Netflix: The Most Valuable Lesson for Investors
Netflix: The Most Valuable Lesson for Investors
Q2 2024 Update
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Edited by Brian Birnbaum
Studying Netflix in depth reveals how we can make over 400 times our money on the stock market and then some.
Netflix provides investors with one of the more valuable lessons in recent memory. Namely, that companies obsessed with iteration, optimization, and the end customer tends to yield excellent long term returns; and, further, that despite bouts of fundamental underperformance and resulting pessimism in the stock market, the company will likely find its way back to excellence.
Netflix stock is up over 250% since the market temporarily decided that the company had lost its way. IPO (initial public offering) investors that sold in April 2022 missed out on an additional 41,000% return simply by missing one more year. Netflix serves as a lesson that, when it comes to long-term winners, trimming the flowers to water the weeds or bailing when things appear less favorable will almost certainly result in lower returns–often by orders of magnitude
The stock price increase has ultimately been driven by Netflix’s rising operating margin, which in Q2 2024 came in at 27.23%, up from 7% in Q4 2022.
What’s fascinating is that selling Netflix in early 2022 was a seemingly rational and well informed idea by all traditional standards. But operating margin trending to all time highs in the last two quarters is merely the result of Netflix simply carrying on with its operations. Investors totally missed the point. Digging into the Q2 2024 earnings call reveals that the main drivers have been a strong content slate and correspondingly increasing yields on its value–both of which being entirely quotidian aspects of Netflix’s operations.
For all the complexity involved in most quantitative analyses, investors that sold in April 2022 didn’t understand that Netflix would bounce back by being Netflix. This fiasco reveals the importance of deep qualitative analysis in achieving and protecting extraordinary long term returns.
Here’s what co-CEO Spencer Neumann said about this topic during the Q2 2024 earnings call about the revenue growth:
In terms of growth generally, there's probably kind of three key factors that drove member growth.
First, strong performance of our content slate, a wide variety of titles that delivered across genres and regions and I'm sure we'll talk more about that.
There was some positive impact from paid sharing that continues.
As we've said on recent calls, it's tougher and tougher to tease that out. We're clearly seeing healthy organic growth in the business, but we're also continuing to get better and better at translating improvements in our service into business value, including getting better and better at converting unpaid accounts.
There’s no way one could have foreseen this by only looking at the numbers in 2022. On the contrary, it’s entirely reasonable to ascertain the causality between a real focus on the end customer and great financials. The main premise behind all of my investments is that companies maintaining extraordinary organizational culture eventually yield world-class financials because they tend to find new ways to bring value to the market at defensible margins. Which certainly has been the case with Netflix.
The entertainment business consists of aggregating talent who work together based on a series of rules, otherwise known as culture. By protecting the autonomy of creatives and enabling executives to reliably franchise, entertainment businesses yield IP (intellectual property) and means to distribute it effectively to an audience. Over time this equates to entertainment, which if good enough, equates to free cash flow.
None of the components that you see in the graph below went markedly wrong during 2022. Netflix saw higher levels of competition and arguably went through an IP cold streak, but a review of this mental abstraction could have saved many investors from jumping out of a true compounder.
The question remains: How to spot a company that is organisationally excellent? This is essentially the main question that I answer in my Tech Stocks Goldmine course. In practice, these companies solve a growing volume of acute customer pains in a way that is increasingly harder to imitate at scale and profitably. The market thought Disney Plus and others could eat Netflix’s lunch, but the former bunch simply could not quite match Netflix.
During the Q2 2024 earnings call, management laid out Netflix’s competitive advantage very clearly. They deploy creative teams across the globe to produce local hits. Sometimes these local hits become a global phenomenon, returning many times their original investment. Netflix then reinvests this money to keep the flywheel spinning. In turn, Netflix constantly improves all aspects of their platform and content slate, further accelerating the flywheel.
It turns out that Netflix’s focus on the above infrastructure is superior to that of its competitors and so its overall capital efficiency is higher. Netflix is marginally better at producing hits and enhancing the user experience of its platform, such that over time this translates into an unfair advantage. Every dollar Netflix reinvests simply translates into more value for the end customer.
Of course, this analysis has the benefit of hindsight. But it serves as further validation of the method I use to spot undervalued companies with huge potential. Quantitatives are essentially the tip of the iceberg, while qualitatives hold the vast majority of the information required to obtain truly excellent returns.
Investors that sold in April 2022 are also likely to miss out on future returns. Indeed, Netflix has not only bounced back but is also gearing up to continue producing astounding returns over the next decade. I explain in my original Netflix deep dive how increasing profitability essentially consists of producing more IP (intellectual property) and increasing its surface area, so as to increase the amount of money the company makes per unit of IP, as depicted in the graph below.
If you find a way to multiply the surface area, you can yield a non-linear increase in value of the business.
Netflix moved into games two years ago and has now released more than 100 of them. 99 games are currently being developed. While the jury’s still out on their gaming results, we know that Netflix is executing the same playbook that brought great success with the production and distribution of its originals. Qualitatively speaking, therefore, the gaming business is powered by underlying drivers that are likely to equate to success.
Here’s what co-CEO Greg Peters said about this during the Q2 2024 earnings call:
And I think you've seen this trajectory with us before, whether it's been a new content genre like unscripted or film or maybe getting the content mix right for a particular country, you can think about Japan or India, which we're now in an amazing place through the hard work of our teams there.
We continually iterate, we refine our programming based on the signals we get from our members. And if you look over several years with that model, we can make a huge amount of progress.
Further, the gaming and the original production verticals are now set to synergize. Games can further grow fandom, which could spill over into the series and movies and vice versa. Hence, this new vertical not only promises to increase revenue per unit of IP, but also decrease the cost of user acquisition. Every additional vertical beyond the gaming business should continue to compound this dynamic.
So long as Netflix stays organisationally excellent, the future looks bright for shareholders.
Until next time!
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