Netflix Coverage Initiation Report
Author: Ross Griffiths, Published: December 15, 2016 at 10:30pm EST, Category: Coverage Initiation
I am initiating my coverage of Netflix Inc (NASDAQ:NFLX) with a Hold rating, and target price of $126, based on a 20x Price-Earnings ratio applied to my 2020 earnings forecast and a Discounted Cash Flow valuation.
Having launched in more than 130 new countries, Netflix is now a global provider of subscription video on-demand (SVOD) services. Management is pursuing a strategy of aggressive international growth with operations now reaching over 190 countries, and an expanding content budget expected to reach $6B(1) in 2017. The business faces key challenges in achieving international subscriber growth, however, recent results in new markets have been encouraging. Netflix is already a market leader in providing original content at a lower cost to the end user, and the business will likely have sufficient flexibility in its model to meet short-term challenges, as well as scope for further capital raising, being currently underleveraged relative to its peers.
Competitive Landscape
Netflix is a market leader in the SVOD space but faces competition, particularly in its domestic market, from operators such as Amazon Prime, Hulu, and HBO, with YouTube also frequently cited by company executives for its leadership in localization and language-specific capabilities. In terms of international and global expansion, however, the company has stolen a march on its rivals. Whist a stated ambition of Hulu and Amazon Prime Instant Video is to make their content offerings available internationally, at present the competitive threat they pose is very much centered on the domestic market(2). It is possible quite possible that in the long-term Netflix and Amazon Prime could rival one another as the largest players in the SVOD space internationally. A global expansion of Amazon Prime Instant Video is anticipated following the announcement that the company’s flagship original program The Grand Tour will be available to stream in over 200 countries(3).
Increases in content spending at Netflix have thus far been financed through cash reserves and issuance of debt. Underleveraged in comparison with rivals with a debt-to-total capital ratio currently near 5%, the company’s 5.875% (4) February 2025 bonds (NFLX4335215) continue to trade at a premium(3), and there is sufficient room for further expansion of the content budget as paid membership increases. We view this as an important source of competitive strength, with a high-quality library and sought-after original content already proving vital in attracting new membership and controlling ‘churn’. Netflix has gone through a period of consolidation in its library with the number of titles shrinking by close to 50% since 2012, coupled with a shift in emphasis to original content which management expects to expand to a 50/50 ratio for original/licensed content.
Having announced an increase in its content budget to an estimated $6B on a P&L basis for 2017, Netflix leads the field in film and program spending, beaten only by sports broadcaster ESPN in terms of content spending by TV and SVOD networks, in spite of Amazon having pledged to double its spending on video content. Being able to match the spending power of Amazon Prime Instant Video and Hulu which are backed by larger entities(5) is vital for Netflix in maintaining the quality of its library and original content. The company has invested heavily in content production, with shows such as The Crown and Narcos being produced at an estimated $10M and $7M per episode respectively, in comparison with Amazon’s The Grand Tour, which costs an estimated $7-8M per episode. Risk is increasing though from bidding competition for licensed and original content. Amazon also may not require its Instant Video service to be profitable on a standalone basis, particularly in the short-term, or whether it may be willing to spend heavily to gain market share internationally for its Prime service.
Generating the membership growth to sustain a competitive spending capability is paramount as the Netflix is expected to be a net consumer of cash in the near-term. Management has guided Free Cash Flow for calendar year 2016 of to an outflow of $1.5B. Extracting value from content spending will be equally important for SVOD providers across the industry.
Earlier this year, Morgan Stanley surveyed 2,500 people for their opinions on the providers of the best original programming for premium TV and internet video subscription services. Netflix was the highest ranked with 29% of respondents, followed by HBO on 18%, while Hulu, Amazon and Showtime received 4-5% each. Netflix has also received recognition across a wide range of content, picking up 54 nominations at the 2016 Emmy awards (up from 34 in 2015). While Amazon has received critical acclaim, and beat Netflix in total of Emmy awards in 2015, the range of content for which the studio was nominated was significantly narrower, with all 5 of the 2015 awards received for comedy Transparent. This provides cause for optimism on the company’s prospects, however investors should continue to monitor spending on content. The original series The Get Down, experience significant budget over-runs and was produced at an eventual cost of $16M per episode.
In the second quarter of 2016, Netflix announced a deal that would make the company the U.S. subscription payment broadcaster of content for Disney, Pixar and Marvel. The popularity of content from such producers is a source of competitive advantage in attracting subscribers, but also offers an opportunity for family viewing and engendering brand loyalty with users who are not the subscription payers within their household. Accurate estimates of the extent to which this may boost subscriptions in coming years are difficult to conduct, but industry analysts have remarked upon the potential for subscription growth from users migrating to their own memberships from those of their families.
Netflix is a market leader in the SVOD space but faces competition, particularly in its domestic market, from operators such as Amazon Prime, Hulu, and HBO, with YouTube also frequently cited by company executives for its leadership in localization and language-specific capabilities. In terms of international and global expansion, however, the company has stolen a march on its rivals. Whist a stated ambition of Hulu and Amazon Prime Instant Video is to make their content offerings available internationally, at present the competitive threat they pose is very much centered on the domestic market(2). It is possible quite possible that in the long-term Netflix and Amazon Prime could rival one another as the largest players in the SVOD space internationally. A global expansion of Amazon Prime Instant Video is anticipated following the announcement that the company’s flagship original program The Grand Tour will be available to stream in over 200 countries(3).
Increases in content spending at Netflix have thus far been financed through cash reserves and issuance of debt. Underleveraged in comparison with rivals with a debt-to-total capital ratio currently near 5%, the company’s 5.875% (4) February 2025 bonds (NFLX4335215) continue to trade at a premium(3), and there is sufficient room for further expansion of the content budget as paid membership increases. We view this as an important source of competitive strength, with a high-quality library and sought-after original content already proving vital in attracting new membership and controlling ‘churn’. Netflix has gone through a period of consolidation in its library with the number of titles shrinking by close to 50% since 2012, coupled with a shift in emphasis to original content which management expects to expand to a 50/50 ratio for original/licensed content.
Having announced an increase in its content budget to an estimated $6B on a P&L basis for 2017, Netflix leads the field in film and program spending, beaten only by sports broadcaster ESPN in terms of content spending by TV and SVOD networks, in spite of Amazon having pledged to double its spending on video content. Being able to match the spending power of Amazon Prime Instant Video and Hulu which are backed by larger entities(5) is vital for Netflix in maintaining the quality of its library and original content. The company has invested heavily in content production, with shows such as The Crown and Narcos being produced at an estimated $10M and $7M per episode respectively, in comparison with Amazon’s The Grand Tour, which costs an estimated $7-8M per episode. Risk is increasing though from bidding competition for licensed and original content. Amazon also may not require its Instant Video service to be profitable on a standalone basis, particularly in the short-term, or whether it may be willing to spend heavily to gain market share internationally for its Prime service.
Generating the membership growth to sustain a competitive spending capability is paramount as the Netflix is expected to be a net consumer of cash in the near-term. Management has guided Free Cash Flow for calendar year 2016 of to an outflow of $1.5B. Extracting value from content spending will be equally important for SVOD providers across the industry.
Earlier this year, Morgan Stanley surveyed 2,500 people for their opinions on the providers of the best original programming for premium TV and internet video subscription services. Netflix was the highest ranked with 29% of respondents, followed by HBO on 18%, while Hulu, Amazon and Showtime received 4-5% each. Netflix has also received recognition across a wide range of content, picking up 54 nominations at the 2016 Emmy awards (up from 34 in 2015). While Amazon has received critical acclaim, and beat Netflix in total of Emmy awards in 2015, the range of content for which the studio was nominated was significantly narrower, with all 5 of the 2015 awards received for comedy Transparent. This provides cause for optimism on the company’s prospects, however investors should continue to monitor spending on content. The original series The Get Down, experience significant budget over-runs and was produced at an eventual cost of $16M per episode.
In the second quarter of 2016, Netflix announced a deal that would make the company the U.S. subscription payment broadcaster of content for Disney, Pixar and Marvel. The popularity of content from such producers is a source of competitive advantage in attracting subscribers, but also offers an opportunity for family viewing and engendering brand loyalty with users who are not the subscription payers within their household. Accurate estimates of the extent to which this may boost subscriptions in coming years are difficult to conduct, but industry analysts have remarked upon the potential for subscription growth from users migrating to their own memberships from those of their families.
Potential Acquisition Target
Netflix has been rated as a potential takeover target, with companies such as Google, Apple and, predominantly, Disney speculated as potential acquirers. Of the companies suggested, Disney may be the more logical buyer. However, there are hurdles to such a deal, particularly as the structure would need to be heavily stock-based, and so potentially very dilutive, accounting for Netflix’ $50B market cap and Disney’s cash balance of $5.23B as of September 30, 2016. There is appeal for Disney in terms of leveraging Netflix’ technology to access the consumer, but as the deal to license their content to Netflix unfolds, they already have avenues to meet this goal. In addition, bringing Netflix on board may prove cannibalistic to Disney’s core TV network operation. A deal certainly is plausible, though the expense may prove to be a stumbling block. In addition, the main driver behind a deal would be the acquisition of Netflix’s technological platform and production studio, leaving costly liabilities for licensed content which will not be greatly additive to the business. Therefore, it is unlikely that a deal to aquire Netflix will be announced in the near-term.
Netflix has been rated as a potential takeover target, with companies such as Google, Apple and, predominantly, Disney speculated as potential acquirers. Of the companies suggested, Disney may be the more logical buyer. However, there are hurdles to such a deal, particularly as the structure would need to be heavily stock-based, and so potentially very dilutive, accounting for Netflix’ $50B market cap and Disney’s cash balance of $5.23B as of September 30, 2016. There is appeal for Disney in terms of leveraging Netflix’ technology to access the consumer, but as the deal to license their content to Netflix unfolds, they already have avenues to meet this goal. In addition, bringing Netflix on board may prove cannibalistic to Disney’s core TV network operation. A deal certainly is plausible, though the expense may prove to be a stumbling block. In addition, the main driver behind a deal would be the acquisition of Netflix’s technological platform and production studio, leaving costly liabilities for licensed content which will not be greatly additive to the business. Therefore, it is unlikely that a deal to aquire Netflix will be announced in the near-term.
Outlook
Overall I am positive on the outlook for Netflix. The company has grown its streaming service well since 2007 and despite some missteps, has managed its transition well from a premium video distribution channel to a subscription video streaming service accounting for 35% of U.S. prime-time broadband downstream traffic. The proliferation of high-speed internet connectivity internationally offers significant opportunity for what has proven to be a globally scalable product. The company has a coherent strategy for its growing international business, trying to avoid competition with local producers and targeting an 80/20 split between producing Western and local content, but exercising discretion in certain localities such as Japan where the split is much closer to 50/50. Original series have performed proportionately well internationally, and the company expects this level of popularity to continue. Netflix’ well-reviewed browsing experience and use of data analytics to match users with suggested shows can play a role in this as new users can be directed toward recommended content to minimize browsing time.
The company’s growth has made it a household name internationally, and it is expected that revenue growth will outpace that of marketing expense, with an overall contribution margin of 40% by 2020. I believe that internationally, we will see higher ‘churn’ relative domestic, but expect this to follow the pattern of the U.S. streaming business and settle over time. The U.S. business has now un-grandfathered in excess of 75% of members on older deals, so I expect the domestic market to revert to a normal level of churn. The variability in quarterly subscription growth should continue, particularly internationally, but a convergence between the underlying organic growth rates of the domestic and international businesses should occur over time. I agree with CEO Reed Hastings’ assertion of steadiness in net subscription adds over 3 and 4 quarter periods, with individual quarters proving volatile. However, as the streaming business matures I expect management guidance to factor in these fluctuations and for earnings shocks to become less frequent.
Overall I am positive on the outlook for Netflix. The company has grown its streaming service well since 2007 and despite some missteps, has managed its transition well from a premium video distribution channel to a subscription video streaming service accounting for 35% of U.S. prime-time broadband downstream traffic. The proliferation of high-speed internet connectivity internationally offers significant opportunity for what has proven to be a globally scalable product. The company has a coherent strategy for its growing international business, trying to avoid competition with local producers and targeting an 80/20 split between producing Western and local content, but exercising discretion in certain localities such as Japan where the split is much closer to 50/50. Original series have performed proportionately well internationally, and the company expects this level of popularity to continue. Netflix’ well-reviewed browsing experience and use of data analytics to match users with suggested shows can play a role in this as new users can be directed toward recommended content to minimize browsing time.
The company’s growth has made it a household name internationally, and it is expected that revenue growth will outpace that of marketing expense, with an overall contribution margin of 40% by 2020. I believe that internationally, we will see higher ‘churn’ relative domestic, but expect this to follow the pattern of the U.S. streaming business and settle over time. The U.S. business has now un-grandfathered in excess of 75% of members on older deals, so I expect the domestic market to revert to a normal level of churn. The variability in quarterly subscription growth should continue, particularly internationally, but a convergence between the underlying organic growth rates of the domestic and international businesses should occur over time. I agree with CEO Reed Hastings’ assertion of steadiness in net subscription adds over 3 and 4 quarter periods, with individual quarters proving volatile. However, as the streaming business matures I expect management guidance to factor in these fluctuations and for earnings shocks to become less frequent.
Overview of Financials and Underlying Valuation Model Assumptions
I calibrated my Netflix model to reflect my forecast for paid membership growth for the domestic and international streaming segments, with a constant decline in DVD services. Management has stated their belief that U.S. streaming membership can grow to between 60M and 90M paid subscriptions. I am optimistic for the company’s prospects and have forecasted quarterly growth rates to meet membership levels near the top of management’s estimate by the end of my forecast period, while also reflecting the seasonality apparent in past membership growth. Domestic Streaming Revenue per Paid Member has been trending toward the price of a standard membership, so I have forecasted that this will be reached in the fourth quarter of 2017 and maintained for a period until management introduces price increases (estimated to be in the first quarter of 2019). I assume stability in Domestic contribution margins, growing slowly at the end of my forecast period as the domestic business settles and the company is able to reduce costs, also reflected in my assumption for a concurrent fall in marketing costs.
The opportunities in the international streaming market and my confidence in the company’s ability to attract subscriptions underpin my assumption that this segment can grow to roughly twice the size of the Domestic streaming business by the end of the forecast period. My quarterly growth forecasts again reflect this and the seasonality of membership growth, culminating in a 2021 ending membership of 166.4M International paid subscribers versus 82M Domestic. I am forecasting a convergence in the contribution margin of the International Streaming business with the Domestic by the end of the forecast period, and a convergence of revenue per user with the price of a standard membership by 2018, with price increases lagged by a year compared with the domestic market.
Remaining items within the Segment Data do not have a material impact on the Income Statement, and the Domestic DVD business is a small and shrinking segment in terms of both membership and revenue. I have therefore only forecasted a constant rate of decline in paid memberships for this segment, estimating a membership of 2M at the end of the forecast period.
I calibrated my Netflix model to reflect my forecast for paid membership growth for the domestic and international streaming segments, with a constant decline in DVD services. Management has stated their belief that U.S. streaming membership can grow to between 60M and 90M paid subscriptions. I am optimistic for the company’s prospects and have forecasted quarterly growth rates to meet membership levels near the top of management’s estimate by the end of my forecast period, while also reflecting the seasonality apparent in past membership growth. Domestic Streaming Revenue per Paid Member has been trending toward the price of a standard membership, so I have forecasted that this will be reached in the fourth quarter of 2017 and maintained for a period until management introduces price increases (estimated to be in the first quarter of 2019). I assume stability in Domestic contribution margins, growing slowly at the end of my forecast period as the domestic business settles and the company is able to reduce costs, also reflected in my assumption for a concurrent fall in marketing costs.
The opportunities in the international streaming market and my confidence in the company’s ability to attract subscriptions underpin my assumption that this segment can grow to roughly twice the size of the Domestic streaming business by the end of the forecast period. My quarterly growth forecasts again reflect this and the seasonality of membership growth, culminating in a 2021 ending membership of 166.4M International paid subscribers versus 82M Domestic. I am forecasting a convergence in the contribution margin of the International Streaming business with the Domestic by the end of the forecast period, and a convergence of revenue per user with the price of a standard membership by 2018, with price increases lagged by a year compared with the domestic market.
Remaining items within the Segment Data do not have a material impact on the Income Statement, and the Domestic DVD business is a small and shrinking segment in terms of both membership and revenue. I have therefore only forecasted a constant rate of decline in paid memberships for this segment, estimating a membership of 2M at the end of the forecast period.
Balance Sheet
The company issued $1B of new debt in October of 2016, which is reflected in my fourth quarter long-term debt balance. In spite of the company remaining underleveraged, I do not anticipate further entry into the credit markets in the near future and feel that they will be able to manage their cash flow. While I am modeling extensive cash consumption in the near and mid-term, I see positive cash generation returning in the fourth quarter of 2018. Changes to the Balance Sheet are predominantly driven by content assets and liabilities. Smaller, less material line items such as Other Current/Non-Current Assets & Liabilities, and Short-Term Investments are held constant throughout the forecast period, and aside from the aforementioned debt issue in the fourth quarter of 2016, there are no changes to long-term debt prior to the repayment of the $500M principal on the January 2021 5.375% fixed rate bond. The treatment of content assets and liabilities are addressed in the following discussion on the Cash Flow Statement.
The company issued $1B of new debt in October of 2016, which is reflected in my fourth quarter long-term debt balance. In spite of the company remaining underleveraged, I do not anticipate further entry into the credit markets in the near future and feel that they will be able to manage their cash flow. While I am modeling extensive cash consumption in the near and mid-term, I see positive cash generation returning in the fourth quarter of 2018. Changes to the Balance Sheet are predominantly driven by content assets and liabilities. Smaller, less material line items such as Other Current/Non-Current Assets & Liabilities, and Short-Term Investments are held constant throughout the forecast period, and aside from the aforementioned debt issue in the fourth quarter of 2016, there are no changes to long-term debt prior to the repayment of the $500M principal on the January 2021 5.375% fixed rate bond. The treatment of content assets and liabilities are addressed in the following discussion on the Cash Flow Statement.
Cash Flow Statement
I believe that the company will be a net cash consumer in the near-term, and forecast positive movement in the company’s cash balance to return in fourth quarter of 2018. Management has guided Free Cash Flow of -$1.5B for the year ending December 2016, and the company’s cash consumption profile is integral to my valuation. Cash Flow from Operations (CFO) is the key driver to the overall Cash Flow Statement, but without greater access to the company, a number of the line items within this section are not possible to predict with any certainty. The overall impact of these items (Stock-Based Compensation Expense, Deferred Taxes etc.), however, is relatively muted, and as such, I am comfortable that forecasts for the material line items within CFO (Additions to streaming content library, and Change/Amortization of streaming content liability) provide a solid foundation for overall estimates of the company’s cash consumption/generation.
Net Income is carried forward from the Income Statement as the basis for the indirect method of reconciling CFO, and items including Depreciation & Amortization, Purchases of PP&E and changes in Other Assets/Liabilities are estimable through examining historical ratios, or directly from the Balance Sheet as below.
The company has invested heavily in its content library, and I expect this level of investment will remain high in the near-term, but decrease to a stable rate by the end of my forecast period (I model the cash expense of additions to the company’s content library decreasing to 60% of revenues by the end of 2020, down from 100% in my 2016 estimate). Incremental decreases in this rate, in line with my estimates for subscription growth, align the forecasts on the cash consumption profile of the company in the near-term and beyond (FCF at -$1.5B for 2016 in line with management guidance, and -$1.0B for 2017 before turning positive in fourth quarter of 2018). Changes in Streaming Content Liabilities have trended close to 25%, so I believe it to be a fair assumption to hold this rate constant, likewise for Amortization of Streaming Content Liabilities at close to 50%.
To incorporate these estimates into the Balance Sheet, I apply the Additions to streaming content library, minus the Amortization of the content liability, as increases in Content Assets and apportion this between Current and Non-Current based on the previous quarter’s ratio. Changes in Streaming Content Liabilities are apportioned to Current/Non-Current Content Liabilities in the same way and provide a link between spending and revenue growth.
CFF is unmoved for forecast periods save debt issues and repayments, and reflects my view that the company will not be required to raise capital either through a debt or equity issue in the near-term. CFI is much smaller portion of cash flow statement and the only line item I have forecasted is purchase of PPE. I believe that 15% (a much lower number than in previous years) is appropriate, and the materiality of this line item to the overall Cash Flow Statement is small and shrinking as CFO grows.
I believe that the company will be a net cash consumer in the near-term, and forecast positive movement in the company’s cash balance to return in fourth quarter of 2018. Management has guided Free Cash Flow of -$1.5B for the year ending December 2016, and the company’s cash consumption profile is integral to my valuation. Cash Flow from Operations (CFO) is the key driver to the overall Cash Flow Statement, but without greater access to the company, a number of the line items within this section are not possible to predict with any certainty. The overall impact of these items (Stock-Based Compensation Expense, Deferred Taxes etc.), however, is relatively muted, and as such, I am comfortable that forecasts for the material line items within CFO (Additions to streaming content library, and Change/Amortization of streaming content liability) provide a solid foundation for overall estimates of the company’s cash consumption/generation.
Net Income is carried forward from the Income Statement as the basis for the indirect method of reconciling CFO, and items including Depreciation & Amortization, Purchases of PP&E and changes in Other Assets/Liabilities are estimable through examining historical ratios, or directly from the Balance Sheet as below.
The company has invested heavily in its content library, and I expect this level of investment will remain high in the near-term, but decrease to a stable rate by the end of my forecast period (I model the cash expense of additions to the company’s content library decreasing to 60% of revenues by the end of 2020, down from 100% in my 2016 estimate). Incremental decreases in this rate, in line with my estimates for subscription growth, align the forecasts on the cash consumption profile of the company in the near-term and beyond (FCF at -$1.5B for 2016 in line with management guidance, and -$1.0B for 2017 before turning positive in fourth quarter of 2018). Changes in Streaming Content Liabilities have trended close to 25%, so I believe it to be a fair assumption to hold this rate constant, likewise for Amortization of Streaming Content Liabilities at close to 50%.
To incorporate these estimates into the Balance Sheet, I apply the Additions to streaming content library, minus the Amortization of the content liability, as increases in Content Assets and apportion this between Current and Non-Current based on the previous quarter’s ratio. Changes in Streaming Content Liabilities are apportioned to Current/Non-Current Content Liabilities in the same way and provide a link between spending and revenue growth.
CFF is unmoved for forecast periods save debt issues and repayments, and reflects my view that the company will not be required to raise capital either through a debt or equity issue in the near-term. CFI is much smaller portion of cash flow statement and the only line item I have forecasted is purchase of PPE. I believe that 15% (a much lower number than in previous years) is appropriate, and the materiality of this line item to the overall Cash Flow Statement is small and shrinking as CFO grows.
Share Valuation
With a target value of $126 and the share price as at completion of this report at $125, I am initiating my coverage of Netflix with a HOLD rating, based on a WACC of 6.7% and a stock price 3-year daily volatility of 2.7%.
With a target value of $126 and the share price as at completion of this report at $125, I am initiating my coverage of Netflix with a HOLD rating, based on a WACC of 6.7% and a stock price 3-year daily volatility of 2.7%.
| Ross Griffiths NFLX Model.xlsx |
Footnotes
(1) Management guidance of $6B content budget for 2017 (on P&L basis) in Q3 shareholder letter.
(2) Hulu is currently available only in the US and some overseas US Military bases, and Amazon Prime only in US, UK, Japan, Austria and Germany (with India announced).
(3) On November 14th 2016, Amazon announced in a Youtube video that The Grand Tour would be available to watch in over 200 countries.
(4) As at 11/28/2016, trading at price of $107.50 with yield of 4.76% Source: Morningstar
(5) Hulu ownership structure as at publication: Fox (32%), Comcast (29%), Disney (29%), Time Warner (10%)
(1) Management guidance of $6B content budget for 2017 (on P&L basis) in Q3 shareholder letter.
(2) Hulu is currently available only in the US and some overseas US Military bases, and Amazon Prime only in US, UK, Japan, Austria and Germany (with India announced).
(3) On November 14th 2016, Amazon announced in a Youtube video that The Grand Tour would be available to watch in over 200 countries.
(4) As at 11/28/2016, trading at price of $107.50 with yield of 4.76% Source: Morningstar
(5) Hulu ownership structure as at publication: Fox (32%), Comcast (29%), Disney (29%), Time Warner (10%)
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The author of this article has no financial investment or other conflict of interest related to the subject company or other companies discussed. Any views made or implied in this article represent the author’s opinions. Click here to visit Ross' Contributor page.
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