Netflix: Why Selling Winners is (Likely) a BIG MISTAKE.
Q3 2024 ER Update
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Edited by Brian Birnbaum and an update of my Netflix re-deep-dive and Q2 2024 update.
Netflix continues to show investors the path to long-term wealth creation in the stock market.
I remain fascinated by the rebound of Netflix stock from the June 2022 lows, with the stock now up 371% since. At 24% in Q3 2024, Netflix’s trailing twelve month net income margin continues to trend up from 17.64% in Q3 2022. As I explain in my Netflix re-deep-dive, this performance is largely due to Netflix’s ability to exploit cultural asymmetries, producing content at a marginal cost in over 60 countries. If any piece goes viral, the reward is non-linear.
Co-CEO Ted Sarando’s remarks in the Q3 2024 call point to such:
This year, we've maintained very healthy engagement, about two hours of viewing per member per day, and engagement on a per owner household is up to the first three quarters of 2024.
[…]
So when we look forward into 2025 and beyond, we want to build on that success. We plan to build on that success.
And we've been making original programming now for more than a decade. And the core has become very strong. We have a team of people who are the best creative talent around the world. We have a culture and an operating model that allows us to create stories in more than 50 countries and thrill audiences of more than 600 million people all over the world.
Rather subtly, Netflix’s operations are more finely tuned than that of its competitors in producing and capturing the aforementioned asymmetries. This property got lost in the narrative that Netflix had lost its edge, which sent the stock down over 70% in the summer of 2022. Reviewing the Q3 2024 earnings report in depth continues to reveal no particular operational change versus 2022, as has been the case in my previous updates. Netflix simply continues to focus on acquiring more members and increasing engagement.
As I explain in my previous Duolingo update, the absence of any particular drivers coupled with notable outperformance indicates either organizational excellence or temporary secular tailwinds. Netflix falls clearly within the former camp. The company is more obsessed with delighting end consumers than others. And, ultimately, the higher levels of consumer satisfaction equate to financial rewards.
I was among the individuals in the summer of 2022 that could not see the superiority of Netflix’s operational algorithm. It was extremely hard to see that marginal superiority in producing and distributing content would lead to the level of financial outperformance we see now. It was even harder to see that, without meaningfully altering its operational framework, Netflix would attain higher levels of capital efficiency than in 2020, when Netflix held an unprecedentedly captive audience.
There’s a huge lesson here.
Despite increased competition in 2022, Netflix’s organisational properties had not degraded in any form. Netflix was as focused as it had ever been on delighting the end consumer. Although Netflix’s widely-acclaimed competitive position before 2022 was technically the result of being the first entrant in the streaming market, at a deeper level, they entered the space in the first place due to superior focus on end consumers versus competitors in the broader entertainment space. The lesson to be learned is that so long as organisational properties remain intact, financial rewards likely await in the future - this was definitely the case with Meta in late 2022 as well.
As a result, selling winners is usually a big mistake.
This is one of the main premises of my Tech Stock Goldmine course, in which I’ve taught hundreds of students to date how to identify winners in the tech space early. Indeed, there is no guarantee that the above equation will hold every time. But in my research I have found that extraordinary organisational properties are a strong predictor of financial outperformance. Consider the graph below, in which you can see how Costco’s return on total capital outpaced that of Walmart in the 2011-2016 period.
As is the case with Netflix, there was no particular driver that led to this outperformance. Costco’s superior focus on delivering value to customers at a lower real cost has equated into the below inflection. This was as unpredictable as the resurgence of Netflix’s financial performance–except that both are driven by the same intangible force.
On January 2022 I wrote my Amazon deep dive, with the stock down nearly 50% from its previous highs. In this case, I did understand Amazon’s operational algorithm in depth and this enabled me to foresee that the company’s ability to deploy capital was untarnished. Indeed, much of the decline in the FCF/share levels that you can see in the graph below was due to Amazon stepping up its CapEx, to effectively double the size of its fulfilment network. In the deep dive I ultimately explained that Amazon’s unmitigated organisational properties all but guaranteed that FCF/share would not only rebound but reach new highs.
As you can see in the graph below, FCF/share exceeded the pre-2022 highs and the stock is up 116% since I wrote my deep dive. Similar to Netflix and Costco, this was unforeseeable by traditional quantitative means. Only qualitative factors can predict quantitative futures, and a superior focus on delighting end consumers equates to superior financials.
My students take from the Tech Stock Goldmine course an invaluable ability to evaluate organisational properties over time, allowing them to separate the winners out from the market’s mass of mediocrity.
Much of any company’s success comes down to whether a given management team does what it said they will do. On the last call, Netflix co-CEO Greg Peters said the following about the company’s focus on end-consumers:
Just jumping on that, we've always been focused on trying to constantly improve every aspect of our service. It served us quite well for the last 1.5 decades. We hope and expect it will serve us well for decades to come.
And then the question I may mention priorities, too. And our top priority is really bringing that mindset to improving our core film and series offering.
It thus seems that Netflix is now looking to embed its operational algorithm deeper into its content production efforts. So long as management executes, the odds are high that Netflix will enhance its earning power over time.
In the meantime, Netflix is deploying its operational algorithms across three new business lines: games, live content, and advertising. I believe odds are high that Netflix will multiply its earning power over the coming decade by enhancing and channeling its algorithm across these new segments.
When asked in the Q3 2024 call when advertising was going to evolve into a major revenue source, Netflix co-CEO Greg Peters answered by elegantly depicting the opportunity that lies ahead for Netflix:
So it starts to become a material contributor of revenue over the next several years. But if you step back and you think about this opportunity ahead of us, over $600 billion in consumer spend in the areas and countries that we operate. We're only capturing roughly 6% to 7% of that today. That's a tremendous upside if we can just stay focused on that continuous improvement and drive to that future.
Thus, the second main lesson to be learned from the Netflix case is that the losses from selling a winner early tend to compound over time. With no cultural or operational degradation in sight, it seems that Netflix is poised to capture the above opportunity. As a result, the size of the total mistake for those that sold at the June 2022 lows is likely to get much bigger. Because a small minority of stocks yield the vast majority of returns, it would be extremely difficult to replace a Netflix sold at recent lows.
Additionally, both the Netflix and Amazon cases illustrate that the ultimate test of a company’s culture (and thus of its operational algorithm) is its succession engine. Their respective co-founders, Reed Hasting and Jeff Bezos, stepped down in 2022, exacerbating the dramatic declines of both stocks in the second half of the year. With execs from within each company stepping up, both new CEOs have spent decades soaking up company cultures. It’s much likelier, as a result, that they’ll be capable custodians.
Not surprisingly, this is also the case withCostco. Two CEOs have followed the departure of co-founder Jim Sinegal in 2012, and both have led the company well. Current Costco CEO Ron Vachris’s remarks during the Q4 FY2024 call reveal how he also places great emphasis on the succession engine:
Succession planning continues to be a key focal point for us, as we're continually working on identifying the future leaders of our company.
In fiscal year 2024, we promoted 95 new warehouse managers. 85% of those promoted, started at Costco as an hourly employee. This promote from within culture and the long-term career it helps to build is core to who we are as a company, community member, and retailer.
Until next time!
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