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Netflix (NFLX) Stock | NASDAQ: NFLX

Covered by Stratosphere

Streaming Sensei

Netflix is a streaming service provider since 2007. The company pioneered the world of streaming with the service initially being regarded as discretionary. Today, the service is most certainly a staple in millions of households as the world shifts away from linear TV towards connected devices.

Netflix provides TV series, documentaries, films, and mobile games across almost 200 countries. Users have the ability to view Netflix on almost any device, either through an internet connection or pre-downloading shows and movies.

Netflix operates as one segment. Over 99% of revenues are generated from the online streaming service. Under 1% of revenue is generated from its legacy DVD-by-mail service, which only exists as a service in the US today.

Stratosphere Score

9

Growth

9

Valuation

10

Quality

8

Margins

9

Dividends

0

Balance Sheet

6
Adrian Iwanicki

Author

Adrian Iwanicki

Equity Analyst

Investment Thesis

  • Netflix is the leading global streaming platform with over 220 million subscribers binge-watching for hours a day.

  • Netflix has immense pricing power that it has flexed time and again. This pricing power stems from Netflix's robust content catalogue and high content spending. This creates a flywheel effect that keeps subscribers on the platform.

  • Through these competitive advantages, Netflix has benefitted from strong operating leverage. As its margins expand, Netflix is able to shove money back in to its content investments to keep the flywheel going.

  • We see some major risks with Netflix if they are not addressed properly, primarily related to slower post-COVID growth, subscriber losses, and higher reliance on international regions for growth.

  • Ultimately, we think Netflix can navigate past these challenges due to its strong incumbent position, high margins, and massive subscriber base. As long as the company continues delivering on its subscribers' content desires while keeping pricing at reasonable levels, we think the stock will be a winner over the long run.

Key Company Metrics

A set of metrics we constantly keep updated to monitor the investment thesis.

Competitive Advantages

Robust Content Catalogue

Netflix's content catalogue is the most robust of any streaming platform, and it contains the highest number of high-quality original shows and movies.

While Amazon Prime Video has more TV shows on its platform, Netflix has more high-quality TV shows, many of which are originals.

Netflix has a leg up on competitors through its content through two simple factors:

  1. Netflix has a lot of original content

  2. Netflix has the best original content as indicated through various surveys

Netflix has been able to generate this high number of high-quality shows and original content through high content spending.

Netflix's high content spending serves as a towering barrier to entry that only other large and focused streaming services can compete against. So far, Hulu, Prime Video, and Disney Plus appear to be the capable contenders of Netflix.

This high content spending also introduces a flywheel effect. Netflix produces compelling original content and licenses other high-quality content for its subscribers. Subscribers are intrigued and continue paying for the service. If subscribers are satisfied, they are likely to accept and adapt to price increases for the product. As the subscriber base and price increases result in more revenues for Netflix, the company can spend more on content. The cycle then repeats, and subscribers face increasingly high switching costs given Netflix originals are exclusively streamed on Netflix.

Operating Leverage

Netflix's platform is highly scalable that benefits from immense operating leverage as its user base grows.

Netflix has been able to grow its margins primarily through the flexing of pricing power by increasing prices and spreading fixed costs (especially content commitments) over a swelling user base.

Netflix's cost of revenue line primarily includes costs related to licensed and produced content. Over time, we note that these costs have been decreasing as a percentage of total revenue.

Similarly, Netflix has been able to scale back on marketing (expressed as a percentage of revenue) because of the large international user base it boasts today. It is no secret to anyone how good Netflix is, so people know it's out there.

As a result, Netflix has seen its operating margin expand tremendously through operating leverage. With expanding margins, Netflix keeps more of each dollar of revenue generated.

As we explored above, the flywheel effect is important to Netflix's growth as a content creator and streamer. Content is everything. More and more cash means more and more great, exclusive content.

Pricing Power

Our discussions earlier have already attested to the factors that strongly contribute to Netflix's pricing power.

Here, we show how often these price hikes have occurred.

While prices have been hiked between 70 - 100% between April 2013 and January 2022, the subscriber base had more than quadrupled.

Despite the hikes, there is consumer appetite for great content. As consumers indulge in more Netflix shows and movies as time goes on, it becomes more difficult to drop the platform. Instead, many subscribers have accepted the price hikes to stay connected to the platform.

Without the price hikes, Netflix would have greater challenges fighting off heightened competition. Ultimately, we believe these price increases are a net positive for Netflix subscribers given the intent is for Netflix to continue licensing and creating bingeworthy content and other competing platforms also consistently raising prices.

Opportunities Ahead

  • The opportunity is global. While the North American market is saturated with Netflix (and other streaming service) subscribers, other markets around the world are still largely untapped. Internet penetration in these countries is increasing, internet speeds are rising quickly, and smart / connected TVs are finding their way into people's homes around the world. Today, there are almost 1 billion households around the world. Netflix's robust catalogue and great user experience will be sought by many prospective subscribers for years to come.

  • New entrants appear to be threatening Netflix's competitiveness, but it could also help reinforce Netflix's current standing. Netflix is a pure-play content provider with a powerful balance sheet. Netflix can use its strong financial position to license content and also advance on its original content, both in number and quality. In 2022, Netflix will be releasing many new titles in the back half of the year, which we believe will aid in reducing churn and attracting new subscribers.

  • Netflix venturing into other forms of entertainment (ex. mobile games) could be a major contributor to new subscribers down the line. We feel that the value-add Netflix's mobile games are adding are limited today. However, over time, Netflix could become a one-stop-shop for entertainment - shows and movies, but also games, and potentially other forms of video and audio entertainment. Keep your eyes peeled.

  • Netflix is working on converting households who have been using the passwords of true paid subscribers. There are approximately 100 million households who are using Netflix for free, simply by logging into their friends' or family's Netflix accounts. The company views this as a major conversion opportunity, as these households are typically frequent users and also highly familiar with the streaming service. Netflix is currently testing a paid-sharing feature outside a subscribing household in Chile, Costa Rica, and Peru. Over time, this 100-million-household opportunity will be increasingly monetized over the "short- to mid-term". We believe this is an intelligent step on the part of Netflix, and this step appears to be along the lines of what Autodesk did to convert "non-compliant users", which turned out to be a great success.

  • In light of weak financial results in Q1 2022 and weak guidance posted for Q2 2022, Netflix mentioned it is finally considering to create an ad-supported, low-priced tier for price-conscious consumers. In 2022, Netflix hiked prices on its subscribers to help cover increasing content spend in an effort to keep the original content pipeline robust. Unfortunately, this caused about 600K subscribers to cut the service in Q1 2022. As such, an ad-supported tier may be a great compromise for churning customers who may not view the current pricing structure as good value, yet would like to stay subscribed in some way. If Netflix decides to pursue this ad-supported tier, it would not be in place for another year or two. However, this tier could soften the blow Netflix is currently taking financially and on its subscriber count. Churned subscribers may one day return to Netflix at a lower price albeit with some ads. We believe this is a prudent strategic shift considering that Netflix's competitors - Hulu, Disney, and HBO - currently have, or have plans to implement ad-supported tiers.

Risks

Slowing Growth

After the Q4 2021 quarterly and annual financial update, management provided Q1 2022 guidance of 2.5 million net adds, well short of analyst estimates at 7.25 million. Unfortunately, even management's "low" guidance was missed - there was a net subscriber loss of about 200K.

Netflix management attributed the slow growth to strong competition and high existing household penetration, especially in North America. Netflix is increasingly reliant on weaker economies to drive growth while pricing increases in developed economies frustrate a substantial amount of subscribers to the point of them churning. For example, in Q1 2022, the United States and Canada lost about 600K subscribers, which management largely attributed to the pricing increase made in the same quarter.

While Netflix has had clear pricing power for a long time, it is evident that there is now some subscriber fatigue. Netflix must continue increasing value for subscribers to not only keep them engaged, but also be willing to pay more for the service over time. Once again, with market dynamics like this, Netflix's growth will increasingly rely on "volume" over "price" in the price * volume = revenue equation.

Streaming Wars

Netflix is facing intense competition from other major streaming platforms - Prime Video, Disney Plus, Hulu, HBO Max, and Apple TV, namely.

There are several financial and non-financial risks associated with intensifying competition:

  • Netflix faces potentially higher content acquisition costs to license high-quality content, weighing on margins over the long run.

  • Churn increases due to lower availability of high-quality content on the platform, better perceived content available on competing platforms, and erosion of operating leverage preventing strong reinvestment.

  • Inability to continue lifting prices while Netflix struggles to put out great original and licensed content without facing outsized churn.

The truth is, though, there may never be a clear winner of the streaming wars. Each streaming platform may be able to carve out its own niche and co-exist with others.

Losing Focus?

While competition is intensifying, Netflix is also venturing out into non-core business ideas, particularly video games (starting with mobile).

While this may be an excellent way to exercise optionality and deliver more great content to subscribers, we see several potential risks, or indications thereof:

  • In an increasingly competitive streaming environment, game development will be sapping dollars away from content acquisition and development.

  • Subscribers may not particularly be looking for such content (i.e., gaming). There are established video game publishers and gaming consoles that will probably continue developing incredible games at quality levels magnitudes greater than Netflix.

  • Netflix may be concerned about its long-term growth profile, so it is exploring other avenues to grow in unconventional ways. One such way is creating an ad-supported tier. While this presents a solid potential revenue stream that will boost profit and retain subscribers, too many ads or irrelevant ads could frustrate subscribers and lead to churn regardless.

International Growth Reliance

Much of Netflix's subscriber base is situated outside of the US and Canada. These regions have limited opportunity for growth, growing currently at low single-digit rates. Market penetration is high in these regions (~70%), limiting growth primarily through pricing increases.

About two-thirds of subscribers are from the rest of the world.

In these areas, average revenue per user is lower than the US and Canada. Additionally, potential consumers in these markets are often less inclined to use Netflix due to poor access to connected devices, online banking methods, and reliable internet.

As a result, Netflix may face challenges if one, two, or both things occur:

  • US and Canadian subscribers begin to churn more as prices increase

  • International subscriber growth slows due to a lower natural addressable market as a percentage of total population (penetration).

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