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<\/figure><\/div>\n\n\nNetflix has a unique business model.<\/mark><\/strong> It absolutely disrupted the media industry and the way that customers consume content forever.<\/p>\n\n\n\n Even with this fact, we can still estimate a valuation without calling an analysis of its financials impossible.<\/p>\n\n\n\n This post will cover the following [Click to Skip Ahead<\/em>]:<\/p>\n\n\n\n You probably want a deeper understanding of accounting if you truly want to grasp this post. Try reading about depreciation and amortization<\/a><\/strong> first if that’s you. I promise it will be well worth your time, especially when you consider how much Netflix has been investing in its own exclusive content, and how that is integral to its future financials.<\/p>\n\n\n\n The vast majority of Netflix\u2019s revenues comes from paid subscriptions to its streaming service. Most of us know about the company\u2019s streaming service. It provides instant access to a vast library of movies and bingeable TV series on any paid customer\u2019s internet-connected device.<\/p>\n\n\n\n This service has been so successful that as of 4\/19\/2022<\/strong>, Netflix now boasts 221.64 million<\/strong> paid memberships in over 190 countries. In fact, check out these insane <\/strong>growth numbers on their paid memberships (annually):<\/p>\n\n\n\n\n\n\n\n To answer the question of Netflix\u2019s stock valuation before going super deep into the accounting weeds (which we will do below), we need to realize that it\u2019s not just subscriber numbers which drive the company\u2019s stock value.<\/p>\n\n\n\n It\u2019s the fact that the company can, and has, significantly improved profitability margins over time through long term investment in content assets.<\/p>\n\n\n\n Since a great TV series or movie only needs to produced once and can provide significant long term value for customers indefinitely, the costs to produce content are less about recurring expenses and more like long term investments.<\/p>\n\n\n\n Really good content can have a very long shelf life\u2014just think about how many people still binge TV shows like Friends or The Office. Original Netflix shows include Stranger Things and Squid Game.<\/p>\n\n\n\n As Netflix spends less on investments in great content, it can vastly expand its profitability, which drives huge bursts of growth to the company\u2019s Earnings and Earnings Per Share. That\u2019s great for valuation.<\/p>\n\n\n\n In fact, that process is already in the works, evidenced by the company\u2019s Operating Margin:<\/p>\n\n\n\n Finally, as customers stay longer with the service, the recurring nature of a subscription business increases the ARPU (Average Revenue Per User)<\/a><\/strong>, assuming the company can keep churn (subscription cancellations) down. Netflix has also seen nice growth in their ARPU:<\/p>\n\n\n\n All of this has boosted Operating Margin for the company in the last 5 years and could continue to drive huge gains in EPS in addition to its fantastic revenue growth rates it has seen lately (posting because they are also truly incredible):<\/p>\n\n\n\n Revenue Growth YOY<\/strong><\/p>\n\n\n\n The key to answering the Netflix stock valuation question is through analyzing the company\u2019s content assets. If content produced in-house is fully amortized at cost, yet continues to drive new subscribers and retention (think a hit series like Game of Thrones or Netflix-produced Stranger Things), then the company\u2019s balance sheet is likely severely undervaluing these assets.<\/p>\n\n\n\n With enough legacy content assets which drive additional profitability for the company, Netflix could probably continue to increase its operating margin by reducing future content spending and lowering Cost of Revenues (similar to COGs), which increases Gross Margin and flows down to Free Cash Flow.<\/p>\n\n\n\n This screenshot shows the balance of Netflix\u2019s content assets between licensed (third-party) and produced (in-house):<\/p>\n\n\n We could track amortization of these produced content assets over time; another way to measure this is to monitor ROIC over time.<\/p>\n\n\n\n An invested capital calculation for Netflix is not the same as an average company; we must include content assets as part of Invested Capital<\/a>. This is because PPE (Plant, Property, and Equipment)<\/a> doesn\u2019t sufficiently include Netflix\u2019s real capital outlays to maintain and grow profitability. If some content assets fully amortize at cost over time, and these content assets indeed drive retention and new accounts, then the Invested Capital part of ROIC gets held constant while NOPAT (profitability) in the numerator<\/a> continues to increase, driven by both revenue growth and the expanding margins discussed above.<\/p>\n\n\n\n This could trigger huge potential increases in future ROIC for the company, representing an incredible amount of future capital which can be returned to shareholders through buybacks and dividends, as the company reaches a cash cow status on its blockbuster TV series and movies investments.<\/p>\n\n\n The extent that Netflix\u2019s valuation can reflect this long term content asset thesis depends on how effective their in-house content assets can continue to drive retention and customer acquisition, which are major KPIs (Key Performance Indicators) followed by analysts and reported regularly by management.<\/p>\n\n\n\n As (or if) the ROI on legacy in-house assets declines as evidenced by these KPIs, the valuation for Netflix\u2019s stock can compress significantly as the projected incremental improvements in ROIC reverse in the exact opposite direction, compressing margins and reducing top-line growth which inevitably flows down to Free Cash Flows.<\/p>\n\n\n\n Whether these declines happen depends on a myriad of factors, many of which are quantified in Netflix\u2019s 10-k \u201cRisks\u201d section, which we need to analyze (and its influence on valuation) next.<\/p>\n\n\n\n Competition is fierce in the media and entertainment industry, as major players are fighting for not only market share and customer dollars, but share of customer attention and engagement.<\/p>\n\n\n\n A subscriber who spends more time on the Netflix platform should, in theory, be more likely to continue paying for their subscription, and also respond positively to any future price increases. This assumes, however, that the amount of new content on Netflix is able to satisfy this ideal subscriber\u2019s appetite for new and engaging content, making churn<\/strong> and customer satisfaction<\/strong> one of Netflix\u2019s primary risks<\/mark>.<\/p>\n\n\n\n While great legacy content assets can create a cash cow situation for the company, a complete absence of new investment is likely to reduce customer satisfaction as subscribers run out of content to consume.<\/p>\n\n\n\n In other words, the company can\u2019t <\/strong>rest on its laurels.<\/p>\n\n\n\n Incremental improvements on ROIC is not likely to continue indefinitely, and at some point the company will likely run into a maturation phase on its margins expansion, where a maintenance level of capital outlays will need to be established to satiate subscribers\u2019 appetites.<\/p>\n\n\n\n This maintenance level of capital outlays can be influenced by so many other things\u2014production costs and their trend over time, competing content and its production costs, customer tastes, and many others.<\/p>\n\n\n\n Monitoring a risk like this is not about measuring every single potential factor, but rather watching the trend of content amortization and investment, and subscriber churn over time.<\/p>\n\n\n\n If measurements like these start to embark on a secular downtrend, the valuation of Netflix\u2019s stock is likely to also face a secular downtrend.<\/p>\n\n\n\n What can make analyzing media conglomerates and streaming peers difficult\u2014especially those peers which include the companies who own Disney+ ($DIS), HBO Max ($T), Peacock ($CMCSA) and Paramount+ ($VIAC)\u2014 is that competing pressures can additionally persist outside of the customer share of mind competition.<\/p>\n\n\n\n There are many examples of this; let\u2019s just take a few.<\/p>\n\n\n\n Some ways that customers are delivered the Netflix platform are completely out of Netflix\u2019s control.<\/p>\n\n\n\n For example, many of the new smart TVs, such as the Roku, include various apps inside of their ecosystem. Some of these ecosystems choose to highlight Netflix as a default, pre-installed choice for every user.<\/p>\n\n\n In the future, this access can change, particularly when competition for customer attention becomes more direct. If Roku were to decide to get into the media content game, good competitive strategy would likely indicate they would eventually replace a default Netflix app with a version of their own.<\/p>\n\n\n\n Not only is the possible entry of new participants a risk here, but so are the competing interests of their main rivals today.<\/p>\n\n\n\n Take AT&T for example. The company is not only an ISP (Internet Service Provider through their Communications segment) but also a content creator (through its HBO assets within its WarnerMedia segment). It\u2019s unlikely that the company would do something so explicit as to block its ISP customers from accessing Netflix (you know, laws and regulation and all of that), but it could increase exposure to its HBO platform in more veiled ways, such as maybe including the app as a default in phones they service or packaging internet service with free HBO access, etc.<\/p>\n\n\n\n Almost every major competitor to Netflix has an interesting mix of businesses within each of its conglomerates\u2014between movie studios, theater chains, and amusement parks\u2014that each competitive strategy can have its own unique twist that either drives Netflix\u2019s success today and in the future or could hinder that success.<\/p>\n\n\n\n Again, it\u2019s impossible to analyze every possible factor, but if market share and new customer acquisition between the major players starts to shift towards a significant long term trend, it could be from one or a combination of industry dynamics.<\/p>\n\n\n\n I think the biggest tangible way this has played out so far has been with licensing deals. As these companies have launched their own streaming services, they have pulled some of their content assets out of the Netflix ecosystem by choosing not to renew certain licensing agreements. This could continue over time, which is why Netflix has been so focused on investing in its own exclusive content. It goes back to the amortization of its production assets and the long term ROI of those assets, and why I made the claim that they were key to a Netflix stock valuation estimate over the long term.<\/p>\n\n\n\n Interesting tidbit<\/u><\/strong>: management disclosed a recent 10-k that most of their agreements with partners tend to last 1-3 years, in the context of some of their delivery agreements. Licensing deals could also potentially follow this timeline, or they could also follow the amortization of Netflix\u2019s produced content which is about 90% over the first 4 years.<\/p>\n\n\n\n Due to everything we\u2019ve discussed in this valuation piece so far, it\u2019s clear that Netflix had to spend heavily as a key competitive strategy. A significant portion of this had to be financed through debt, especially since the company was a growth company with little in the way of cash flows and profits (at least in the beginning).<\/p>\n\n\n\n From the 10-k<\/a>, Netflix reported about $15.4 billion in Senior Notes. The interest rates on these notes fluctuate mainly between 3%- 6%.<\/p>\n\n\n\n Let\u2019s take a standard solvency metric to analyze the totality of its debt, first with the Net Debt to EBITDA ratio<\/a>.<\/p>\n\n\n\n EBITDA is not explicitly stated in the company\u2019s income statement, so we\u2019ll have to start with what we have and work our way up or down. In this case, I\u2019ll use Operating Income to calculate EBIT, which the company reported as $6,194,509 thousand for 2021.<\/p>\n\n\n Next we want to get from EBIT to EBITDA, which means we need to add<\/strong> Depreciation and Amortization to EBIT. Looking at the company\u2019s cash flow statement, this will mostly come from Amortization. The line item for Amortization of Content Assets was $12,230,367 thousand for 2021, and Depreciation and amortization of property, equipment, and intangibles was $208,412 thousand\u2014adding this to EBIT brings us to a 2021 estimate for EBITDA at $18,633,288 thousand.<\/p>\n\n\n Net debt is much simpler to calculate, we can simply look at the company\u2019s balance sheet.<\/p>\n\n\n Simply adding the Short Term Debt and Long Term Debt item brings us to a Net Debt of $15,392,895 thousand.<\/p>\n\n\n\n We have the two components we need for Net Debt to EBITDA. The formula returns 15,392,895\/ 18,633,288 = 0.83x. Comparing this to the market, the company\u2019s total debt looks pretty good. Anything above 3.5x would be considered high, and Netflix falls multiples lower than that.<\/p>\n\n\n\n However, because of the potential unique relationship between Netflix\u2019s content spend (included in Cost of Revenues) and amortization (to get from Gross Margin to Operating Margin), Net Debt to EBITDA might not be the best estimation of the company\u2019s debt risk.<\/p>\n\n\n\n If the company spends less on future content, this would reduce Cost of Revenues (COGs) while amortization from past higher investment stays high – the combination of both increasing EBITDA – but the effect of this could be a reduction of future revenues from higher churn and lower customer acquisition, which would lower EBITDA.<\/p>\n\n\n\n Additionally, the EBITDA is under pressure from the many forces discussed in Risk #1 and Risk #2. So Netflix\u2019s EBITDA might not be as reliable as another more matured company\u2019s would be, making the Net Debt to EBITDA ratio a potential misrepresentation of the true risk of Netflix\u2019s indebtedness.<\/p>\n\n\n\n Trying a few other debt ratios for Netflix:<\/p>\n\n\n\n Understand that each of these metrics also have their own inherent risks and possible misrepresentations due to Netflix\u2019s unique business model.<\/p>\n\n\n\n Therefore, a big picture view of these might work as a better analysis of the company\u2019s solvency and its impact to your valuation estimate.<\/p>\n\n\n\n It also comes down to the company\u2019s ability to produce future results similar to the past.<\/p>\n\n\n\nBusiness Overview<\/strong><\/h2>\n\n\n\n
Amortization: The $1 million Question<\/strong><\/h2>\n\n\n\n
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<\/a><\/figure><\/div>\n\n\n![\"\"](\"https:\/\/eor7ztmv4pb.exactdn.com\/wp-content\/uploads\/2022\/07\/Screenshot-2022-07-08-135827.jpg?strip=all&lossy=1&ssl=1\")
<\/figure><\/div>\n\n\nRisk #1: Churn<\/strong><\/h2>\n\n\n\n
Risk #2: Industry Dynamics<\/strong><\/h2>\n\n\n\n
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<\/figure><\/div>\n\n\nRisk #3: Debt<\/strong><\/h2>\n\n\n\n
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<\/a><\/figure><\/div>\n\n\n![\"netflix](\"https:\/\/eor7ztmv4pb.exactdn.com\/wp-content\/uploads\/2022\/07\/netflix-cash-flow-statement-2021-903x1024.jpg?strip=all&lossy=1&ssl=1\")
<\/a><\/figure><\/div>\n\n\n![\"netflix](\"https:\/\/eor7ztmv4pb.exactdn.com\/wp-content\/uploads\/2022\/07\/netflix-balance-sheet-2021-918x1024.jpg?strip=all&lossy=1&ssl=1\")
<\/a><\/figure><\/div>\n\n\nHow to Value Netflix with a DCF<\/strong><\/h2>\n\n\n\n
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