NFLX Quick Thoughts

Disclaimer: I and my funds own common shares in NFLX. Do your own work.

Before we get to the stock, let’s briefly talk about NFLX’s business model. Reed founded NFLX as a distribution company, hired a bunch of Silicon Valley engineers, and optimized the hell out of video distribution – first DVDs by mail, then streaming. Knowing that NFLX’s business was just distribution and his suppliers, the TV and film studios, would eventually figure out streaming and cut him out, he had to backwards integrate and become a studio. However, he and the engineers had no idea how to make content, so they did what Silicon Valley does best and threw massive dollars at the problem.

So where does that leave us now? NFLX is now a slowing growth company – in my opinion, revenue growth is not over, but NFLX is certainly not a >30% grower – with a clearly bloated cost structure. Hollywood openly mocks them for how aggressive they are with content purchases:

South Park – How Netflix Answers Calls

SNL – Netflix Commercial

From a studio executive friend:

“TV as a business and creatively works better when you have financial constraints, in my opinion. There’s a sweet spot between giving a production what it needs to secure the best talent and look great, and not just bloat a budget. Some great creative moments come out of producers having to work within budgetary constraints, which can force smarter storytelling choices rather than easier, more expensive ones. So as a consumer you could actually end up getting more, better produced content overall if you have more producers and studios operating responsibly… But not everyone is able to pull that type of management off consistently.”

For now, as I doubt Reed fully thinks growth is over and there’s obvious “platform” potential for NFLX, I wouldn’t expect a complete retrenchment, but over time I am sure NFLX will use their content budget more judiciously.

So where does that leave us? NFLX has roughly 125MM subs in developed markets paying $15/mo. and 100MM subs in emerging markets paying $8/mo. Rounded up that’s about $35B in revenues. At a 20% margin, that’s $12 in EPS, in line with Street for 2023. Legacy cable networks with scale consistently managed >30% operating margins, with most >40%. There’s puts and takes – wholesale/retail, international, ad supported, churn, etc. – but at its core, NFLX is not a wildly different business model. There’s definitely a lot of competition, so Netflix can’t just kick back and chill (#netflixandchilljoke), but at steady state, in my opinion, this is the largest subscription revenue business in history with medium-to-high pricing power and modest cyclicality – aka a pretty good business. 5-10% revenue growth plus a move towards 30% margins puts you at ~$25 in EPS in five years.

At $220, we are paying 18x current and 9x five-year out earnings. I think that’s a decent investment compared to the S&P 500, which is 18x 2023 and 14x five-year out EPS, particularly if you need to buy large caps. I also think you’re getting good upside skew here. There are a lot of ways numbers come in better than 5-10% revenue growth with 30% margins and this was 50x EPS six months ago, and, given the margin opportunity, I think it is hard to see earnings not growing over a few years. I’d also add that given the dominant position they have with a sticky, recurring revenue model, without a major change, it’s the type of thing I’d probably feel comfortable adding to if it went against me.

In my view, that makes NFLX a decent but not incredible idea. There’s no real term catalyst and I have no idea when and where this might bottom, but I’m cautiously interested and could see this as a bigger position at some point.