Netflix – The Discovery Channel
Apr 2023 ($340)
Potential Value = [market scale]*[power][1]
The more we have looked at the strength of Netflix’s market position the more we like it. Its network scale and now owned content are tangible advantages. However, we note many other unseen intangible ones that we think just as important. It offers customers great value for money in a media sector known more for its price gouging and contract tie-ins. The success of its in-house produced content in such a short period of time is remarkable. As is the fact that this IP is now evident in wider global culture (e.g. Chess set sales and Kate Bush’s revival). This suggests Netflix has both a strong in-house ability to identify and produce quality content. Also, that its share of mind is even higher than its market share. What was once a counter-positing upstart has morphed into a powerful, hard to catch, consumer friendly Scale Economy leader.
Importantly we also think the company is about to enter a “discovery” phase as to its pricing power and its true current customer value. This will come via the combination of its new rules on password sharing and an offering of advertising backed subscription. Companies who always maximise price, likely see jumps in churn when they make such enforcements. We think Netflix is poised to experience the opposite and we are excited about what value these coming changes might reveal.
Turning the pages
Holland Advisors’ approach to investment analysis has long been anchored in the abbreviation WWW i.e., What Would Warren do… if he were looking at this company, or the universe of companies we are addressing? In the last c.5y we are more influenced by Charlie Munger. Charlie’s use of Mental Models to identify powerful businesses/models is something that resonated strongly with us. Having spent decades as sector analysts and often not seeing the wood for the trees, we love the ability these models give us to distinguish powerful, sustainable growth models from mere noise. We are always attracted to texts that enable us to develop these skills further. Jim Collins’ Good to Great and Built to Last helped us a lot, as of course did Phil Fisher’s Common stocks and uncommon profits. With such books and Charlie’s help we started to find business models and companies that we thought powerful but underestimated. The EDLP/flywheel model is our often-used example. Upon reading Nick Sleep’s articulation of these companies as “Scale Economy Shared” models we realised his description far better encapsulated what these companies were doing. As such we have shamelessly copied/cloned it.
Owner managers
The other driver of what we are seeking to find is clearly aligned owner managers. This is mostly due to the invention, innovation and often-times brilliance they bring to their companies. As a result, we have devoured the biographies of Charles Schwab, Jeff Bezos and Michael O’Leary amongst others. A book that helped us better collate our thinking on owner mangers was The Founder’s Mentality by James Allen and Chris Zook. An introduction to which can be seen here.
Seven Powers
Last year’s we discovered 7 Powers by Hamilton Helmer. In the same way that Owners Mentality helped us put a framework around the traits we had found recurring with the owner managers we encountered, 7 Powers did the same with our business model thinking. It looks at Sustainable Competitive Advantages (SCA) under the moniker of ‘Power’ and how that power can be derived in different ways. Some of its content is not new, but the way it structures and looks at the interaction of different SCA’s is very useful.
Both books have been great additions to our arsenal. As we search for an ever-better stock selection net to catch our fish in, we find ourselves referring back to these texts often. We cannot recommend them enough.
Serendipity & generosity
Before discussing Netflix in the context of this reading/approach we want to give out a sincere ‘Thank you’. There are so many stock ideas to look at and so many companies that touch our lives day to day. As such we all have a little knowledge of many businesses, but that does not mean we have properly considered them as potential investments. Whilst the textbooks above and c.30y in the job give a good framework for what to look for, they don’t tell you where to fish. Something needs to tip you over from knowing what a company does to really seeking to understand it. That something in your authors case came from a chance meeting with a bright young analyst. He had read a little of Holland’s work and was insistent that we should look at Netflix, believing that it, and its founder were the type of business/managers we seek. From the reading and reflections we have done so far, we think his observation correct. So: “Thank you, Analyst X”
The Path to Power
The reflections that follow on Netflix are similar to those we made on Amazon last year. In truth we can achieve very little edge over other 52(!) analysts looking at Netflix in analysis of such companies’ day to day operations. Instead, what interests us is a recognition of a powerful model if we have seen it before.
In Amazon’s case our research on the company found us quickly feeling as if Jim Collins’ work on how to build a great company was coming to life in front of our eyes. In Netflix’s case the more we read the more we reflected on traits that we remembered reading in 7 Powers last summer. As a result, we decided to read it again. Only on doing so, did we remember that the preamble for the book was written by Reed Hastings! Indeed, Helmer also uses many Netflix examples throughout the book. Clearly on our first read through we were not properly paying attention! If we had we might have looked at Netflix harder some months ago. This is a shame as share price watchers will have noted the falls/volatility in Netflix shares during that period. Did we miss a wonderful opportunity? Maybe. But again, we are thankful to Analyst X for making us do what even a great textbook seemingly could not – dig properly and think.
We strongly recommend anyone interested in properly understanding Netflix, not only read Reed Hastings No Rules Rules book, but also 7 Powers. Before we highlight a few traits from 7 Powers relevant to Netflix, ‘No Rules Rules’ deserves a mention.
No Rules Rules
Co-written by Reed Hastings, No Rules Rules is great way to understand the pretty unique culture of Netflix. The culture comes across as genuinely different to other companies and likely hugely empowering for those that work there. Netflix believes in trying to ensure it always has talent-density across the organisation and will pay top dollar salaries to ensure this.
It is also a company with no expense or holiday policy where employees are actively encouraged to both talk to head-hunters and told not to try to please their boss!
“In some industries, preventing error is essential. We are in a creative market. Our big threat in the long run is not making a mistake, its lack of innovation. Our risk is failing to come up with creative ideas for how to entertain our customers, and therefore becoming irrelevant.” Reed Hastings – Extract from book
This quote is something we might have expected Walt Disney himself to have said 70 years ago.
Counter-positioning
Sometimes it is hard to remember where you first heard something. We had read about counter-positioning before reading 7 Powers, but the book’s work on it we thought useful. We have certainly seen a great deal of real life counter-positioning via the challenger businesses we follow in Ryanair, JDW, Amazon, Schwab etc. 7 Powers articulates well the common traits that these business often display and how they impact incumbent players. Helmer brilliantly refers to the five stages of how incumbents react to counter-positioning. They are listed below:
- Denial
- Ridicule
- Fear
- Anger
- Capitulation (frequently too late)
Source: 7 Powers, Hamilton Helmer
These are excellent and so true. Your author as an ex-airline analyst saw these close at hand when British Airways or Lufthansa was often asked about Ryanair in its early days. Denial and Ridicule were common. With Ryan’s intra-EU market share now at 16%, such companies are at the capitulation stage! Whilst we did not hear Blockbuster answer questions about early-stage Netflix, we can only imagine their replies were similar. Denial, Ridicule, then in their case bankruptcy.
Power Progression
The second area of Helmer’s work we think appropriate to highlight for Netflix is what he describes as ‘power progression’. This is his way of thinking how a Sustainable Competitive Advantage (SCA) is being developed. Holland’s approach has been to look for SCA of some form and also the presence of owner managers. Helmer links the two. For many years now we have watched great owner managers innovate and pivot businesses. Helmer rightly describes “Innovation as the first step to gaining some sort of power.”
Whilst this is not rocket science it is a useful mental tool as we see the best owner manager’s change and adapt to new market positions. What they of course are looking for is a SCA in the future environment. We have now seen more than a few owner managers make such transitions. We have also seen Mr Market often terrified of the potential consequences during such a period of flux. (Next moving online, Facebook’s Meta/AI investment, Frasers stopping discounting ++).
Again, whilst these observations don’t change our thinking, they do help solidify it. We have long been interested in companies at points of uncertainty or inflection, if they are owner manager lead (#ref our ‘Engine overhaul’ note in Appendix 1). The reason for our attraction at such uncertain times is the opportunities it throws up to invest in wonderful businesses when they are offered on sale. Each founder is trying hard to re-invent or pivot the business towards a position of power in a likely new market environment that is emerging. More often than not Mr Market hates them for trying to do so!
Helmer’s book referenced a 1987 article by Professor Henry Mintzberg. Mintzberg describes this period of ‘innovation’ by founders as:
‘crafting’, or ‘intelligent adaptation’. Source: Crafting Strategy, Professor Henry Mintzberg, HBR, 1987
These are good depictions of what is going on. Simply put, if you find owner managers who are good at repeated intelligent adaption then a) they may well be on path to future SCA; b) they are likely to be able to do so again in the future. The best owner managers we meet and admire are truth tellers. If the outlook is difficult or uncertain they will tell us as such. However, they are also often very good at intelligent adaptation, it often being in their DNA. Sometimes these adaptations yield easy and fruitful growth and Mr Market celebrates. Other times the crafting/pivot they are undertaking is hard, taking a long time. This is when markets lose trust in the very people they used to worship. This especially happens when owner managers are being truthful about a tough outlook.
“You want the Truth: You can’t handle the Truth” Jack Nicolson, A Few Good Men
The reason for so much reflection on this area is partly a real-time development of our own learnings which we are sharing with readers. It is also because in Netflix’s past actions and its management/ethos we see signs of repeated intelligent adaptation. This is very appealing indeed.
Netflix’s – Route to Power
Whilst we could easily have summarised our thinking on Netflix without reference to 7 Powers we thought it interesting framing. The reason being is the unusual and significant changes over time we have noted in the company’s SCA. Netflix’s many changes of direction have been management/culture led (e.g. to embrace streaming, then exclusive content, then owned content, now games). Clearly Netflix started its life in counter-positioning mode, successfully out-manoeuvring Blockbuster with its innovations and the evolution of its streaming offering.
What is interesting is how Netflix SCA’s today are not those that it might have claimed 10 or even 5 years ago. Today the company still has a strong focus on intelligent adaption meaning it is looking for new future ways to grow and dominate. However today it is now doing so from a position of great strength.
Scale economies/share of mind
It is self-evident that Netflix now has massive scale, but it is also using that scale intelligently. It’s very rapid move into original content has changed its content costs from variable to fixed. Spread over an ever-larger base of subscribers this is a Scale Economy Shared benefit. What has been of interest to us looking at the company with a fresh pair of eyes is the speed at which such transitions occurred. The companies first exclusive content was only House of Cards (in 2012). Its first internally produced series (2016) and internally produced films were much more recent than that.
In the long history of content viewing and production these are massive changes that have occurred in a very short space of time. Not only does Netflix now offer an alternative network for creative types to work with/for. It also offers a different/more stable financial model via its Netflix Preferred Fulfilment Partners program for content producers.
It also now provides a unique outlet for locally produced content. Such content is not only popular amongst local language viewers, it is also getting far greater viewings in many other regions also. We do not yet have the knowledge we would like about film production financial models, but our sense is that this is becoming an area of great advantage to the company. Clearly Netflix still has a deep pocket to outbid other streamers for content or ideas if needed. Crucially it also seemingly has fast and astute decision making to quickly say yes to potentially great ideas (this we read is what happened with Stranger Things).
At a local production level, we suspect Netflix are now almost the only game in town. For years we have read about how local content producers could neither finance local story telling, nor get them distributed to market. Clearly streaming has changed that dynamic significantly and quickly, and no company more so than Netflix. This is sea change and thus is maybe Netflix’s market now to lose.
If they treat local content producers fairly why would such companies want to work for anyone else? The scale of their now established market leadership positions in diverse but large countries like Japan and Brazil is notable. This is not just a US/European centric platform.
Share of Mind
Two further reflections come from our reading in the area. The first is what Munger calls: “share of mind rather than Market share”. This always struck us as powerful when he first explained it. Irrespective of the market share positions of Disney, Netflix, Paramount, Amazon Prime et al where is Netflix share of mind in the consumers attitude of streaming? Is it where it was five or ten years ago? No, we suggest it is way ahead, despite huge, expensive rollouts of competitor offerings.
It is interesting to perhaps compare it with Disney is this regard. Clearly Disney still has a strong share of mind in global content viewing, but arguably Netflix’s relative share of mind compared to Disney’s is much more powerful than it was three or five years ago, even allowing for the success of Disney+. This we think an important realisation.
Whilst the likes of Amazon and Apple TV have spent very significant sums to expand in this space, almost all others are losing large chunks of relative share of mind, mostly to Netflix (or maybe Prime).
At the start of this piece, we used the following formula from the 7 Powers book. We think a reflection of how fast Netflix has evolved and grown its power in such a short period of time interesting. A separate consideration of what the future global market scale for consumption of content looks like can be answered as either bigger, or a lot bigger! Their combination suggests Netflix should be a very valuable entity years from now.
Potential Value = [market scale]*[power][2]
Cornered Resources
The speed with which Netflix has transitioned to owned and internally produced content and importantly the remarkable success rate of this content suggest to us a further force might be at work. That in addition to scale economies and a strong share of mind, it might also have cornered resource. The last time we thought about this SCA in reference to a group of people and their collective ability inside a company was TSMC. Before that it was in reading about Pixar. This is a rare SCA.
Something is clearly occurring at a cultural, decision-making level inside Netflix that is enabling it to back and produce surprisingly good content with low failure rates. The reason we say ‘surprisingly’ is because this was by no mean as easy exercise (i.e. backing new successful content/films was never an easy task, until Netflix made it look that way!). Whilst we are impressed, clearly cornered resource is a hard area to measure and is somewhat circular, i.e. the better the companies ‘content’ the stronger we will conclude its team/decision making is. Poorer content for a while might lead us to the opposite conclusion.
Netflix only relatively recently started producing in-house content and its success at both a local and global level suggests that more talent and leading industry decision makers will be sucked towards the company, either as employees or exclusive partners. That this is happening at the same time when Disney is struggling culturally is notable.
Customer centricity/pricing power
Whilst in many of our industry positioning comments we are contrasting Netflix with Disney we should state that we are still impressed with the scale of subscribers that Disney+ was able to attract in such a short period of time. As we observed in earlier year pieces on Disney this was due to the power of the global franchises that Disney possess.
The success of Netflix recent content creating ability (#All quiet on the western front) needs to be seen in this light. I.e. how hard it has been to make a non-Disney movie into a global success in the last twenty years.
The relative pricing (and true power) of Netflix vs Disney is not fair to compare due to Disney’s relatively new subscriber base. I.e. we don’t yet know what Disney+ subscriber will agree to pay in future.
What does stand out, at the financial level in this sector is Netflix’s high profitability in streaming, whilst Disney and others are still loss making. Whilst Disney+ might yet catch up with firmer pricing we do not know how its subscribers will react. We do however already know Netflix’s scale and that its current pricing is accepted by subscribers we also know:
a) its low churn levels
b) and good profit margins (c.20% EBIT margin)
Simply put, this is not just a popular streaming service, but a highly successful financial business model [Post-tax RONTA = 15% in 2022].
Another important distinction we would make between Netflix and companies like Disney and cable operators is its attitude towards giving customers value for money. When researching the company this is a constant mantra it repeats time and again. Whenever it is asked about the potential for future price rises, the company always answers the same way “we will only ever look to raise prices if we get a message from the customer about how much extra great value we are delivering to them”. This is Scale Economy thinking, not pricing a quasi-monopoly. Investors we think should compare this mentality to that of Disney, where the cost of attending its parks always rises much faster than inflation (see Appendix 2: The costliest place on earth). Or to US/EU cable companies who constantly seek to hike prices, even though they often accompany lower, not higher, levels of service. As per our piece last Spring (Roads trips & Modern Moats) the brands of the past try to cut costs and service levels to bolster/hold margins. The trusted brands of the future are hugely more customer centric in their thinking. This we think gives them untapped pricing power…. which by-the-way we never expect them to fully use.
Netflix has changed much of the status quo in the media/viewing industry. A crucial and underreported value of this company is how customer centric it is. Its thinking seemingly aligns with a company like Amazon or even Costco, that wants to give its customers great value for money. In a media world of constant ticket and bundle price escalations this stands out. Oh! and we think customers have noticed this difference, but we will come on to that.
Netflix – Why?
There will be many pieces of research available to investors that outline various elements of the Netflix story. Analysing its past subscriber growth, how popular its recently produced content has been or how the competitive landscape is changing. All of these points we take as read. What we are interested in is Why. Why this growth, innovation and industry dominance is occurring and what it means for the future of Netflix?
Some of our reasoning on answering this “why?” question we have hopefully outlined above, but there are further reflections we should make.
The Capital Cycle
It is said that inexperienced investors try to forecast the demand that lies ahead of a company or industry. Those with greyer hair look at the supply side. I.e. what have been the changes taking place to add or reduce capacity in this industry. These changes being the most likely drivers of future pricing power. Observed through this capital cycle lens the streaming market has for c.5years been awash with new entrants with large cheque books determined to make their mark.
We make some observations on this issue:
- Of those who had brands and scale in media distribution pre the streaming explosion, few still have it now. A company like Paramount is perhaps a good example
- Despite the vast sums that companies like Apple have spent to develop a streaming platform, success in subscriber growth or content has been patchy
- Even Amazon with all its scale and early entrance into streaming has had nothing like the content success rate that Netflix has
- With its amazing IP Disney was always going to attract many subscribers. Indeed, our past work on Disney was right to be optimistic on this point. What we did not foresee was that at c.160m subscribers it would still be loss making and Mr Market would be unimpressed.
The scale of capital entering this sector and the determination of some of the biggest and best companies in the world trying to target it is telling we think. On the one hand these new entrants have helped expand the market. On the other they surely made the economics of Netflix a little harder during this period. I.e. more low-priced competitors arrived to tempt Netflix customers and content providers away. Post all this a few Netflix observations:
- Netflix still grew its subscriber numbers strongly during this industry capital-cycle splurge
- Netflix achieved a high level of profitability. (20% EBIT margins) before this capital cycle started to roll-over. [NB: We think its margins are set to rise a good bit more]
- Today many companies that are subscale or unprofitable are rightly coming under shareholder pressure to scale back expansion plans. More than few we expect will end up accepting a need to be consolidated. This shows the capital cycle has peaked, creating what will likely be a tail wind for sector leaders. This follows a >5y headwind
- During this heavy industry investment period the quality and breadth of content that Netflix has produced has continued to surprise on the upside. Considered from the perspective of five years ago, this is perhaps a consistent surprise that we might not have expected during such a battle for eyeballs and production talent
In the section below we will look at Netflix’s potential earnings power. What interests us is that the outlook for the next 5-10years of capital cycle in this sector is very different from that of the period just ended. Just a short reflection of the changes in management and strategy taking place at Disney alone informs this point of view. Today, at multiple levels we can see Netflix’s dominance. This being either its huge, low-churn rate subscriber base, its premium pricing or award-winning content. Arguably it is also still the player innovating the fastest. It has also now flagged a levelling off in its own capital spending. As such, while competitor’s scale back in a search for returns on capital, Netflix’s relative power and profitability both look set to improve further still.
Other Intangibles – Niches & Surfing
“What you can’t measure often matters more” Charlie Munger
In further trying to answer our “Why?” question above we suggest a few other intangibles drivers aiding Netflix charge. Reading Reed Hasting book No Rules Rules is interesting as it gives a glimpse into the culture of this organisation.
Whilst the importance of culture is a hard point to address, it feels as though it is helpful to the company when combined with the other competitive advantages we observe. Does a cornered resource raise the bar on the quality of future hires by building a great talent rich culture? This in turn attracts yet more resource to be cornered.
Another obvious point to observe is the company’s niche focus only on its core streaming market. This has enabled it to out-think those who once had bigger reach and bigger wallet size. Indeed, in researching the company we are reminded of our Spotify work. This was also a company whose niche focus on audio streaming saw it grow faster and force strategic changes at Apple, who in theory had market dominance with iTunes. Companies focused on a single niche can sometimes outsmart even the biggest gorilla.
Fibre = Refrigeration
When Charlie first made the statement below, he did not use Microsoft or silicon-chips as his examples, but instead Coke and Disney. In Coke’s case nationwide refrigeration gave the company a huge and long-lasting boost to the future popularity of its product. The same was true for Disney with the invention of video cassettes. Suddenly Disney could not just sell its IP in cinemas but a million of times over via video cassettes and then of course later as DVDs.
“You have to work out when technology is going to kill you, or help you” Charlie Munger
Ever-faster broadband speeds are to streaming what refrigeration was to Coke. Clearly all future industry players saw this, hence their excitement/expansion plans over recent years. Whilst broadband/fibre speeds are increasing at different rates in different parts of the world, they are only going one way. It is important that whilst we understand the changing competitive landscape that Netflix seems set to dominate, we do not lose sight of the fact that this is a company with a technology helping tailwind that will extend for decades. A technology that it gets for free.
Surfing
“Surfing” vs “Wallowing” is our last mental model reflection. From its early use of counter-positioning, to its use of scale and then building owned content, Netflix has managed to stay ahead of competitors. Much of what we have noted above is the external and internal driving forces that got it to this point. The more we reflect on them the more we can only conclude they will continue. As such Netflix looks a lot like one of Mungers ‘Surfers’ riding on the front of the wave it astutely caught. Many competitors are paddling hard, but despite strong efforts they are actually falling further behind. Soon, might a few give up?
Netflix – The discovery channel
This note has in truth been written in the reverse order in which we researched the company. On initially reading about Netflix in the last few weeks one thing struck us immediately. This being that investors were very soon going to find out what pricing power has company really has. Also how big the companies reach is globally and how big it can be. On this we are referring to the underway changes now being implemented of password sharing and the rollout of advertising backed subscriptions.
Password sharing – 100m people’s dirty little secret!
Finding businesses and ideas that we touch with our everyday lives is often a way to invest with insight. We can have a strong understanding of what really drives loyalty to a product, its brand value or pricing power. With this in mind a great many investors can reflect on the issue of Netflix password sharing just by chatting with family and friends. We observe:
- Netflix password sharing is very widespread. This is self-evident to users but the scale has also been disclosed by the company (Over 100m of its users, they tell us share their logins). Notably they do not say how many times. It is not just once in good number of cases, we will opine
- For disclosure your author will reveal that not only do his two university student sons use his login, but so too do two sets of parents. And yet your author considers himself to be highly law-abiding in all areas of his life
The reality, of course has been that up until recently this was not an area that Netflix enforced at all. Indeed, maybe quietly it even encouraged sharing it as it wanted Netflix to become ubiquitous when the industry was in land-grab mode. Were that an unstated strategy we think it safe to state, it has worked!
As the company has rolled out changes to password sharing rules in Latin America it has not seen notable rises in cancellation rates. This is unsurprising to us, and we think importantly speaks to the value Netflix offers users. Importantly we also think it relates to the share of mind we observed earlier. With many of the company’s shows now becoming part of wider culture, no one wants to miss out (examples here are becoming plentiful, but Kate Bush’s ‘Running up that Hill’ becoming the most streamed global song post Stranger Things is a good marker). Crucially we observe were Netflix enforcing such new password sharing rules five or even three years ago the reaction might be very different. In that intervening time however the quantity and quality of offering they have provided to consumers is huge. Whilst there have been some price rises, they have been modest even during the massive increased usage between 2019-2021. In that two year period ARPU + 8% (+12-16% in EU/US). Consumers got all this new product for a fixed, non-escalating price.
To share (a password) or not – that is the question?
The link here gives UK/US users an idea of what is to come when password sharing rules are implemented. There will of course be complaining and pushback, but we observe some new realities will soon be in front of Netflix and its investors:
How do the many users using a login really value what they are watching? Let’s explore this ideas via your authors’ house:
- If offered a £4 extra charge to add a new user in another location he will likely accept it, so that his two sets of parents can continue watching without a need for their own accounts/login etc
- A different user sharing a login with say his dog-groomer and barber will likely not do this. These parties then have a choice to either subscribe for a paid account themselves, or sign up for an advertising-based one
- Back to the author’s house. In addition to paying more for parents’ access, his two sons might sign up for their own accounts. Maybe these are ad-supported to save them money
The counter positioning of the two changes coming (i.e. password crackdown and ad-supported) we think is very interesting. Over the course of maybe two years it will enable the company to:
- Get a fairer view for the true value of its current offering from users already watching
- To widen its net to many users who would like to see the content without paying for a subscription. In which case they can watch with ads.
How to make $10 into $30-$40
Whilst we doubt the following counts as ‘analysis’ or can be directly read across to Netflix. We still think it instructive.
Today your author is a typical user measured as ‘one’ out of Netflix’s 220m subscribers. He pays Netflix a flat fee and allows others in the family to use his account. Quite likely he will agree to pay c.£4 each for two new household users. As such his ARPU might increase to £19 from £11. In addition, maybe his two sons living away from home might sign up for their own accounts, but accept advertising to save money on the subscription.
Crucially Netflix last year disclosed that they believed an ad-based subscriber would be just a valuable as a subscription one:
Overall, the reaction to his launch has confirmed our belief that our ad-supported plan has strong unit economics (at minimum In line with or better than the comparable ad free plan). Source: Reed Hasting. Investor letter Jan 2023
Taking this to its logical conclusion for the perspective of a Netflix investor, your author’s account could potentially be worth 3-4x its current level:
- Main account ARPU goes from £11 to £19. There is no greater usage for this increased fee, so it is pure profit
- Additionally, two new accounts created that Netflix believe have the same value to the company as the author’s original £11 a month one
- In this way an original account with an ARPU of £11 a month rises to a potential value to Netflix of £41 a month (£11+ £4+ £4+ (2x £11))
- Hence how one account could yield 3-4x the value of its original worth.
- Crucially, all of this value would be created without ANY any extra viewing than the company experiences today
This is the value ‘discovery’ period for Netflix we are very interested in.
Pricing Power/What will the customer do?
The reason for entitling this report “Discovery channel” we hope is now clear. Netflix is about to find out the true value of its current network and the content it distributes today. Also, the true scale of how many customers it really has.
An advertising backed account also brings in more new potential users. Whilst we think the scale of such users attracted to Netflix will not likely mirror those at Spotify, it is notable that 260m out 455m total Spotify users are on the free/ad-based account. It has successfully used ad-based subscribers as a way to achieve far greater reach and to bring in subscribers that may one day convert to a paid subscription.
As for how consumers will react to Netflix password changes, we think in many cases, it will be with little more than a shrug. If we are right about this the financial implications for the company could be very substantial (EBIT margin jumps from 20% to 30%!). Maybe some analysts are worried about the noise a few complainers are making in chatrooms etc. This will always be the case in any corporate pricing change event. What matters is what the bulk of subscribers do. Crucially as per our earlier observations, we think consumers can see the value that Netflix now offers them. Additionally, many know the password sharing they have been engaged in for years was wrong/showed an odd level of tolerance by Netflix. If the transition is handled in the right way by the company we expect consumers to evolve in the same way your author’s household will. If so it suggests far greater value to Netflix and its owners.
A starting point of ‘value’ and ‘customer trust’ matters a great deal in such situations. The cable companies/Sky in the UK come with high price tags and escalating contracts for those that do not constantly negotiate hard. Against this history Netflix (and arguably Amazon Prime) have offered customers more for less. The point at which consumers expected to be called out on password sharing is now long since past. They know they have been getting something very good for nothing. They like it and now will pay for it.
Just before publication of this piece we stumbled across a study that suggests your author’s hunch on consumer reactions to password sharing might have some merit. An FT article (‘One of the best things in life is no longer free’, 18th February 2023) highlighted a survey done by Horowitz Research. The survey specifically looked at how customers might react to Netflix password changes. Its conclusions include:
- “7 out of 10 Netflix users who password share would be willing to pay full price for the service if they could no longer share access.”
- 18% of TV content viewers share access to Netflix (i.e. do not have their own login)
- 83% of Netflix users and 81% of Amazon Prime users think the respective services offers excellent value for money (our emphasis)
Source: Horowitz Research, 17th January 2023
Netflix the investment
Clearly a wonderful time to buy Netflix shares would have been mid-way through 2022. That said the last 6-12 months has seen investors get greater clarity on a number of issues. These include Netflix’s important admission on the economics of an ad-based subscriber. Investors can now also see a genuine rollover in the capital cycle in the streaming sector.
The phrase below informs our thinking in how we view Netflix’s longer term value. That is to say the streaming/eyeball market looks set to grow in scale for many years/decades to come and those control the main network/content will keep surfing this wave. Netflix power in this streaming arena is already huge, but everything we see (tangible and intangible) leads us to believe it will get even stronger from here.
Potential Value = [market scale]*[power][3]
Short term value to be uncovered
We have chosen in this piece to focus on the driving forces behind this franchises longer term compounding value rather than probe the minutiae. However, for all of our admiration of the companies we research we always want value at the point of purchase to ensure a margin of safety. This we think we are about to receive courtesy of the coming password and ad-subscription changes. We suspect the current underearning of the franchise will soon become apparent.
Netflix has good long term growth prospects. Both in global subscribers that can be added (ref Spotify at 455m!) and in multi-year ARPU rises that can accompany subscriber maturity and more content dominance. It has articulated that it expects attractive network economies to bring c.3% increases in EBIT margins pa, albeit in a lumpy nature. This, we believe it can achieve without diminishing the quality of its customer offering or its value proposition. Such a combination from starting c.20% EBIT margins is a powerful business model that should be attractive to investors.
A bump to help our margin of safety
Returning to the idea of your author’s household there is clearly latent value in the company’s existing subscriber base. This we could try to adjust for. We have looked at this in many ways, but provide just a crude single sensitivity below. With 100m accounts out of 220m sharing passwords this is not an area where we think we need precision. Roughly right will do, until the company shows us the detail in the months/years ahead.
As such consider the following:
- Were each of the 100m households currently password sharing to pay a single add on charge of $4 per month to keep their current usage. This would add $4.8bn to the company’s revenue line
- c.90% of this would arguably be pure profit. As such it would also add $4.4bn to 2022 full year EBIT of $5.6bn
- As a result, Netflix EBIT margin at $10bn of EBIT would rise from c.20% to c.30%. RONTA would rise from 14% to 25%
- Today Netflix’s historic (i.e. Dec 22) EV/EBIT is 25x. Adjusting for this scenario makes this ratio 16x
Not all Netflix 100m password sharers will respond in the same way. Were the above change however to be the one chosen by your author, then in future neither Granny, nor my two teenage boys will have any access to Netflix at all!? The company has cleverly started these password policy changes outside US/UK/EU, so all know what is coming. In core western regions however is great wealth amongst its well-established subscribers. Many, many, households in these markets can easily afford much greater than $4 a month rises.
We think c.16x EV/EBIT an attractive price to pay for such an outright leader in such an important industry. We also think such a potentially value realising event will lead Mr Market to think hard about this company’s true leadership position, and its far superior economic model.
Put us down as ‘Buyers’.
Andrew Hollingworth
The Directors and employees of Holland Advisors may have a beneficial interest in some of the companies mentioned in this report via holdings in a fund that they also act as managers to.
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