NFLX 0.00 deep dive here. Enjoy.
1.0 Lessons from a 300 Bagger 2.0 Beyond the Rat Race
3.0 Key Competitive Dynamics 4.0 Financials 5.0 Conclusion
Edited by Brian Birnbaum.
1.0 Lessons from a 300 Bagger
Netflix may turn out to be like Disney 70 years ago.
A historic analysis of the entertainment industry reveals that companies in the sector can be reduced to two core fundamental drivers: intellectual property and distribution. In turn, the evolution of the two over time is determined by talent and culture. Seen through this mental model, which I will elaborate on in this section, streaming is simply Netflix´s current state rather than its essence, which is actually to entertain. Thus, it may be just the beginning for the company, despite its ~300X return since IPO.
Diving deep into Netflix somewhat implies doing so into Disney too, and the latter is a very instructive case which perfectly elucidates the above flowchart. Throughout Disney´s history, IP and distribution have ebbed and flowed asynchronously and have in retrospect been great predictors of the evolution of the company´s fundamentals and stock price. This dynamic, as I shall explain further down, is perfectly analogous to Netflix´s evolution over time and serves to describe both companies with more focus and granularity.
During Michael Eisner´s tenure as CEO (Sep 1984 to Sep 2005), Disney was mostly focused on distribution, giving much centralized power to franchisers (executives) and little to creatives. During this period, the stock went 20X, but elevating margins at the cost of creativity destroyed the company´s ability to continue generating value over the long run. After all, it is the stories that attract the fans.
By 2001, six years after Bob Iger´s arrival via Disney´s acquisition of ABC, Disney was highly reliant on Pixar for creative work. Pixar was behind most of Disney´s creative success over the decade, such as Toy Story and Ants. Despite this reliance, Steve Jobs (Pixar owner) and Eisner had a bad relationship, which threatened the creative supply propping Disney up at the time. Disney´s own IP was failing to perform, with Disney Animations reaping one failure after another at the box office. ABC audience ratings were declining sharply, too, and all this led to the board eventually ousting Eisner and selecting Iger as CEO.
At this point in Disney´s history, the focus on distribution over creativity exhausted the company. Profits quadrupled from 1984 to 2005, but this growth was unsustainable because they were running out of creative gas (IP). Iger then took over as CEO in 2005 and he set Disney on a course to:
Create great IP again.
Distribute its IP via streaming.
Disney is investing heavily in IP now and is cannibalizing its profitable linear TV business by moving into streaming. The company is much more relevant now after the acquisitions of Pixar, Marvel, and Lucas Films that Iger orchestrated from 2006-2012 and managed to successfully integrate. However, the company is taking a financial hit as it invests in distribution via streaming. Reading Iger´s books about his (first) stretch as CEO of Disney, it is fascinating to learn that the key component behind this new chapter involves fostering a better culture, which has allowed Disney to 10X the IP it has acquired over the last decade.
In his book, The Ride of a Lifetime, he explains how the centralized decision flow during Eisner´s tenure effectively choked Disney´s creativity: a group of ~60 MBAs were basically making all key decisions. When Iger stepped up, he decentralized the company and returned autonomy to creatives and franchisers alike. He talks amply about the importance of not scaring people away so they can share their ideas freely and thus encourage innovation across the company. If you read last month´s deep dive on Microsoft, this will come across as familiar. Satya Nadella´s turnaround of Microsoft teaches us the same lesson: letting great people innovate is important and great CEOs understand this.
Further, I learned in the book that Steve Jobs´ primary concern about the Pixar acquisition was whether Disney could preserve the latter´s culture, which he considered as the primary driver of its success. After getting to know Iger, Jobs was eventually convinced that he would be able to manage Pixar´s culture adequately and agreed to sell the company to Disney for $7.4B. Since then, Disney has succeeded in two fronts:
Giving Pixar, Marvel (2012, $4B), and Lucas Films (2012, $4.05B) enough autonomy to preserve their respective cultures and, therefore, give continuity to their IP.
Plugging the respective IPs into Disney´s distribution infrastructure.
Taking a step back, Disney´s 100-year history consists of similar intermittent fluctuations between a focus on IP and distribution, starting with the relationship of Walt and Roy Disney. But what makes the company truly relevant is the cultural significance of the stories it tells the world. Great IP has propelled the company forward through time, which in turn has been the result of creativity and in turn once more the result of:
How effectively the talent engages in the pursuit and creation of new stories: also known as culture.
The higher the talent density, the better people work together, the more statistically likely that the entertainment organization in question will generate competitive IP and therefore attract end consumers. Apart from the acquisitions, what changed most notably at Disney during the Iger era is the culture and how people came together to create new stories. Naturally, distribution is also a vital component of the equation, but Disney´s performance over the past few years (in terms of its relevance, not its financial performance as yet) suggests that IP is paramount.
Netflix´s history can similarly be compressed to advancements in IP and distribution. However, Netflix is an outlier in the space since it started with distribution and moved onto IP later, rather than the other way around. As such, the market has labeled it a “streaming” company when, in fact, it is a close counterpart of Disney’s. What is striking about Netflix is how often it has been able to reinvent itself at the highest level, which begs the question, what is really going on under the hood? What makes this engine go? What is it really? It turns out that Reed Hastings (CEO) has been able to reinvent corporate culture and create one of the world´s best environments for creatives to thrive–and perhaps most importantly, create a company capable of improving itself autonomously.
Netflix has gone from renting out DVDs to producing global hit shows in unexpected corners of the globe, such as South Korea (Squid Game, for example).
Reed´s book, No Rules Netflix, gives an insight into the code/culture that enables the above. Yet its essence boils down to maximizing talent density and then fostering an environment that makes people responsible for their own excellence and for that of their colleagues, without any specific rules. Reed´s emphasis on culture comes from his own experience in founding Pure Software, which he believes grew stagnant over time as it got increasingly process driven. Essentially, Netflix is the opposite of process driven, since it is able to channel chaos into creativity by empowering its employees.
Apart from the wokeness issues experienced over the last few years, this has enabled the company to successfully confront what market analysts saw as insurmountable challenges. Too many pundits, with the benefit of hindsight, believe Netflix´s evolution to be blasé–but at every transition point, the organization´s skills and culture were highly stress-tested. Transforming from a streaming platform into an Oscar- and Emmy-nomination machine is quite a change in scope. Both are creative achievements, but they require very different skills. To any other sort of organization the shift may have been impossible–but not for Netflix.
“In some organizations, there is an unhealthy emphasis on process and not much freedom. These organizations didn’t start out that way, but every time something went wrong the python of process squeezed harder.
Specifically, many organizations have freedom and responsibility when they are small and everyone knows each other. As they grow, however, their business gets more complex, and sometimes the level of passion and talent goes down.
As the informal, smooth-running organization starts to break down, pockets of chaos emerge. At this point, the general outcry is to “grow up” and add processes to reduce the chaos. As rules and procedures proliferate, more value is placed on following the rules.
The system is dummy-proofed, and creative thinkers are told to stop questioning the status quo. This kind of organization may be very specialized and well adapted to its business model. However, over 10 to 100 years, the business model inevitably has to change, and most of these companies are unable to adapt.”
Culture is always diffuse and hard to talk about without using vague buzzwords, but what else can explain the meteoric rise represented above? Naturally, the seemingly limitless resources Netflix wields–spoils of the streaming wars–have helped, but without the adequate culture (and strategy, which arguably emerges from the culture too), the deployment of said capital would have likely been futile. Netflix places tremendous emphasis on its culture and goes as far as saying the following:
"That cultural excellence propels our business excellence, which increases member satisfaction and in turn propels our long term growth and stock price. It’s how we build an extraordinarily successful company entertaining the world." - jobs.netflix.com/culture
Netflix stock has gone ~300X since IPO and this has taken 21 years and has included 3 pullbacks of ~75% along the way. $100K invested then would be worth around $32M today, but holding through those pullbacks would have been quite tough. Indeed, during each one of these pullbacks the general sentiment was that Netflix was not going to continue growing over time, but if you had just focused on culture and understood its relevance, which is elusive to say the least, then your odds of catching the 300 bagger would have been much higher. The culture kept on delivering out-performance through time both on the IP and distribution sides and this translated into higher stock prices.
My fundamental observation here is that Netflix is not a streaming company. Such is simply its present incarnation, because streaming is the distribution method of our time, but at its essence, it is a high-performance creative organization that is able to adapt to market changes and continue delivering entertainment with increasing convenience. Although its relevance has decreased somewhat over the last couple of years, it has produced and is producing a lot of the world´s most culturally meaningful IP. So long as it maintains its creative edge, it should continue producing world class IP over time and keep on delighting more end consumers, by timely adopting the latest distribution methods.
The unit economics of streaming are still unclear across the board, but to a company like Disney that is of less importance. Disney has the ability to multiply the surface area of its IP and this is what gives the company much of its current financial buoyancy: notably parks. This can be visualized in the graph below. The company is currently confronted with The Innovator´s Dilemma as they invest heavily in streaming. Despite its current profitability, linear TV is headed towards a precipice and thus Disney is sacrificing near-term financial performance for long term value creation. So long as it has the mind-share of its end consumers–the odds of which being high as they move into streaming–Disney can foster and monetize more profitable surfaces.
This is crucial as Netflix hurtles toward a content rat race.
The company´s first-mover advantage in streaming is gradually fading, demanding that they make better content than its “streaming” peers. However, if it manages to multiply its surface area like Disney, the content rat race and profitability may not be mutually exclusive. The cultural relevance of Disney’s IP has enabled them to prosper alongside competitors in the market. People just want to spend more time interacting with it and thus are happy to pay for more and better experiences, like parks, cruises, and all manner of other products and services. So long as it gains more mind-share, Netflix has the option to do the same over time and thus increase its intrinsic value, regardless of how saturated contemporaneous distribution channels become.
Netflix may be on the brink of emulating Disney, only 21st-century style, and one question that I’ve yet to answer is: how much of Netflix´s ability comes down to its culture and how much comes down to Reed Hastings´ ability to see around corners? With Hastings having stepped down now into the chairman role, this is something worth pondering, although I believe he will still be involved in the company going forward. It seems that Reed has been thinking about succession for some time, and I like that the new CEO has come from within.
So that’s a good thing. In so many ways, the way that Reed has been able to see around corners. That’s why he has been thinking about the succession for the last decade. He generously opened up more of a co-leadership model over a decade ago for he and I, and like he said, 2.5 years ago made it a little more formal. - Ted Sarandos, Netflix´s new CEO @ Q3 2022 ER.
2.0 Beyond the Rat Race
Gaming may evolve into a source of significant operating leverage for Netflix.
For Netflix to escape its current situation, it must return to non-linearly growing the output of the function below. Since its move into streaming, it has experienced non linear growth on the user component of the equation, while the other two have flown along nicely with the resulting scale, in very simplistic terms. The narrative is that with other entertainment companies entering the streaming distribution channel, the below equation is bound to be largely contorted, with user acquisition being more costly across the board: hence, slower user growth and higher content costs per user.
Today, Netflix accounts for just 8% of total TV time in the UCAN (US and Canada), from which most of its revenue comes from. Upcoming generations are unlikely to go back to linear TV, so the company has plenty of growth ahead as streaming moves closer towards 100% of TV time. Over the last decade, as Netflix has gained more users, it has been able to deploy more capital towards content production and thus, achieve higher economies of scale. Although this dynamic is likely to not be as prominent going forward, Netflix does not seem to have fully lost its distribution lead just yet.
The problem is that as its current distribution advantage fades, the content cost per user is likely to not decline with scale as fast as it would otherwise. Now that it is competing on an increasingly even playing field, it has to invest more (or more efficiently) to retain old users and attract new ones. The entertainment space is packed with other creative organizations with excellent IP and rapidly improving distribution, such as Warner Brothers Discovery. Incidentally, I find myself watching HBO more and more lately and although this is just anecdotal evidence, the slowdown in Netflix´s user growth points to a sea change.
The way forward for Netflix now is to find some new surface which acts doubly as a new distribution channel and an interface for users to spend more time engaging with the IP, giving the company more monetization depth per unit of IP. Throughout 2021, Netflix went on a shopping spree and acquired a number of gaming studios, starting with Oxenfree in September 2021. Incoming generations increasingly prefer to play games as a form of entertainment and even socialization and thus, this may be the optimal surface for Netflix to leverage its IP.
Netflix´s proprietary content does not quite lend itself to the sort of games that have traditionally gained massive traction (shooters etc), so it may have to create/acquire new IP that lends itself to video game appeal. However, as it matures its gaming division and its library of IP grows in affinity towards the surface, it could become a real source of operating leverage, radically increasing the time the average user spends interacting with a given IP and and decreasing the cost of production per unit of IP, thus maximizing the output of the above equation.
Netflix´s acquisition of The Roald Dahl Story company for $500M in 2022 particularly caught my eye: to me it seems like the Disney that never franchised (somewhat failed at distribution, in relative terms). When Iger acquired Pixar, Marvel, and Lucas Films per the thoughts in his book he effectively saw a depth of IP and potential synergies among them that others did not, which then Disney was able to realize and multiply. One Roald Dahl book is sold every 2.5 seconds, yet we barely hear about these stories on the streaming and gaming fronts: it looks like deep value to me too.
Netflix´s previous shifts from DVD rental to streaming and original content production would suggest that the move towards gaming is perhaps not far-fetched. Or, in other words, that the company has the fundamental properties to give it a legitimate shot. Indeed, success is more likely than not so long as the company´s corporate culture continues to evolve favorably and it is able to integrate the gaming studio acquisitions.
However, gaming is a highly complex industry and it is also attracting some of the world´s top companies, such as Amazon and Microsoft. While it will likely give Netflix some additional operating leverage over time, it is unlikely to be the blue ocean that the streaming channel has been for the company since 2007.
3.0 Key Competitive Dynamics
Evergreen content is the key for value creation over time and content spend is going up across the board. As streaming gets crowded, streaming margins will naturally shrink over time, but this may actually benefit Netflix.
While the IP versus distribution mental model is generally applicable across the industry, not all content is the same. For instance, Disney has a broad library of content that individuals can engage all throughout their lives. This is inherently franchisable content, that is quite conducive to surface area expansion. The same applies to Warner Brothers Discovery, with stories like Batman and Harry Potter, that keep on coming back time after time. It is this form of evergreen content that has largely enabled Disney and Warner Brothers to live on for 100 years now.
Specifically, Disney and WBD have plenty of IP that appeals to the supernatural and subconsciously satisfies humanity´s longing for something bigger than itself. Stories like the Avengers, Star Wars and Harry potter tap into our desire for magic and meaning and are actually spiritual masterpieces at their core. They push all the right buttons to quench the existential dread of the average fan and that is why they are so profoundly impactful. I have observed that the more a given IP leans into this dynamic, the more successful it is financially over time.
On the other hand, the franchisability of Netflix´s IP remains in question. It has a notably different air to it, with particular emphasis on documentaries about dodgy occurrences and relatively sinister TV shows like House of Cards and Squid Games. All of this is nonetheless a subjective take and perhaps, it is vexed by the recency of these intellectual properties. Looking back, Disney´s IP is “obviously” franchisable but at the time of its creation it may have not seemed like it. Perhaps, Netflix´s content does become franchisable for future generations over time but at this point I note that it generally does not feel like it.
Further, while Netflix has been outspending its competitors over the last decade in content creation, this is now changing as mentioned above. Disney and WBD are expected to notably outspend Netflix in FY2023 and unless their capital allocation is awful, this is likely to pose a meaningful challenge for Netflix going forward. Indeed, so long as its content is franchisable and it continues to secure mind-share, it has the option to expand its surface area and thus increase value non linearly. But Disney and WBD have very powerful IP and are cramming it into the distribution channel that Netflix has been employing all this time and mind-share is finite.
In my view, this will require Netflix to optimize capital allocation to continue performing as it has over the last 10 years. It needs to both foster new distribution channels and create/acquire some great new IP to effectively compete for mind-share. However, it is also interesting to note that Disney´s content spend has historically been higher than Netflix´s, but the latter has just kept on powering through with a relatively constant output of new hit shows. This is indicative of two things:
Indeed Netflix´s talent density and culture are effective.
Perhaps the company will not have such a tough time dealing with its competitors´s increased spending, or at least not a sufficiently tough one for its long term growth prospects to be derailed.
Further, what speaks quite highly of Netflix is that it seems to be the only profitable operation in the streaming space. Every distribution channel comes with its challenges and it takes time to learn the ins and outs of each one. Further, while it lost nearly 1M subs in Q2 2022, there are some interesting observations I have made on this front:
Coming out of the pandemic, I believe we are experiencing a recession in the attention economy. People have been staring at a screen for three years and now prefer to do things outdoors. For streaming platforms at their earlier stages, this is likely to have less of an impact than for a platform in a more mature stage with higher market penetration. I believe that this explains a lot of the subscriber loss in Q2: people just got very tired of watching Netflix and indeed, the content quality seems to have withered recently.
Netflix has resumed its subscriber growth, via the introduction of an ad-based plan and lower price points that enable people to “legally” share accounts. While resumed growth on lower price points is not exactly good news per se, it does show that there is some price elasticity, which means that the platform is still relevant. This stands in contradiction to the narrative that Netflix is no longer appealing. According to management´s comments in its last quarterly reports, users on both of these new plans exhibit levels of engagement equivalent to those on the traditional plan.
As in all markets (other than luxury), more supply tends to equate to thinner margins over time. As more IP gets crammed into streaming, each platform will only be able to command gradually lower prices. However, Netflix is profitable while its competitors are not. Thinning margins are therefore likely to put more pressure on its competitors than Netflix, which is presented with the difficult task of producing great IP and sending it off into the world “for free” for an indefinite period of time. The fact that the ad and account sharing plans are working may be more of an advantage than it initially seems, if the ultimate mission is to grow the fanbase and then monetize it via other surfaces.
The income statement exhibits significant operating leverage and the cash-flows seem to indicate the presence of franchising power in the IP. The balance sheet does not look too healthy.
A glance at the above glance reveals that Netflix does indeed have a considerable degree of operating leverage, with revenue growth decoupling from costs. With the increasing competition on both its IP and distribution endeavors over the last few years, the trend is rather remarkable. Together with Netflix´s profitability, which is rare in the space, the above would suggest that the company has in fact more earning power than one would initially suggest. I would say there is something intangible going on inside the company, which is hard to appreciate initially.
For instance, one thing that caught my attention studying Netflix´s history is that Amazon actually launched its streaming initiative in 2016 (Amazon Unboxed), one year before Netflix did. Despite this, Netflix is still winning. Amazon has come up in my studies of Block (formerly Square), Spotify, and now Netflix. Amazon is known for having a near 100% kill rate, but it seems to be that when it comes across organizations with similarly excellent corporate cultures (and sufficient resources, good strategies) it seems to not have such an easy time. Amazon gave up with Square one year after trying and it is way behind Spotify despite offering a free alternative.
The Netflix situation has the same feel to it across the board: its focus seems to pay off. Although the company´s environment is now changing, I have the feeling that its qualitative organizational properties are likely to continue paying off down the line.
On the cash flow side of things, the decrease in both cash from operations and free cash-flow is tangible after the company began producing original content. Original content requires plenty of capex and naturally, it eats into the company´s ability to generate cash-flows at the present. However, it is fascinating to see that cash-flows are far more pronounced now than before the shift towards content production and I believe this tells us something about the IP.
Content only produces cash-flows once its original cost has been amortized. This takes time and for most pieces of content, once they are amortized, they are no longer relevant. However, the ones that do stay relevant once the amortization period is over go on to produce excess returns and hence, contribute disproportionately. The trend in cash from operations and free cash-flow would suggest that Netflix is well on its way to producing IP that stays relevant through time and thus, has franchising power.
Over the last decade, Netflix’s debt has ballooned and its balance sheet today is not exactly the strongest one around. In the same time period, Netflix’s content spend has risen spectacularly, and, in FY2022, it spent $16.84B in content production. Per the above data, the content has not been entirely funded by debt, but the push has left the balance sheet very much improved. For Netflix to reach the B/S it needs the franchising power to evolve over time.
This is one of the more complicated business cases I have ever analyzed. If seen as a streaming company, Netflix is in trouble. If seen as an entertainment company, it may have a bright future ahead by continuing to produce great IP and developing new surfaces for fans to engage with it.
Going forward, my fundamental concerns are the following:
How franchisable is Netflix´s IP really? If it is not franchisable enough, can it move in this direction?
Will it be able to successfully move into gaming, while maintaining its strong position in streaming?
To what extent is Netflix´s brilliance a function of its culture vs Hastings´ability to see the future?
As I convey these concerns, I feel the same way I believe many felt during the company´s various transitions. Even though concern number three is pressing, I am very impressed by Netflix´s culture, and, per Hastings´understanding of its importance, I believe he has placed great emphasis on finding a worthy successor. If I had to place a bet, I would say Netflix has very good odds of succeeding in the next generation of entertainment, especially if it does find new avenues to delight fans.
I initially dived deep into Netflix to learn what propelled the stock 300X since IPO, and I now emerge an admirer of the company. The current risk/reward situation is not fitting for me, but I am glad to have Netflix in my research backlog, should Mr. Market do something silly soon.
Until next time!
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I really liked how you framed the strengths of the company, their culture and the risks as they try to figure out where the next wave of growth is going to come from. Here are some ways I've thought about what Netflix is doing differently than others -
1. While there are many other players who make superhit TV shows (HBO ofcourse), Netflix has played their cards differently - they are making a lot of international shows so a cultural catalyst in that way (sitting here in America, I can understand the culture in Poland or Korea or wherever).
2. They are taking the Hollywood machine - the expertise to international markets. So soon - people in countries that didnt have those skills are empowered to tell great stories!
3. They've demonstrated that great stories dont necessarily need to be told by superstar actors and actresses. Many of their shows have casts that you've not heard about but they are excellent stories. In that way, they seem to be democratizing the playing field for the stars.
Fascinating analysis! At this point, I'm not only reading to gauge investment opportunities but to learn about the inner workings of high caliber companies and their creative potential. Your work is very much appreciated, Antonio.