a totally new business now -- it is creating content. While that business model brings with it many benefits, like proprietary 'data' and syndication royalties, it also brings huge risk -- namely risk that the content is poorly received. That's not the secret, but this is:

CBS, Fox, ABC, NBC, and whatever network you can name have shows fail more often than they succeed. In fact, it's not unusual for 50 new shows to be introduced on network TV and the major cable operators but for less than ten to make it through to just a second season. Those are awful odds, is Netflix crazy?

No, not at all. The reason HBO is such a colossal success, beyond brilliance in the creative department, is actually rather boring and mechanical, but totally genius and is exactly what Netflix does. Here it is:

NFLX creates all of the episodes for a season before the show is released. For those of you unfamiliar with the TV business, not only is it uncommon for network and mega cable to produce entire seasons, often times the networks have no idea what the second episode will be. They release a pilot episode and hold their collective breathes too see if ratings are hgh enough to jusitfy a scond episode.

The weakness in this strategy is two-fold. First, if all of the scripts for a TV season aren't written, the creative directors actually have no way to judge the quality of the show -- they simply judge the quality of the pilot episode and guess. It's an impossible job and the result is a 90% failure rate.

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Second, as we all know, it takes time for a TV show to garner interest and one episode ain't enough. HBO figured this out years ago and has mastered Television content: "It's not TV, it's HBO." Netflix is now doing the same thing. The risk of being a content maker is real and different for Netflix, but it's not at all the same risk as network TV and Wall Street analysts don't get that.

How do I know about all of this? I am the only person ever to win first and second place in the same year for the Los Angeles screenplay writing competition (TV scripts). Yep, here it is: Unprecedented: LA Screenplay Competition Winner Takes First & Second Place

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CONCLUSION
There's no arguing that Netlfix has lofty price to earnings and price to sales ratios. It's a business with less than $7 billion in revenue that's the same size as Time Warner Cable with $23 billion. There's also no doubt that Netflix is a hybrid: part technology, part content, and as far we can tell, it's better at both than its competitors.

There will be ups and down, and there could even be a massive correction. But don't listen to the headline noise that screams Netflix has a 500:1 price to earnings ratio. We've seen that earnings are subject to a massive up tick when international expansion cools, when price hikes take effect and when the company goes further into content creation. Watch Amazon, Google's YouTube and Apple TV. There's the risk, a big one but not a comparison to Time Warner Cable, Fox or Disney.

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