Being For the Benefit of Mr. Kite! was a Lennon tune from the Sgt. Pepper’s album, inspired by an old poster in his writing room. Like much of this album, it was a departure musically from the sounds of the day, experimentation that collectively made this iconic work so impactful and remembered.
“The whole song is from a Victorian poster, which I bought in a junk shop. It is so cosmically beautiful. It’s a poster for a fair that must have happened in the 1800s. Everything in the song is from that poster, except the horse wasn’t called Henry. Now, there were all kinds of stories about Henry the Horse being heroin. I had never seen heroin in that period. No, it’s all just from that poster. The song is pure, like a painting, a pure watercolour.” – John Lennon
If there is a current poster standout topping the bill in the big tent of disruption in the entertainment industry today, it’s Netflix. It is an evolving case study on how today’s technology, internet reach and data mining can speed early and fast adapters – excellent execution can excel exponentially. Netflix is in the crosshairs of cord cutting and cable/broadband/wireless platforms scrambling to adapt. And traditional content creation and distribution is in the cross hairs of new entrants, tech giants like Google, Amazon and Apple also carving their own way through these changes.
It’s been 15 years since Apple’s products transformed the music industry with digital download, an industry now again being transformed via the streaming model. Streaming is great example of the emerging ‘access vs ownership’ economic trend. Netflix is a prime example of this phenomenon too, but their impact on film and tv has been encompassing, influencing everything from the writing and creative process to how and where the finished product is consumed.
Likewise their stock is a fascinating reflection of this disruption and the market times we are in.
On Being Netflix
It’s been a fast 20 years in tech and Netflix. From mail order DVD movie rentals to online streaming, they helped transform the movie rental model and shut Blockbuster down – hard to believe only a dozen years ago Blockbuster peaked at 60,000 employees and 8000 stores. Today Netflix has ~3500 employees and streams 125 million hours of content daily over 87mm subscribers in 190 countries, having accounted at times for an estimated 1/3 of all internet data usage.
It’s all been accomplished under the nose of behemoth Apple and their current +800mm iTunes accounts. What would the tv/film industry look like today had Apple plunged in earlier on into content streaming and then maybe even into original programming?
It’s been accomplished under the nose of Google and their 2006 purchase of YouTube, today the world’s largest video platform.
And it’s all been accomplished under the nose of the global entertainment complex. At first happy to tap into Netflix’s growing demand for writing cheques for their content, the industry now hustles to adapt to a cord cutting world and Netflix’s own successful model of original content creation and distribution.
Did Netflix make the shift to original content for survival? It’s hard to know but by some estimates their movie library is down some 50% over the last 4 years, to about 5000 titles. Whether it has been studios pulling the plug on them or expense or a strategic shift in content investment on Netflix’s part, the end result was their subscriber base more than tripled in these 4 years. They will spend $5B for original content this year and $6B next, with the vision of doubling output in 2017 to over 1000 hours, including new unscripted projects. By comparison, stalwarts like NBC or CBS content budgets are in the $4B range. Netflix has suggested a model of 50% licensed content, 50% original.
In Streaming Sharing Stealing, the authors Smith/Telang describe what is regarded as a pivotal moment in the latest Netflix transformation. House of Cards, originally a British series, was being shopped as an American adaptation; typically a $5mm network commitment for one pilot episode. Netflix’s data showed them their customers had rented the original DVD series, that they liked director David Fincher and movies with Kevin Spacey…and that binge watching was becoming a thing. Data persuaded Netflix to scoop the networks by offering upfront $100 mm for 2 full seasons, 26 episodes.
The commitment changed the writing, which no longer had to pander to commercial breaks and hooks for the linear format of tv’s next week’s episode. The project was described as writing a 20 hr movie. It changed character development and story arc and production. It impacted the creative process and execution. And of course when launched in 2013, customers could watch any number of episodes of Season One in one sitting whenever they felt like it. The rest is history. Their data intelligence was right. Was this entertainment’s own version of Moneyball? Was the traditional way of doing things, maybe even human creative bias, ripe for change? Clearly, their distribution platform was also a market research platform. Whatever it was it worked, the industry took note on the Emmy stage and Netflix accelerated original content spending since.
The Netflix bet is now that internet tv, with it’s on demand and personalized advantages and reach could slowly replace linear tv. It is a reinventing of tv. They describe it as a great transitional technology, similar to the switch over from fixed-line telephone to mobile. While Netflix may be 20 years old, internet TV is still in its infancy.
While most businesses describe their real assets as riding their elevators, Netflix has been recognized for creating a unique corporate culture. Flexible holidays, common sense expensing, focus on team performance and ensuring individual skill sets are adapted to Netflix changing needs, generous severance if not – all concepts designed around treating everyone as an adult and fielding a best team. Something they call Freedom and Responsibility and no doubt framework for the success that rides their elevators.
On Being NFLX
Throughout this evolution, NFLX stock has performed incredibly. Since the tech crash NFLX has outperformed AAPL almost twofold during an iconic stretch in which Apple introduced the iPod, revolutionizing the music business, the iPhone, revolutionizing mobile communication and the iPad, revolutionizing the laptop/desktop computer experience. It’s outperformed DIS, the king of content with Disney/Pixar/Marvel/Lucasfilms/ABC/ESPN under wing, about 34-fold.
The performance has been similarly stellar since the credit crisis, especially during these last four years in which cord cutting trends solidified and NFLX cut their movie library in half and plunged into original content spend.
Clearly the driver of investor faith in their business model and stock price is the growth in their subscriber base, in new international markets and revenue.
Valued at over $53B on $8.8B in revenue, NFLX is pricey. While not an entirely fair comparison, that’s about 1/3 the market cap size of Disney’s $160B, which generates $56B or 6x the revenue. Disney also trades at 17x earnings vs NFLX’s >300x.
Clearly the market is pricing in tremendous growth and earnings potential, meaning NFLX stock price is very vulnerable to any growth disappointments that don’t meet the expectations already baked in. Case in point, the stock has almost doubled just since the summer on recent better than expected subscriber growth. When so hot, the markets give NFLX a currency clout over much of their industry to invest in that growth.
Macro environment can allow for this. Since the credit crisis the Fed et al have been printing money to lift asset prices and stock valuations. Meaning NFLX is expensive in an entire US stock market that is historically expensive.
This takes me back to a story in 2000 when I was selling energy equities institutionally. I recall conversation with a well-known successful growth portfolio manager at a large mutual fund. In talking about what was clearly a bubbly Nasdaq, even though he felt it couldn’t last and that tech stocks were going down, he was fully invested – because that was his mandate. His was not to make asset mix decisions for his firm or their clients – his was to put the money pouring into his particular fund to work, period. It struck me there was an inherent crack in the system when a smart plugged in professional gets pigeon-holed into a position his insights don’t agree with. Call it a flaw, but such can be a characteristic of the fund management beast.
I’m not at all suggesting that a broad bull is all that’s driving NFLX’s valuation, just that environment can create extremes. NFLX is the premier pure play cord-cutting entertainment disrupting fast growing internet TV story out there, period. A growth manager wanting to invest in these themes long-term has probably got to own it, even if stock markets are frothy. Given NFLX performance over multiple time frames, how has not owning it worked out? Amazon has been perennially expensive based on its actual earnings, but shareholders have been clearly less concerned with valuation and instead focused on their ubiquitous disruption of retail. So, NFLX is an expensive stock but could easily stay that way.
“[T]wo years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking!” – Scott McNealy, Sun Microsystems, post 2000 –
These words by Scott McNealy are nonetheless a timeless sobering reminder that in the long run common sense and entry price dictate that valuation extremes matter, particularly over various extended time frames.
Competition today and tomorrow
The shift from linear TV to internet TV is in very early innings and clearly NFLX is well positioned for it. What has been astounding long-term stock performance still carries promise because the global internet TV market opportunity does. But high valuation is inherently discounting some of tomorrow’s success.
Aside from the general macro risks of markets being so elevated, and expensive valuation, immediate risks are in growing competition.
Hulu is substantial and backed by a syndicate of studios Disney (ABC), Comcast(NBC), Fox and Time Warner(Turner). Google just announced a deal with CBS to launch a streaming bundle through YouTube with DisneyABC, NBC and Fox also said to be in discussion. HBO has enabled subscribers to access content through a variety of platform applications. Even Facebook, with a massive 1.2B users, has announced intention to get in the game.
While Apple has been relatively quiet given their size and that they’ve already been streaming movies through iTunes for sometime, there are recent rumours of Apple negotiating the stream of newly released films still in theatre. This could potentially be very disruptive – hot off the press content and 800mm iTunes accounts can go a long way in penetrating the consumer’s streaming choices. Their new launch of AppleTV as an app for iPhone and iPad in the US furthers the push of internet TV. There have been rumours of Apple people sniffing around for content at film festivals. What are their content intentions?
Self-cannibalization is an interesting element to competition in this industry. How is it Spotify became the early leader in music streaming, and not Apple? Was it partially because Apple didn’t want to bite into its’ business of music sales? Similarly, wouldn’t Disney streaming content only bite into their network and cable viewership? Maybe this is partially why new content platforms like Netflix and Spotify succeeded; they had no pre-existing revenue to protect. This makes new entrants into content creation and distribution interesting competition.
Maybe the most interesting competitor currently is Amazon. They’ve obviously already disrupted the publishing industry and print content distribution with online book sales, Kindle readers and empowering self-publishing. Not only has their entry in original tv/film content also received critical acclaim, they too are stepping up spending significantly. They have over 60mm Prime customers and just announced launch into some 200 countries, with discounted pricing to Netflix. They have development teams focused on local content in foreign markets. Uniquely though, Amazon is also in a position to offer shopping members what amounts to a loyalty discount over standalone streaming subscribers, an economic lever into consumer wallets that other content providers simply do not have. Clearly they also have quite the formidable market research platform.
In sign of the times, the 2017 Golden Globe nominations have Netflix and Amazon content representing 40% of the top show nominations, each receiving as many as the broadcast networks combined. Add in cable’s HBO which is also available online and streaming services make up 70% of the nominations.
Given that US content travels so well, it’s no surprise NFLX has seen good success internationally. Over time however bigger spend on local foreign content will not only be necessary but could be an expensive proposition. Aside from competitors like Amazon, some of these foreign markets have domestic streaming services of their own. Overall, the global market opportunity for internet tv is enormous and why it will get more crowded.
TV going internet is a big deal for the cable/broadband/wireless complex and no doubt a factor in ATT’s bid to merge with Time Warner. Whether it gets approved remains to be seen but there is no doubt the value of content is being elevated in the industry’s scramble to maintain and capture customer base. With the global clout of Apple, Google and Amazon involved, pipe access, new pipe builds and content demand will keep this complex dynamic for the foreseeable future.
The talk of Trump’s new administration possible dismantling the FCC is also a possible risk to NFLX. Could net neutrality standards be abolished, subjecting NFLX and/or their customers to higher fees for access? It is interesting that NFLX just enabled their service to download content for later viewing, advertised as a necessary feature to help further penetrate foreign markets with poorer internet signal access. While probably true, I wonder if enabling content download also sends a message to the industry that NFLX customers can get around any new US industry visions of disadvantaging some mobile data plans, or advantaging newly acquired carrier content driven binge plans.
The Street Thinks
Street research opinion of NFLX ranges in extreme. Out of a whopping 42 analysts who rate the stock, 21 have outright buys, 5 have outright sells and 1/3 waffling. Given typical street bull market bias the skew isn’t surprising. Considering NFLX has been adding subscribers at almost a 30% growth rate for the last 5 years, the street is ‘only’ running with assumed growth about half that, clearly respecting both an already well penetrated US market and global competition.
Median 2017 estimates have them earning just under $1.00 per share, but still free cash flow negative. A PE of 125x is up there. One 2018 research piece has them at 126mm subscribers, about 20% annualized growth, and earning just under $3 per share, and still barely free cash flow positive.
There has even been occasional chatter that suggests NFLX is a takeover candidate. Disney, gets mention as a potential buyer. At +6x revenue and little accounting profitability, I find it hard to believe NFLX makes the m&a radar. But NFLX has brand and is the pure play niche success – they could easily become a candidate at lower prices. A broad market correction combined with a growth hiccup could easily produce the kind of material correction in stock price that introduces the m&a conversation.
Those expressing concerns about the stock or are outright bearish, even labelling NFLX a short, hit on recurring themes. In addition to valuation and competition, they dive into the math behind content and capital.
One view on NFLX content spend is that it is a treadmill and expensive to maintain and develop. It is a growing cheque writing model that has yet to provide investors with profitability even with healthy US penetration and international growth.
New Constructs speaks to this concern of NFLX content cost growth overtaking revenue growth.
Obviously this depiction isn’t sustainable – revenue response cannot lag previous new content spend forever. Investment in tomorrow’s consumption needs to show returns. In New Constructs’ extreme scenarios, they conclude the stock is ultimately worth a small fraction of today’s price. Clearly the market is paying for NFLX subscriber growth. The real question? What is the longer term sustainable content spend and what subscriber revenue is required to not only sustain it but turn some handsome profit. With internet TV in early days still and enormous upside in international markets, NFLX’s outsized spend relative to industry standards is an aggressive bet to stay ahead of the coming competition from tech giants with much more financial reach.
Related, there are concerns over how NFLX accounts for their content costs, specifically whether they are being amortized sufficiently to show better profitability today yet building a burdened realized expense going forward. Again, frothy overall markets give unique thematic growth stories a ‘pass’ on valuation and accounting treatments. But froth comes and goes, and scrutiny gets elevated during more challenging times. How NFLX valuation is framed today and how their model plays out over time may prove to be very different conversations.
If content spend growth running ahead of revenue growth are legitimate concern, so is capital – this all has to be paid for somehow. Strapping on $B’s of debt in this low rate environment is smart, inexpensive and shows debt investor faith in NFLX long-term revenue. But this can become a dangerous road if revenue gains continue insufficient to fund operations. Said another way, the markets seem fine lending NFLX money to help fund operations as it builds out its global platform. But markets can turn quickly if the NFLX model proves vulnerable to economic slowdown, competitive pricing, or inflating content costs.
Amazon, Spotify, Uber are just a few examples of companies that have created a fair amount of disruption without making profits early on. We live in an era were markets value the promise of changing trends quickly. A key may be in gauging where one is in a product or concept’s life cycle and a vision of how to monetize maturity. Even though internet TV has enormous growth in front of it, it probably isn’t too early for NFLX to think about the brand it’s created, the loyalty of its customer base and the inherent power of 87mm accounts. Could it make sense to add new revenue lines? Music streaming ? Sports, live events, news? Will they evolve into their own bundle of services? What opportunities for cross marketing exist? Certainly their data mining and research of their customer behaviours have value, maybe even dare say for a commercial free platform, to advertisers.
Dancing the waltz
I’ll confess that when NFLX was taking on excessive stock market valuation as a mail order DVD rental business, I was completely wrong and thought it was a short. When they morphed into a movie streaming company I thought a lack of barrier to entry made giants like Apple and Google more likely to lead the industry. I thought their spend on licensed content made them vulnerable – that studios might either back away from feeding NFLX their content or that content deals could become prohibitively expensive. I never imagined NFLX creating their own original content let alone outspend the industry doing so. I never imagined data mining and Moneyball would be applied to the creative industries. Clearly I didn’t keep up with their ability to adapt and lead and change. But frankly, nor did the rest of the entertainment or tech giants.
I can tell you I think the overall stock market feels frothy and I can tell you I think NFLX stock is expensive and has a lot of future success baked into today’s price. And I can tell you that competition with deep pockets and significantly greater internet presence are after their own slice of internet TV. I can tell you I’m in awe of how NFLX thrives in a world it created without banking considerable profit.
But what I can’t tell you is that Netflix won’t remain a leader in an internet TV space with such enormous possibility. Worldwide there are over 1.4B households that own at least one tv. There are over 3B internet users. Estimates have the smart phone market doubling by 2020, to over 6B phones. Annual worldwide tablet shipments are expected to maintain 180-200mm range. Somewhere between any and all of these will want internet tv.
Netflix is an amazing story. I’ve no clue where the stock goes or how the show ends but for now Mr. Kite tops the bill.
Being For the Benefit of Mr. Kite! – Lennon/McCartney
For the benefit of Mr. Kite, There will be a show tonight on trampoline
The Hendersons will all be there Late of Pablo Fanques Fair-what a scene
Over men and horses hoops and garters, Lastly through a hogshead of real fire!
In this way Mr. K. will challenge the world
The celebrated Mr. K., Performs his feat on Saturday at Bishops Gate
The Hendersons will dance and sing, As Mr. Kite fly’s through the ring don’t be late
Messrs. K and H. assure the public, Their production will be second to none
And of course Henry The Horse dances the waltz
The band begins at ten to six, When Mr. K. performs his tricks without a sound
And Mr. H. will demonstrate, Ten summer sets he’ll undertake on solid ground
Having been some days in preparation, A splendid time is guaranteed for all
And tonight Mr. Kite is topping the bill
A good cover…h/t AndyBoy 63