Netflix: The Anatomy of a 460X Stock
Netflix: The Anatomy of a 460X Stock
Re-Deep-Dive
This is an update of my original Netflix deep dive.
No time to read the update? Watch/listen for free:
Edited by Brian Birnbaum.
1.0 A Lesson for the Future
In 2022, the market gave up on Netflix. Once again, however, the company has bounced back to teach us fundamental lessons about long-term wealth creation.
I wrote my original Netflix deep dive in March 2023, just as the market had turned highly pessimistic on the stock. In the deep dive, I highlight how Netflix should not be analyzed as a streaming company. At a fundamental level, it’s a rapidly evolving entertainment company with a vast runway ahead.
In late 2022, the market was spooked by Netflix’s slowing member growth, which it attributed to increased levels of competition. Netflix was no longer alone in the “streaming” business and so the stock lost its charm. This narrative sent the stock down over 70% from all-time highs, with even great investors like Bill Ackman capitulating.
However, Netflix stock is now up over 200% from the lows, with the company’s fundamentals back on track. So what happened?
In my original deep dive, I focus on what made Netflix a 300X stock since its IPO (initial public offering). Then I pinpoint why investors jettisoned the opportunity to continue compounding capital at a fantastic rate. After all, Netflix is now a 460X stock with the potential to grow more than tenfold from here.
In 2022, many Netflix investors simply didn’t know what they owned.
As I argue in my Netflix deep dive, streaming platforms are merely the contemporaneous manifestation of what we have traditionally termed entertainment companies. They are the combination of an intellectual property and distribution engine, which then combine to deliver entertainment at scale. This machine has many parts, and incremental efficiency improvements compound to yield competitive advantages.
The reward of wielding a world-class intellectual property and distribution machine is scale. Producing intellectual property and distributing it successfully is a risky endeavor. Economies of scale mitigate the financial risk because scale yields asymmetry by maximizing wins and minimizing losses.
Movies and shows are produced locally, relatively speaking, with people working in a specific or few specific geographic area(s). They may even cater to the local culture to optimize initial releases. If the distributed product is bad it then goes on to be a local failure and people forget. But global success proliferates the gains by surging beyond fixed costs.
Scale also generates data, which allows AI models to be trained to predict what audience will like what content. The more and higher quality data the machine accesses, therefore, the more efficiently it will be able to match fans with intellectual property, which over time equates to more scale. As AI keeps improving, the strength and relevance of this moat will increase exponentially.
Thus, the core driver behind Netflix’s 460X return since IPO to date is the company’s prodigious ability to fine-tune the machine, which is fundamentally driven by Netflix’s culture. The second core driver is Netflix’s ability to allocate capital resulting from scale to accelerate iteration. The combination yields a flywheel that has proven very hard to replicate.
Qualitatively speaking, Netflix’s productions are suddenly relevant again. I very much enjoyed the series The Gentlemen, for example.
I remained worried in early 2023 about the difficulty of maintaining this flywheel. But during my research I noted that, when Netflix decided to go global in 2016, its operating margin was 4%. Today, the trailing twelve month operating margin is over 22%, while the competition continues to struggle to turn a profit.
This trend is indicative of Netflix’s unusually efficient ability to produce cultural asymmetries, which is in effect the core of its business. Netflix can repeatedly move into a different culture and produce local hits that go viral worldwide. We now have the benefit of hindsight in the analysis, but it seems that Netflix’s machine is simply superior to that of competitors.
Netflix is constantly iterating both its intellectual property and distribution engines. They have ups and downs, but over the long term, they trend up and to the right. Further, every once in a while Netflix makes a longer iterative step, which seems more discontiguous in nature. For example, Netflix became known as a “streaming” company because of a strategic decision to transition from renting out DVDs to enabling people to watch them online.
Faced with increased competition in 2022, Netflix decided to gradually phase out its entry-level subscription and funnel those customers into advertising plans. According to management, the ad-based business model has better unit economics than the traditional subscription format. Strategically, the shift makes particular sense as consumers have more choices and are thus more reluctant to pay.
What’s interesting is that the market saw this move as a sign of weakness and further justification for the narrative surrounding increased competition. The market wrongly interpreted the core value drivers of the business.
In reality, the shift to ads made the barrier to entry for competitors higher. Getting the intellectual property and distribution flywheel right at scale is hard via subscriptions. But it’s even harder to so while building out an ad-tech stack. I believe this step will help Netflix sharpen its edge over competitors in the coming years, making it harder for them to attain the same level of capital efficiency.
What Netflix must do to continue succeeding is unknown. However, the company has demonstrated that in its present form it can be relied on to execute as required. It also helps to understand the business at its core in order to evaluate management’s decisions.
At its core Netflix is a learning machine with high levels of customer centricity, together with other highly desirable cultural properties. Each challenge that Netflix successfully confronts–i.e. distribution and intellectual property–helps the company address subsequent battles.This quote from co-CEO Greg Peters in the Q1 2024 earnings call sheds some light on how Netflix goes about iterating its machine:
And I would say we're generally taking our entire playbook, everything that we've learned about how do you grow members and we're applying it to our ads tier now.
2.0 Netflix’s Next Stage
Netflix promises to meaningfully increase engagement and thus earning power by fostering a one-to-one relationship with users and multiplying the surface area of its intellectual property.
In 2022, Netflix also cracked down on password sharing to avoid users piggybacking the accounts of relatives and friends. This has enabled Netflix to go from diffusely addressing everyone in the household to developing a one-to-one relationship with each individual customer, thus vastly expanding optionality.
Such a move has the potential to dramatically increase Netflix’s earning power over the long run by multiplying the surface area of its intellectual property, just as Disney has done in the past by introducing theme parks. By having a direct communication channel with each end user, Netflix can now deploy additional entertainment verticals at a marginal cost.
In 2021 Netflix made strides in the gaming industry by acquiring several gaming studios. Gaming provides an avenue for fans to spend much more time interacting with intellectual property and, more importantly, gives way to the creation of communities. Communities generate user-driven content which brings in additional users at a marginal cost.
Thus, gaming not only promises to enable Netflix to increase the average revenue per member but also to decrease the cost of acquiring new fans which then can feed back into its traditional show business. This move may have a considerable impact on Netflix’s unit economics over the coming decade, with much of its gaming revenue accruing to the bottom line.
Much like in the movie business, the gaming industry’s greatest cost is acquiring gamers. Certainly, Netflix has the user base to funnel customers into games of its choosing. Still, and most importantly, it can apply its machine (the combination of the intellectual property and distribution engines) to grow the gaming business intrinsically.
For Netflix, the complexity of applying its flywheel to the gaming space is marginal and accretive to its financials. For competitors, profitably emulating the flywheel becomes exponentially harder. They now have to get it right along two verticals instead of one. The pressure to move towards ads, with the turmoil of building out an ad-tech stack, further accentuates the difficulty.
We want to really grow our engagement by many multiples of where it is today over the next handful of years.
-Greg Peters, Netflix co-CEO during the Q3 2023 earnings call.
Given the similarities of the movie and gaming businesses, I believe that Netflix will succeed in time. In Q4 2023, according to management, Netflix was among the top mobile downloads for a few weeks following the launch of the Grand Theft Auto saga (3rd party), along with some proprietary games like Money Heist and La Casa de Papel.
Netflix is off to a great start and, to date, management has demonstrated great discipline in reinvesting back into the business, with steadily rising margins despite an exponential increase in content spend, which I cover in the next section. For now, management claims that investment in games is small but will grow in line with the business over time:
[If] we continue to see this level of engagement growth and we continue to see what we've been seeing so far, which is evidence, as we would expect, that, that engagement leads to business benefits like increased retention, then we'll be able to scale that investment appropriately.
[…]
And it's worth noting that our games investment is a very small fraction of our overall content budget right now.
-Greg Peters, Netflix co-CEO during the Q4 2023 earnings call.
In turn, Netflix is still at less than 10% of TV hours, even in its most mature markets. Management estimates that Netflix captures less than 5% of consumer spending in movies, shows, and games. Even at a market cap of $241B, Netflix has a long runway ahead and can multiply its valuation considerably from here. In turn, as automation kicks in across the economy, I expect its TAM (total addressable market) to get much bigger.
3.0 Financials
Netflix started printing cash when it became a global cultural powerhouse. Over the coming decade, its levels of free cash flow per share will broadly track its ability to influence culture worldwide.
Income and Cash Flow Statements
Over the long term, stocks broadly track free cash flow per share, so the latter is what we care about. A look at Netflix’s income statement reveals that the company began to print cash shortly after gross margins inflected in 2018. This happened just after Netflix won its first academy award in 2017, with the volume of awards steadily increasing in subsequent years.
Netflix started producing original content in 2013 and went global in 2016. Per the graph above, one can appreciate how gross margins have been trending since. The company has capitalized on the aforementioned cultural asymmetries that have allowed Netflix to keep increasing its content spend, while obtaining better margins.
Therefore, the way to gauge Netflix’s future cash flow per share is through an in-depth understanding of its ability to influence culture worldwide. The distribution methods and intellectual properties morph over time in ways that are unpredictable, but what truly matters is the total cultural impact on the other side of the equation.
Many Netflix investors in 2022 certainly did not think about this, so it’s a worthy mental model to explore.
In turn, Netflix has been sustainably producing positive cash from operations since 2020, ever since it then began to bring OpEx as a percentage of revenue under 21%, when it had previously come in in the 24% range from 2014 to 2019. The cultural asymmetries increased Netflix’s earning power and the increased leanness crystallized it into cash flow production.
It’s fundamental to observe that without the increased earning power, decreasing OpEx as a percentage of revenue would have made Netflix fall behind with respect to competitors. The fact that it was able to cut costs in relative terms and stay ahead confirms that success is the result of the cultural power brought about producing and distributing originals worldwide.
As previously explained, the source of Netflix’s cultural relevance is ultimately a more finely tuned intellectual property and distribution machine versus that of its competitors. In turn, the shift towards addressing end customers on a one to one basis and multiplying the surface area of the intellectual property will make the machine better by increasing user life time value and decreasing acquisition costs.
In turn, this should equate to expanded cultural power, as members spend more time engaging with Netflix’s intellectual property and into higher margins. I also expect the company to go beyond gaming and continue increasing the surface area of its intellectual property multi-dimensionally, via the deployment of subsequent verticals.
This should ultimately increase free cash flow per share levels over the long term.
Further, Netflix can for some time mute the effects of the bottom of declining gross margins by cutting costs. Therefore, the most direct measure of Netflix’s cultural power is gross margins, because they cannot be quite as easily adulterated. Regardless investors in 2022 had to endure a QoQ decline in gross margins from 39.58% in Q3 2023 to 31.18% in Q4 2023, but gross margins then came in at an all-time-high of 46.89% in Q1 2024.
What this proves is that key performance indicators can be quite noisy in the short term, from quarter to quarter, and that a qualitative understanding of the business is paramount. It seems natural that even the most excellent companies experience cyclicality in their capacity to innovate and deliver exceptional output, which is why wisdom is as important as intelligence in long term investing.
If one had interpreted the shift towards ads as a sign of weakness, the inclination to sell would’ve been higher. If one instead processed the pivot as a way to optimize for scale and strengthen the moat, the inclination would’ve been less so. It now seems that the former mental path was the right one.
4.0 Conclusion
Studying Netflix closely has taught me that one has to understand companies on a first principles basis, because eventually the market will test convictions thoroughly. I of course already knew this, but this is a particularly insightful case given Netflix’s incredible returns to shareholders since IPO - and just how quickly notable investors capitulated in 2022 with the company then bouncing back.
Further, a year after studying Netflix deeply for the first time I now see that Greg Peters and Ted Sarandos, the current co-CEOs, are worthy custodians of Netflix and its culture. The company seems to be operating in a fundamentally identical manner to how it operated under Reed Hastings, which means that we can likely expect excellent execution going forward.
Further, I see succession as the key enabler of long term thesis - so long as Netflix carries on producing more Gregs and Teds, the culture will probably be preserved and enhanced over time and returns will ensue. In turn, as folks around the world continue to work less hours per week, the opportunities Netflix will have to entertain the world will multiply over the coming decades.
My view is that at just over seven times sales and at a market cap of $241B, Netflix has a long runway ahead.
Until next time!
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