NFLX 2021: Lord of The Streams; Return of The King!
(A Razor Original: streaming everywhere on earth on any device)
Netflix continues to generate controversy. I figured post Disney commentary and based on recent developments now was as good as a time as any to share my views on the stock.
Note, I started writing this as a quick earnings summary for the gang the night after Netflix reported their Q3, and for one reason or another this kept getting pushed back as new developments in the space unfolded and markets/positions got in the way. To be clear when I started this, I had no Netflix stock position. Anyway, its evolved into quite a bit more than a post-earnings quick take; do what you will with it.
Netflix earnings notes
-Stock dropped just a hair under 7% which was almost an exact instant replay of last quarter. Literally a 1% delta between where it started and finished post results both quarters. Which is part of the story with Netflix now; the results are just not that volatile. Even a giant Covid-19 pull forward barely budged the needle on that huge sub base.
-Headline miss on subs of 3OOK but beat on operating income by 6%. (Company is on pace for about $5bl in EBITDA this year.) Stock dropped last quarter on a 2.5ml sub beat because of the softer Q3 guide. Management did emphasize that they guide for accuracy and in their defense that was pretty damn impressive considering the Covid outperformance in Q1/Q2
-Their head of IR also pointed out that if the quarter ended 48hrs later they would have beat their sub guide slightly. I have seen some shade thrown at them for this, but I’d say in the current climate of COVID volatility that is a material and does give investor’s confidence on their visibility/objectivity with respect to their subscriber trends. I say this btw as someone who actually did bearishly play their 2019 Q2 because of Avengers/GOT landing against what I thought was very stale Netflix content. So, it is actually interesting in hindsight that this was their biggest downside miss.
Competitive commentary commending Disney’s all-in commitment to streaming from recent reorg felt a little more like a poke than the typical Netflix observations/nuggets in here. Also, they did again pound the table on their animation pipeline which is a reminder to the market that they seem focused on breaking that content mystique lockdown for Disney.
So, what about the stock???
Netflix is interesting here as far as stocks go because it’s in its 1st transition phase since Icahn showed up at the end of 2012. Basically, the subscriber prints are not going to be what moves the valuation going forward. Netflix has 74ml US/CAN subs right now which is roughly 80% household penetration of the PayTV TAM. When you account for password sharing and the fact the premium plan allows for four concurrent devices, you are essentially fully penetrated in the traditional US/CAN PayTv household market. That means you are an ARPU & EBITDA story now in this market and nothing more. Some people take issue with that on a global basis based on the marginal sub coming from lower ARPU markets, but that’s one side of the coin. Yes, India’s ARPU and South America are a drag, but I’d counter US/Western Europe ASP still has ways to go.
Consider this absurd VZ FIOS bill….
Each set top box monthly charge is more than Netflix’s ARPU in the USA/CAN. Now this is what the overinflated high end of the PayTv market looks like, but it’s also a reminder of how lucrative the pay-tv biz has been. This is an important fact to remember when evaluating the recent ‘bearish’ developments at Netflix.
“What bearish developments is he talking about; we are in the midst of global pandemic?”
Well, first there is the recent headline grabbing reorg of media execs as new co-CEO Ted Sarandos shakes things up …
And then you have the recently announced price hike in the USA/CAN….
Also, backlash around the launch of Cuties. Basically, for quite a few Netflix observers, the company is feeling the heat of being mature in the USA just about at the same time as the competition really heats up.
What’s my initial read on all this?
Well, to put it simply, these are not exactly ‘bearish’ developments. I get the thesis here that Netflix has more competition now and less appealing subscriber runway as well as maybe content development approach challenges, but this is still Netflix at $10.4 global SVOD ARPU that everyone else is now chasing.
See, it’s easy to confuse Netflix’s evolution with growing pains/mounting challenges which was kind of an underlying driver behind my Disney commentary.
For example, I was quite vocal last year into Disney+ launch that the sub estimates were a joke and that the 3-year tgt would be hit in next 12 months. Credit Iger for managing this, but at the same time analysts deserved to be shamed for the Netflix trajectory modeling.
This was not some election BS I got a feeling theory but rather just common sense.
1) Disney and Netflix streaming don’t have the same starting point. Sounds stupid but it’s been the same argument in mobile adoption in EM. Unlike Netflix, Disney already had a global content brand at launch with hundreds of millions of digital subscribers. They just happened to be being fed via affiliate cable and licensing deals with other distributors.
2) Disney+ launch effectively ENDED the vault. Unlike Netflix, Disney had a massive DVD home video biz still going into the DTC pivot. I am talking the library as well as the box office (7/10 Top DVD titles 2018 where Disney properties) So, even with zero Disney+ originals, it was a compelling physical DVD replacement library proposition at $70 a year for any household with kids.
3) Disney+ launch built on massive MCU/Lucas momentum (post Endgame and post StarWars) by declaring several MCU Box Office based characters would be crossing over to the TV effectively rebooting the Marvel Tv Universe that had been living on Netflix/ABC with its own new phase. They also complemented these franchises by essentially emptying the vault in terms of live action remakes and sequels.
So, Disney is doing a lot of pie shifting here vs organically growing a global brand from zero. That means the start out of the gate will be great, but what follows after is going to be a hell of a lot harder. Markets don’t value these things the same. Effectively speaking, Disney failing to get to 30ml subs in a year would pretty much have signaled major brand fatigue/concerns. Kudos to Iger for executing because this was kind of an upside-down risk/reward scenario for him. (Btw make no mistake I am a huge Disney fan and it’s been my only long for years here and was the only name in this space I picked up when the market crashed in March, but that had very little to do with Dis+ turbocharging the economics of the biz for me.)
Which brings me back to Netflix….
A fully penetrated US mkt with competitors now settling in and linear accelerating their transition demands a different strategy. Now, I could have spent the next month writing Once Upon a Time in Hollywood piece explaining all this….
But thanks to a friend forwarding me this incredible blog post a few days ago that’s no longer needed. I will say this is probably one of the best analysis I have ever read on the traditional media/ OTT streaming space. It’s perfectly timed, and it’s also exceptional in its structure and clarity. On my first read through I didn’t even look to see who wrote it, but it came as no surprise afterwards to discover the author was formerly CSO at Turner Media. Anyway, this is something you should read 2-3x if you interested in the space and where it’s going. I’m going to touch on some of the key points made in here within the context of a Netflix observer because they are the type of stuff a lot of us have thought about for ages.
Netflix: Once Upon A Time In Cable TV
Mr. Shapiro’s conclusion after giving his readers a detailed foundational analysis of the state of the industry is this:
“The cable networks business is one of the most profitable businesses ever; it accounts for the vast majority of profits for the biggest media companies; traditional national TV revenue growth is, for the first time, approaching zero; and, contrary to perception, streaming video has not grown the pie much so far, if at all. But what about going forward? Will streaming grow the profit pool? There are fundamental reasons that it likely won’t.”-Doug Shapiro
Basically, thanks to Netflix’s global scale/disruption/head start and Big Tech Bundling, pretty much everyone else (except maybe Disney) is looking at a far less profitable future for what was one of the most profitable businesses around. Also, due to many structural reasons, it’s likely that these remaining players will be fighting over a smaller pie once the transformation is all done.
I’m going to say I agree with point number one. It’s hard to argue against that today. Having a few bundlers with scale as your dealing with unbundling makes for a near impossible hill to climb, and multiples reflect that. However, with respect the overall pie, I think it’s more complicated. Mr. Shapiro doesn’t venture to deep into how high ARPU’s can go and what the CTV market will end up like as far as advertising goes. That being said, let’s take a closer look at some of the points he makes from the perspective of an existing or potential Netflix investor.
1) Less Ad based viewing time in streaming
2) Current streaming monetizing at roughly 1/6th of PayTV
3) Higher Churn
4) DTC costs at scale being higher than expected for most
Less Ad based viewing time in streaming
This is kind of an obvious one from a Netflix standpoint as they in fact led the market in this direction. It’s no secret that Netflix’s scale would allow them to do ad supported TV tomorrow if they wanted, but they don’t want to. That being said at the margin ad supported OTT is rapidly growing and key players (Roku & TradeDesk) are looking to capitalize on the shifting dollars from linear. Also, international markets have always been far less penetrated from a $ standpoint as paying for TV on a U.S. scale is not the norm for international households. Yet, I think they key point still stands, there will be less ad-based viewing time in scripted over the top TV. The explosion of social UGC video and how kids consume content and the power of platforms like Twitch/Youtube for them will continue to shrink the traditional scripted TV Ad pie. So, when you compare it against the $40bl in advertising revenue pie that has largely been flat in linear; it’s safe to assume the AVOD market will be less compelling. How much will depend on how live News/Sports shift. But anyone arguing that scripted AVOD TV is ever taking us back to “Must See Tv” is dreaming. Whatever it is you might be watching on IMDB/Pluto/Roku Channel is going to be in a tough battle for eyeballs and more importantly minutes. And looking at what is going on with sports and news it doesn’t seem like the consolidated media giants plan to offer much of an arbitrage in the transition. I can however see this morphing into a delayed window for licensed content from the content producing giants (old and new) which would solve some of the terminal value erosion problem facing all the new content being created today. Overall though this dynamic clearly favors the global market leader in Netflix.
Shapiro wasn’t shy about declaring Netflix the overwhelming winner, but he does not spend much time discussing pricing in streaming today vs at maturity. He goes to great lengths to explain why streaming is currently exhibiting inferior economics, but as far as modeling the future he leaves that to the reader. However, several sharp commentators in the space, like Hedgeye’s Andrew Friedman for example, have called Cable an overearning bubble. And he is clearly right as PayTv has offset shrinking organic sub growth over the last decade with pricing (seemingly unsustainable). Which begs the question what is exactly the middle ground between priced to acquire subs Netflix and the overpriced hanging on linear TV Bundle? Because remember that every $2 Netflix can add to its global ARPU is currently worth $5bl in EBITDA till the value prop erodes.
Where is that value erosion point in UCAN?
Before the recent price increase, Netflix’s UCAN ARPU was $13.4. That is now going to be closer $14.5 come next year or roughly $1bl in incremental margin at Netflix’s current content spend (we will discuss where that is going later). As far as I’m concerned, Netflix ARPU in the USA will be $20 very soon. It also doesn’t look like there is going to be some live sports/news consumer steal in OTT. Disney just hiked Hulu+ Live TV to $65/month or $71(no Ads). So, a full pivot to Live Tv OTT with Disney/Netflix/HBO is going to cost you $110-120 month depending on if you want multi-room and or 4k. This is before you figure out what you indirectly paying Apple/Amazon as part of Prime or any Iphone/Ipad purchase bundle you getting from them for their scripted content. So, what you need to consider with respect to OTT Live TV, is that the Netflix value prop remains extremely compelling. Consequently, profitability on the SVOD end has plenty of room to grow. Maybe the real (and most obvious) story here is that there will be far fewer but much larger media winners than before.
STREAMING: CHURN AND BURN
Cables utility level leverage over the consumer thanks to last mile physical infrastructure was (still is??) a rare moat, and a key driver of pricing power. Competition at the regional level has historically been limited, and as a result churn has remained low as cancelling cable is costly and unpleasant. Streaming has reduced that frustrating experience to a couple clicks on your phone or computer. Consequently, the consumer has gained leverage over the content distributor, which means you have lost something in translation. Marketing costs go up and stickiness comes down. So far that is largely true and I personally have taken advantage of this with new streaming platforms like CBS and the much ridiculed Quibi (for the record I enjoyed a good deal of Quibi’s content and still couldn’t see how I’d spend even $50 a year for it). This is where we are at today, BUT it’s definitely not where the industry plans to be at in a few years.
Hulu/Dis+/Hbo Max for example are all offering annual subscriptions options. Netflix has yet to go this route because it’s made little financial sense so far (more on this later). Disney has of course gone right back to bundling to lock you in which makes perfect sense considering their assets across news/sports/tv/film. Also, I doubt it will be very long before streamers are experimenting with six-month plans, minimum commits, and annual cancellation fees to discourage churn. This would be favorable to all distributors, but as things stand this is not what the market leader wants. The embedded churn pressure for new streaming entrants actually favors a leader like Netflix as they are spreading their content/infra costs over the largest global paying subscriber base. Netflix, which gets trolled a ton on FCF still (there was a time where the trolling made sense), could for example easily boost FCF by offering an annual subscription plan at a 15-20% discount. But why would they when their junk rated 5y paper is yielding like 2% in the public markets when even a scandal like……
…leaves their churn looking like this….
Meanwhile, their now pivoting traditional media to streaming competitors need to fund massive original content expansion in a hyper competitive market and cover distribution overhead. At the same time, Amazon/Apple/Google led big tech can spend what they want within strategic reason, but everyone else can’t. So, Netflix maintaining a monthly price that is 20% higher on avg than an annual subscription if their models predict churn isn’t considerably ticking up is smart finance and leveraging one’s moat.
Direct Streaming Distribution Costs at Global Scale Are No Joke
A lot of ink has been spilled over content ownership and strategy (“Content Is King” was a rallying cry for my Netflix short thesis in 2010) when debating Netflix vs. everyone else in media. Captain Twilio and I used to discuss this all the time though with the added twist that he firmly believed Distribution would prove to be King. A decade later I’m going to say I think he was largely right though the leveraging of high-quality content in a tight supply environment and brand building on the back of acquired originals is what got Netflix there. But very little time is ever spent discussing direct distribution overhead because it seems the idea of the ‘FREE INTERNET’ is still buried deep in many an analyst’s subconscious.
The aforementioned Shapiro post does a good of calling this out:
“As wholesalers, historically TV networks don’t do acquisition marketing, handle billing and payments processing, provide customer support, invest much in product, pay for cloud storage and streaming delivery, employ many software engineers, license video players, perform usage or operational analytics, etc. In 2019, Netflix spent about $4 per sub monthly on these costs (Figure 15), and Netflix is as scaled as you can get. These costs are likely significantly higher per subscriber for everyone else.”
By my calculations, Netflix current non-content DTC COGS are about $3.75 per subscriber a month (Disney by comparison is running roughly 50%-60% higher across its DTC x international portfolio). Netflix is definitely as scaled as you can get here, and remember international scale means you are a regulatory/political target in every foreign market you operate. Contrary to some popular belief local distribution partners have provided these essentially hidden services in the past which means once you eliminate them or compete with them these costs become very real. And let’s not forget the aspirations of OTT platform providers like Amazon & Roku. Peacock and HBO Max’s disputes with respect to these services launch availability have grabbed headline attention over the past few months because it turns out in DTC you now have aspiring TOLL ROAD operators. For example, Roku continues to sell the narrative that they will not enter direct content distribution (what is the Roku Channel but licensed content paid for in kind distribution for a Streaming provider’s app) which means they along with everyone else in OTT OS space are a real cost of goods for streaming content media companies. This is an often overlooked but notable distribution advantage for Netflix because as the inventor of the OTT TV must have streaming App w YouTube; they are in a superior competitive position.
Ask yourself, what TV doesn’t have Netflix or YouTube pre-installed?
Now, how the TV OS aggregator/ADVOD CTV model evolves over time will in fact depend on a multitude of hard to predict factors from SmartHome OS innovation, AI assistant voice technology, TV manufacturer display innovation (what’s next here that hasn’t been thought of yet), and of course CTV ad-supported viewing time. However, what is clear today, is that Netflix/Youtube have a huge delivery cost advantage because they are globally scaled distributors who don’t need to pay the same tolls as everyone else. In fact, Netflix is at the point where it’s even ceased support for 3rd party billing on Roku or iTunes (end of 2018) to further take advantage of its global distribution scale. Suffice to say anyone evaluating the streaming space from an investing standpoint needs to realize that are significant distribution costs involved which don’t apply equally to all parties involved, and which Netflix has turned into a significant global moat. Anyway, I think that’s enough of that, now time for some observations.
Netflix: Some Market Observations
Netflix financial commentary is very US Centric; I find this a bit problematic because Netflix business is differentiated by the fact that it is the only truly global OTT TV platform.
A lot of time is spent discussing how XYZ Netflix show faired against the Mandalorian or The Boys in the United States when Netflix is fully penetrated in this market. Arguments are often made that XYZ competitor is getting huge bang for the buck vs. wasteful IP-less Netflix. It’s a charged narrative that at this juncture holds very little water. First, as of August 5th this year, 45% of Netflix library is foreign language based titles.
Netflix presently has 125ml paid subs outside of North America. And to be clear, Pay-TV has been an underpenetrated $TAM market outside of the United States as the rest of the world simply doesn’t spend anything close to the United States on Tv. As such, Netflix is essentially a trailblazer overseas and has built unprecedented brand recognition. All the major studios and networks that compete directly against Netflix in the USA have leveraged them to distribute their original content overseas. (for example-while living abroad I watched the Wire, Breaking Bad, and Fargo on Netflix) Yea, the times are a changing now, but Netflix’s overseas brand identity is like no other. Also, they are a localizing machine. In 2019. Netflix’s local originals were the most popular titles in India, Sweden UK, Japan, Korea, Turkey, and Thailand. And according to Ampere analysis, Netflix’s content library in non-English speaking countries is 90% foreign language based.
So, when measuring the ROI on Netflix content spend, you need to put things in context.
-In India, Netflix’s goal is to get people to spend on TV that have essentially never spent on TV before.
-In, the developed world, Netflix is roughly 70% penetrated into the 200ml PayTV Household TAM, and the remaining 30% is largely in places like Japan/S.Korea. So, new original content to acquire subs has to penetrate beyond what their current mix of global/local has accomplished in those markets. (It’s no coincidence the one Warner film Netflix threw a huge bid at was Godzilla/Kong)
-In France, Netflix is experimenting with linear delivery to improve engagement.
- In USA, Netflix is focusing on animation for the younger audiences, and more hit content to drive retention and ASP growth.
I have people recommending Netflix shows to me on 5 out of 7 continents on earth, and Netflix’s recent blog post highlight’s their global success:
Viewing of foreign language titles was up over 50% this year (compared to 2019)1. The Platform (Spain), Barbarians (Germany) and Rogue City (France) were the most popular - showing that nothing, not even a stay at home order, can shut down our curiosity about other cultures or countries. K-drama (viewing almost tripled) and anime (up over 100% in the US) were also significant winners. Kingdom S2 and The King: Eternal Monarch were our favorite K-dramas. And Pokémon: Mewtwo Strikes Back - Evolution and Blood Of Zeus were the anime titles that most piqued our interest.
And this wasn’t just a US phenomenon: Money Heist: Part 4 (Spain) hit the Top 10 in 92 countries, Barbarians (Germany) in 91, #Alive (Korea) in 90, Ragnarok (Norway) in 89 and Lost Bullet (France) in 89 countries. And while not strictly speaking “French”, Emily in Paris, was one of our most popular comedies of the year - even creating a 340+% increase in searches for Kangol bucket hats.
With all this in mind let’s focus on the two most common Netflix financial market criticisms…
1) Netflix is spending too much on content and is essentially on a content treadmill that will never end.
I have regularly come across critical arguments that will chart Netflix CAC and show the slowing sub ads and rising absolute content/mkt costs to make this point. Let me be clear, this is not how you should measure Netflix or any streamer for that matter. This is because such an approach fails to capture the most important part of being a globally scaled PayTv distributor; the declining aggregate cost per/sub. PayTv is first and foremost about retention as every $ spent on content/marketing is largely attributable to keeping churn low. Even before Covid, Netflix demonstrated notable health here:
One needs to appreciate that at Netflix’s scale the absolute content spend numbers are going to be going up and eye popping as long as things are working. This might seem like a ridiculous statement, but it isn’t if u think it through. Last year Netflix’s cash spend on video content was $14.5bl. To put that in perspective, Disney’s 10k discloses a fiscal 2020 content spend of $20.1bl and ATT owned Warner spent $13.8bl in 2019. Keep in mind both of these two have very large annual sports programming spend (Disney just under $10bl, Turner/HBO $3bl+) which means Netflix’s content appetite was only 20% below all Disney/20TH FOX/WARNER combined.
Basically, it’s scripted TvFilmzilla………
And now the rest of the industry is feeling the impact…….
Anyone, criticizing Netflix from a financial standpoint, need but look at HBO. The formerly revered PayTv premium content network has seen operating margins plunge from close to 40% to 3% over the last four quarters. This was a network with 55ml or so domestic Paytv subs and about 90ml+ international as of 18 months ago. Before the HBO MAX launch, Home Box Office was generating roughly $500ml a month in global subscription revenue plus another $50-80ml in content licensing revenue. Call that 150ml PayTv subs across their brands, and you were talking $3.75 average revenue (I’ve included licensing rev as I view it as part of the monetization since HBO has exclusive licensing partners in some markets) per global sub. That worked out $1.4 per sub a month in PayTv attributable subscriber contribution profit. To any financial analyst that looked closely at HBO over the last five years it pretty much epitomized financial discipline. Content spend between $2-2.6bl which was split evenly across originals and licensed, and nothing but awards and accolades for anything they put out. Quality over quantity was the mantra…..
“We’re not trying to do the most, more is not better, only better is better” - Richard Plepler, Chairman and CEO of Home Box Office, 2018
Basically, as Netflix hit its stride globally, HBO increased total content spend by about $400ml. Netflix increased their spend by $10bl over the same period. Literally 25x at the margin when compared to HBO. And the net result? HBO revenues today are what Netflix’s were in 2015 meanwhile Netflix is approaching a $30bl run rate. Of course, the most notable consequence/driver (chicken or egg?) of this was HBO being stuck at 35ml or so subs or the net decline of cable subs for the combined HBO/CINEMAX brand. And how has HBO decided to remedy this? They have started to spend significantly more on content and are prepping an ad-supported offering to try and broaden their audience. As far as HBO is now concerned MORE is now NEEDED to actually retain its overall base let alone grow it. Meanwhile, Netflix has seen its domestic ARPU climb from $8 to nearly $14 as it has gone from 40ml to 70ml subs. Bottom line, Netflix can spend like this because it’s achieved massive economies of scale and has won as far as creating a pure globally scaled media brand from nothing.
Anyone arguing Netflix’s content spend in aggregate is unsustainable is essentially arguing there is no future for the most globally scaled distributor. That is clearly not the case. So, really this is more of a question of what it takes to compete these days as a media giant. And let’s be clear HBO isn’t the only party that’s felt this pain. Disney’s non parks division business has generated about $8bl or so in total operating income the last two years. Back out the $3.5bl or so ESPN generates on $11-13bl in revenue and you have a 13-15% margin media business which is where Netflix is already at today.
So, if your Netflix bear thesis is about content spend being out of control, well………
1) Content rights are the foundation of the economics of content AND Netflix has no real IP and is thus doomed like Sisyphus to keep pushing the content rock up the streaming hill till their balance sheet collapses.
Netflix gets epically trolled with variations of this argument, and it is often mixed in with the headline grabbing absolute numbers around their total spend or some new major rights deal like Seinfeld. Basically, this bear argument takes the form of……
Netflix is too stupid to negotiate content deals properly and is perpetually overpaying Hollywood for mediocre branded originals. Meanwhile, most of what is regularly consumed on Netflix is licensed second-run hit TV shows and thus Netflix will never truly reap the rewards of this premium quality IP as competitive bidders steal viewership and erode the margins here. The Office/Friends cliff approaching at the end of this year is the equivalent of big pharma’s patent cliff and will usher in the new era of churnmageddon.
I can see how in theory this bear thesis would appeal to a lot of people, but it simply doesn’t hold water.
First, let’s start with the easy counter here by pointing out that HBO has pretty much crushed it on quality for decades, and despite owning their originals (few rare exceptions) and coining the phrase….
….they are now being forced to adapt to a media world in which they are not so special. And let’s be clear I love HBO, and my 2010 Netflix bear thesis was they needed to become like HBO to accomplish the pivot from DVD renter to streaming TV platform. But at this point there is no denying the era of Peak Content has diluted the HBO brands economics vs. enhancing them. HBO thrived on scarcity and owning Sunday night, but Netflix completely changed viewing habits by unleashing an avalanche of supply. More didn’t need to be better, it just needed to be more and change the value proposition. And as I pointed out earlier, HBO, the king of original hit TV shows, has now collapsed their profitability to increase volume at just about peak competition. So, HBO’s multi-decade lead and expertise developing hit shows as well as financial discipline did not slow down Netflix.
Honestly, what more does someone need than to look at that? HBO went from maintaining its premium supply-controlled model and riding out the Netflix threat with minimal new sub penetration to having to invest massively for retention and hopefully growth. Their owned IP was no savoir even on the back of their greatest hit show ever. Ah, but it’s not Disney, you may counter!! They don’t own rich franchises like Pixar/Marvel/LucasFilm.
Well, let’s talk Disney’s media empire and best in class media IP driven economics……
The bulk of Disney’s media empire operating margin is coming from licensing and distributing live sports content ($3.6bl ESPN Op income based on my estimates) and not developing original IP. And while their film franchise acquisitions have been huge pop culture successes, the studio biz has never been much more than 15% of Disney op income. Exhibitor share, film producers, gross participation for star talent like Robert Downey Jr, marketing spend, etc all adds up. Because at the end of the day the real IP in the content biz is the creators and their hands always tends to find their way deep into the cookie jar.
The creator element is key to franchises, but it’s also unpredictable. This is why Warner Bro’s has failed with many DC characters and why despite a steal of a deal Sony had to turn back to Marvel for creative talent help with Spiderman. It’s also why MCU/Netflix TV Universe started seeing viewership declines and why the last X-MEN FILM was a total bomb with an all-star cast while mostly unknown actors have received rave reviews for The Boys and the Umbrella Academy. Thus, it’s no surprise the film/tv biz has always been about risk mitigation for most (Consider that Warner sold 40% of $50ml Joker 6 months after the AT&T acquisition), and why financing of content projects involves multiple partners. Yea, Disney has avoided that of late by ponying up $16bl (what is now a year of content spend for Netflix) for the most globally recognizable franchises of all time, but there was a time when Marvel made movies that didn’t crush. And there is a reason why 7/11 Pixar films, a studio built on the back of fresh originals, were sequels. It’s also no coincidence that Disney felt it had to spend $70bl acquiring 20th Century FOX despite its rich film franchises.
The Hollywood studio biz has never been a sexy financial game. For example, despite owning the rights to some of the best hit library shows on TV as well as monster hits like The Blacklist and a banner run for Spider and Venom; Sony’s entire Film/TV/Cable Network division is a $500-600ml a year operating income biz. That’s a single digit operating margin business. And remember this in a world where Netflix is very good customer. So, investors need to ask when Jerry/Larry alone take 30c out of every dollar what exactly is left for the shareholder? What is the ownership of Friends worth if you need to pay the cast their cut based on an open market auction? Jennifer Aniston and Courtney Cox are not going to subsidize HBO MAX to help out AT&T wireless subscriber churn. The idea that content library/franchise ownership equals huge future windfalls isn’t exactly a compelling narrative anymore. Will The Morning Show even make it to a third season? Will Ted Lasso(maybe my favorite show of the summer) be drawing sizeable viewership in five years let alone a decade? One of the consequences of streaming and abundant content is the terminal value of scripted content has declined. This means residual streams are worth less and cash up front is worth more which of course favors Netflix’s model over the traditional players. This also means everyone calling Netflix debtflix should consider where industry cash content spend is going without back end rights or international rights to fund development costs. Look at the current mess around Warner Bros decision to release its entire 2021 film slate on HBO MAX concurrently with the Box office. Does all the talent get Gal Gadot money to offset lost gross points? What happens to co-finance partners who put up 75% of the money for some films? What are the transfer pricing deals for them or they just left contractually holding the bag? What exactly is the value of HBO’s existingfilm output deals with Warner if there is no pay window?
But sadly, most people don’t even bother looking under the hood to see just how ridiculous it is to compare these businesses when you decompose the economics. I can romanticize content ownership and famous pitfalls like Marvel selling Spiderman to Sony for $10ml and 5% gross participation as well as 50% merch with the best of them; Marvel was the 1st detailed long pitch I ever originated and published back in 2003. I thought I was so clever figuring out that a virtuous cycle of high margin film licensing revenue was coming and that exiting the toy business would lead to a rapid financial narrative shift, but that’s not the world we live in today. Marvel could have never been Marvel without Disney’s financial resources and distribution. Yet, Netflix’s current content distribution capabilities are unmatched in the history of TV/FILM Media. However, this won’t stop plenty of intelligent people from throwing shade at Netflix prospects to ever generate meaningful cashflow because they “own” only a small slice of their content.
Which begs the question does it mean to “own” TV/Film content in 2020?
The most recent round of IP shading of Netflix started when news of Narcos streaming on Pluto was announced. It’s also popped up in the past with respect to Bojack Horsemen going to Comedy Central or House of Cards (MRC)/Orange Is The New Black (LGF) not being available in every foreign market because Netflix didn’t secure those rights when it first dived into TV originals. And as far as licensed second run hit shows it’s been particularly in focus this year as The Office and Friends move to Peacock and HBO MAX. It’s gotten to the point that when Nielsen releases their weekly viewing streaming data that I see some people label Netflix’s content based on ownership status…
So, here is another related content ownership question for you, what’s an “original” these days?
Critics will say it’s content Netflix developed themselves and owns in perpetuity throughout the universe and which can be monetized and merchandized in every single manner known or unknown to mankind. This goes back to my starting point that bears seem to think Netflix’s licensing teams are idiots (are some of Disney’s MCU films coming back in 2026?). Contracts are about consideration, and if Netflix doesn’t retain something well then it’s paying less money for it. This was the game with the bulk of Netlfix’s early acquired originals. Netflix orders a show and gets to slap its brand on it. Rights for markets it had not penetrated yet or off-network syndication sale were not exactly a priority let alone a concern at that stage of their content push into originals. Now, as Netflix has grown it has created more developed originals like Stranger Things, but this doesn’t happen overnight. To go from acquiring your originals from third party studios at a 20%-50% mark-up over production cost to developing them yourself you need to have top creators working directly for you and not the third-party studios. That takes time. Signing the creators of The Office, Game of Thrones, and prolific showrunners like Ryan Murphy and Shonda Rimes didn’t happen overnight. Also, at Netflix’s massive global volume, licensed and co-licensed originals are necessary and valuable part of the content pie. This is simply because nobody else has global TV distribution anywhere near Netflix’s scale. This means Netflix’s ability to work with foreign production studios is unmatched, and more importantly it can flip the script on the old model by making foreign acquired or developed originals hits in its home market.
But does the audience at this point know the difference between what’s acquired, developed, or licensed? Does a GEN Z viewer who discovered The Office or Friends on Netflix know this was an NBC show? And better yet, do they care? The answer is no. They simply want to be entertained by Netflix, and that is all that matters.
And what does it mean to be entertained?
Based on the top 5 searched TV shows on Google for 2020 Netflix is doing a pretty good job…
Looking at this list you can’t but help realize what it means to be entertained by TV in today’s world is definitely not what HBO thought it meant for the last two decades. Netflix is almost a content grab bag at this point with a little something for everyone. The have that intense edgy HBO level TV series content but then they have kids stuff or comedy/reality snacks whose total contribution might just be some joke material for online dating ice breakers while other shows might simply provide background noise fillers while your attention is turned to social media or exercise. So, when it comes to Netflix content you could be talking documentaries, reality tv, foreign films, 90’s sitcoms, and or comedy specials. But whatever form the content may take all Netflix cares about is gobbling up minutes. This is why Reed Hastings has often cited sleep, video gaming, and social media as his competition.
When viewed through this lens Netflix’s content spend makes a lot more sense. For example, was the $500ml Netflix shelled out for Seinfeld global streaming rights that big of a deal? Netflix was paying $80ml a year for Friends in the USA before HBO MAX stepped in at an estimated $85ml. But what is the cost per hour here? Seinfeld clocks in around $1.6ml per hour of content a year for global rights vs. $660k or so they were paying per hour for Friends US rights.(Netflix still holds international rights for Friends though those remain undisclosed) The Crown has been tossed around as high as $13ml per hour though my checks indicate its roughly half that. GOT season 8 cost HBO about $12.5ml an hour. Meanwhile Apple is spending something close to $15ml an hour for the morning show. Basically, developing another scripted show that runs as long as The Office or Game of Thrones is now prohibitively expensive. One could also argue that with content as abundant as it is today, it’s also highly unlikely you can keep viewers interested for that long. This is why the limited run series format is now so appealing, and why nostalgic short reboots work so well (acquiring Cobra Kai for example after YouTube exited scripted). They are cost effective. But this also tells you that Netflix could in theory have bid way more for what they lost domestically, but their audience insight and current strategy didn’t warrant it. And I think the recent executive shuffle in Netflix’s content division also tells you a lot about where Netflix is skating to puck wise. Bela Bajaria, whose head Netflix’s international content strategy, recent replaced Cindy Holland as VP of Global TV. Again, Netflix Wall Street analysis is very US centric, but Stranger Things and The Irishman are the not needle movers for this business, shows like Money Heist and The Witcher are. Netflix’s success content wise can be measured by things like the hit German show Dark getting nearly 90% of its viewers outside of Germany or The Queens Gambit being a number one show on Netflix in 63 countries. It can be measured by their hiring of Jiro Dream’s of Sushi Director David Gelb to create the wildly popular a Chef’s Table. And we will soon be able to measure whether they can turn $35ml comic book publisher acquisition like Millarworld into their own global streamingverse.
So, again film ownership isn’t what it used to be. Netflix btw figured this out a long time ago. They were licensing huge libraries that nobody was watching in the early days. They quickly moved on from this approach. So, in hit TV series land, there are obviously a few assets that remain scarce as they bridge a generational divide. But beyond those when you are talking IP you really are referring to blockbuster franchise rights it seems, and their perceived ability to lower overall content development costs. Spinoffs, sequels, and prequels as far as the eye can see. For example, one could argue that Disney has achieved immeasurable success with The Mandalorian and thus seeded a global streaming service with minimal content cost because of their Star Wars franchise ownership. But as I stated earlier, this is not how I view the Disney+ launch. To me Disney+ remains a film library substitute for kids and a TV/Movie pass for the most recent hit franchise content. However, this still comes with creator expectations that I’m going to stay vested in the entire universe and don’t eventually run into franchise fatigue. Whether this will happen to Disney or not remains to be seen but Warner Bros knows what that is like and the FOX flops with superhero MCU franchises are a reminder that even Marvel IP in the wrong story tellers hand turns to dust.
This whole section could probably have been summed up with Netflix has demonstrated that they are constantly evolving with respect to content and the results speak for themselves. But I think it’s important to look at their content spend/original mix and conclude Netflix is driving the market, and not the other way around. They are obviously now in a position to spend far more on their own developed originals but at their scale they will always be licensing and acquiring content from 3rd parties because it’s in fact great for their business. I also think you will see more demand out of some of non-Disney/Warner controlled world to work with them.( CBS is now rumored to be crossing over Star Trek to Netflix, and as someone who watched Picard and canceled I think they should do it) So, if Netflix doesn’t want something or leaves it to a partner, odds are very high that they know exactly what they are doing. I also think with respect to ‘ownership’ investors should consider that Netflix has made crazy progress with respect to brand equity amongst top creators.
Just ask Dave Chapelle “Why he Fucks with Netflix”…
Now, Chapelle’s quite a passionate creator, who clearly still feels he was wronged by the industry (Viacom circa Sumner Redstone are the guilty parties as far as he’s concerned) and that sucks. Anyone who has ever made a bad financial decision or dealt with a crappy biz partner can probably identify with Chapelle, but as my sixth -rade geography teacher used to say, “if you want fair, go to Timonium.” But whether you agree with Chapelle or not with respect to Hollywood artist contract ethics, there is no denying he and many other creators like him have become powerful brand evangelists for Netflix. Top talent wants to work with Netflix because they treat them well and been writing the biggest checks. But it also helps that Netflix has built a streaming biz from the ground up without the legacy Film/TV biz model debt of the traditional media industry. Because as the recent WarnerBros Film Slate drama has demonstrated, change in Hollywood is never easy.
Which bring me to the state of Film/TV……
2020 has been a wild year for many industries, but there is no denying the Film/TV industry the shock doctrine playbook is in full effect. It’s as if a week doesn’t go by without some earth-shattering news…
Or this gem from the Hollywood Reporter..
It’s no secret the pandemic is allowing/forcing (depending on your POV) some companies to make the type of sudden business moves they could not have made pre-Covid. WB declaring their entire 2021 FILM Slate will be available day and date on HBO MAX without really negotiating with their talent/partners jumps out here. In some instances, you could argue the likes of WB/HBO are willing to burn bridges (Legendary Pictures) they don’t expect to need going forward. (If you can legally subsidize the launch of your streaming service on the back of content your partners have largely already financed you’d be crazy to not consider playing that card.) In other instances, you could argue that media giants are positioning themselves for a new financial model the likes of which existing talent will have no choice but to live with. Whatever the case may be, over the last few weeks we have gotten a far clearer picture of what the future will look like, and again the answer seems to be more TV. WB/DISNEY have committed to output that will leave almost everyone drowning in a sea of franchise content over the next 3 years.
Some things to consider….
Is a hit film the same hit film if it goes straight to streaming?
The straight to video moniker used to be a kiss of death for a film (but a nice cash cow for some actors), and there is no denying that we have seen the big budget version of that with some of the films Netflix has financed. To be frank I have never enjoyed watching cinema replacement movies on Netflix. These are movies I categorize as expensive Netflix features that could otherwise have gone to the box office based on headline cast and directors. I say this because Netflix has made consuming episodic TV a far richer story telling experience and educational documentaries far more accessible. So, if it isn’t a franchise I didn’t want to go see it in theaters, odds are TV has something I’m far more interested in than an original Hollywood feature film on my TV. I’m far more likely to watch a foreign film for example before the next Will Smith/Adam Sandler straight to Netflix movie. But again I’m the HBO/MCU/Pixar/FX target audience and I realize that there is a sizeable Smith/Sandler audience that Netflix is feeding. So, I’m sure some people will get excited about movies that were meant for the big screen to be available on TV, but so far it all has a very PPV Hotel or rare Amazon rental feel to it with a nasty twist. Meaning what’s a hit film that I missed which everyone else saw in the theater if nobody saw it in the theater? Answer is nothing, it doesn’t exist. Which means that great movie I heard about but never got to see now needs to outstrip all the streaming TV content I’m being algorithmically fed to actually become that great movie I missed in the theater. How do you do that? A hell of a lot of marketing dollars. But why would splurge like that if well I’m not going to pay for it on a transactional basis?
Yet, Netflix has gotten a lot of shit here, as the general view has been they been wasting tons of money trying to make the streaming equivalent of straight to video Steven Segal Hollywood movies to compete with the theaters. (But were they really ever competing with the theater blockbusters even if they hit us with metrics on reach trying to make it look that way?) I’d counter that this is far less of an issue than many people think as Netflix is again filling up different buckets with minutes of programming. I’d also counter that with more movies going day and date it’s Hollywood that faces the story telling problem going forward. If a movie is first available at home it is now competing against TV content choices vs other ‘event’ experiences. Again, episodic drama TV has gotten very good at rich story telling. I ran into this problem with the Marvel/WB superhero shows after a while, as I basically determined watching a full season of Fargo or the Crown was a more rewarding use of my time. So, I do wonder what happens to films that go day and date on streaming other than some level of dilution as the shine the box office adds cannot be replicated at home. For example, I would never ever have wanted to experience the Joker (I mean the intensity of the music alone had me stressed out, no way u get me tensed up like that at home) at home for my first viewing of it. So, day and date there does nothing to help, but for the non-Joker demand curve and quality of content it gets them in front a home audience that can choose to spend that same amount of time on the Queens Gambit or Succession. At which point what does it mean to make a FILM that’s also available at the same time on TV? Seems stupid to discuss, but the supply of TV series has without a doubt diminished the library value of film content. What 20yr olds are digging up classic films to watch on date night?
This of course brings us back to the debatable question of franchise fatigue and IP rights as a path to prosperity. Disney recently announced 20 new Marvel/StarWars franchise features for Disney+ to go with film slated content over the next 3 years. The talent for these projects so far looks to be of the most expensive variety which essentially means Disney has little margin for error. I say this because the MCU is tightly woven together. I can already tell you my excitement with respect to the crossover TV series is a fraction of what it was when End Game ended. So, unlike the bucket approach of Netflix if you lose me on the whole universe, then you are about to piss a lot of money away on content I’m not vested in. As I just pointed out, I got to this point at the end of Marvel’s TV Universe run on Netflix despite the fact that all the characters and performances were great. I just ran out of bandwidth between MCU and GOT for this, and the WB was an even earlier casualty even though I really loved Gotham. On the flip side, the Mandalorian has been masterful story-telling and far more enjoyable than any of the recent Star Wars films (I did really enjoy Rogue One). So, while I doubt Disney stumbles story wise, there is no mistaking the fatigue risks are very real. Netflix, on the other hand, by virtue of its delivery approach isn’t particularly vested in any type of content. Conventional wisdom used to say you’d rather be Disney and that the franchise IP reduces TCO versus the likes of a Netflix which in fact has to constantly come up with something new. I think today there is a case to be made that based on the scale and variety of content Netflix provides for its customers that the opposite might now hold true. If TV/FILM converge, TV wins. Now, I don’t see this happening, and I expect the box office to be back because of precisely this problem. However, it seems we are going to have to fill up some straight to streaming body bags before we realize Daddy Warbucks had this all figured out ages ago …
“LET’S ALL GO TO THE MOVIES!!”
Netflix: Why Investors Should Fuck W Netflix
Ok, industry dynamics are all fine and dandy, but what I’ve discussed so far isn’t exactly an investment case. I will say that if you are bearish on Netflix based on content spend or ownership rights you probably shouldn’t own anything in this space. (Hand your money to Cook and Bezos and move on) Because what’s interesting with respect to Netflix is the financial picture which they have gotten nonstop shit for over the last five years now actually looks relatively appealing.
Netflix presently trades at about 9.4x CY 2020 (7.4x 2021 est) revenue and clocks in at an EV/EBITDA multiple of 45x based on roughly $5bl in 2020 EBITDA. Operating margins for the year will come in around 19%, and debt as a percent of market cap is about 6%.(Net debt is half that) Not exactly a value stock, but with Apple at an EV/EBITDA OF 25X this isn’t the butt of every balance sheet/profitability joke Netflix of old. Like can anyone who doesn’t have a sudden epic churn argument in hand call this debtflix anymore? I’d in fact counter that in this macro environment Netflix is actually drastically under geared here.
Now factor in that HBO is headed into the red and Disney has given you DTC guide that has losses peaking next year and overall division content spend doubling over the next four years. Clearly, Netflix is no longer the financial ugly duckling of media. In fact, after the damage Covid has done to their parks/resorts business, Disney is also trading at a remarkable 45x EV/FY2020 EBITDA. Then you have ROKU at a 1/5th of Netflix’s market cap as it is set to break $1bl in platform revenue or roughly a 40x sales multiple. Anyway, I am not trying to directly compare the fundamentals of these overall businesses as each is quite unique, but the point is for those who love to look at the surface financials Netflix actually is one of the simplest and cleanest pictures today.
One way to look at Netflix here is essentially based on what it could be financially. The way I see it; Netflix at $10.40 ARPU remains a ridiculous value proposition to global consumers. That means you really don’t even need to give much thought to how many more subs they can get but rather how underpriced the product is. For example, every $2 in ARPU works out to $5bl in incremental EBITDA. Some people might counter well to increase ARPU you need to increase content spend, but actually that’s not the argument here. The argument is in fact that Netflix is underpriced to the point it could in fact be commanding a $13+ global ARPU today w minimal churn impact. That would amount to $6bl in incremental EBITDA or leave Netflix today trading at a 10% discount to Apple’s current EV/EBITDA multiple with maybe a 25%-30% earnings CAGR for the next decade.
This is something an investor needs to think about when they look at Netflix’s competition. Remember HBO/DISNEY are not greenfield plays. As I mentioned earlier, HBO’s varying MVPD distribution agreements allowed them to claim some 150ml global subs across HBO/CINEMAX. That works out to about $1 a month per sub or roughly a quarter of what Netflix’s delivery/marketing costs are for its 100% OTT DTC model. Disney’s cable era non-content costs come in even lower at cents on the dollar as their media networks count hundreds of millions of global PayTv subs. Compare this to the forecasted economics of Disney+ which Disney is guiding you (a lot more honestly this time) will reach profitability in 2024 with roughly 245ml subs.
Disney+ in developed markets outside the United States is essentially being merged with Hulu/TCF content wise (prices will run $11-12$), and in the USA the ad free triple play bundle is going to cost you $19 next year. Essentially if you get HULU (ad free)w/DISNEY+ standalone you are an idiot cause you can save $1 and get ESPN+. But this is the Disney comp today with an ARPU of $4.5 for Disney+ and around $12 for Hulu. (Hotstar at 35% or so of the base is clearly a drag as the wholesale pricing and discounting they been doing to acquire subs.) Now, I can back into Disney’s forecast model for Disney+ FY2024 breakeven at $8.5bl in content spend and 220ml avg subs for the year at around $7 ARPU or essentially a 12% CAGR from today’s levels. That means Disney is aiming for Netflix level non-content monthly operating/mkt cost per sub of just $3.5-$4 by 2024 for Disney+. Does that range look familiar? Based on this analysis, I figure Disney’s USA ad-free bundle will cost $25 a month by 2024. Meanwhile across the board Disney is aiming for total DTC spend in 2024 ($15bl midpoint) that is roughly on par with Netflix today. I think the cash content spend dynamics are an important element for investors to factor in as well. Because as we can model what Disney will add topline wise in DTC, we can conclude more TV and DTC and less wholesale distribution and licensing will weigh on FCF margins. Netflix’s business on the hand is natively structured around DTC, and thus theyy have always run far higher cash content costs as financing options available to alternative modes of distribution combined with licensing demands have not comported with their distribution model. The rest of the industry, as I have alluded to a few times, is now playing catch-up here. So, if international rights or backends are no longer meaningful sources of revenue/financing for projects, well the real cash costs of content for media giants pivoting to DTC will go up. So, I don’t see how you can crunch the numbers without concluding that Netflix here is financially compelling.
This is of course the beauty of what Disney has accomplished consolidating as it has and why Netflix management doesn’t frame this as a streaming war with the Mighty Mouse. They are going to drive pricing higher and likely pressure supplier leverage over the long haul at an unprecedented global scale, and Netflix/Apple/Amazon/Google are not going to complain.
What’s the bear case?
There are always reasons to be bearish, and I can start with Covid ending being one. 2021 is not going to be an easy year comp wise for Netflix w respect to subscriber metrics. The first half will have tough year over year Covid comps, and the back half will potentially have the end of Covid get out of the home and travel headwind. Meanwhile, the Office is going to be gone, Warner’s entire film slate is going to be on HBO Max, Apple/Amazon have some big projects slated to launch, and Disney+ will finally start releasing some decent volume of original content other than the Mandalorian as the MCU makes its way into the streaming wars.
This means Netflix is going to experience persistent narrative heat and skepticism against a backdrop of financial metrics you could plot Captain America’s heartbeat too. This combined with the unique macro backdrop should make for some notable volatility. I can tell you now that if by the end of the year there hasn’t been some mass subscriber exodus and Netflix has managed to withstand this streaming content blitz largely unscathed from a retention standpoint, well, Netflix shareholders are going to be feeling really good. Because at that point its game over for any bear thesis.
It’s almost exactly the 10-year anniversary of my Netflix short thesis and me declaring the stock finished. The shares are up about 1650% over that time. That being said If you are looking for comfort with respect to my history with this name….the stock fell 75% over the 18 months after I published my thesis….and I did have a pretty decent crystal ball….
With respect to what could go wrong as a former bull at the time I definitely was worried about mgmt……
And with respect to what I would do if I was in charge, well, I hit the nail on the head here as Netflix went from old episodes of cheers to we are competing w HBO mantra wise over the next few years…..
With the benefit of hindsight picking a table reservation platform as the alternative is comical especially as I would go on to short that stock later and then flip it again, and because well I let a juggernaut slip through my fingers as I for the most part concluded this was all way too obvious.( Well, played Captain Twilio!!!) But a decade of near zero rates also helped, and a whole host of other factors globally with respect to expansion/distribution and competition. Anyway, hope you got something out of this, and constructive feedback is welcome. I apologize for not pairing/editing this down, but tbh I just don’t have the time with all the shows I’m watching.