Netflix: Media Mogul or Middleman?
Board: Value Hounds
Netflix is in metamorphosis/transformation. Without looking at the history and the recent results, it is tempting to think of it as a huge bargain in the mid-$60s down from $300 last summer.
If you do spend some time with the company pre-and post-streaming, it is clear Netflix will never again be the fast-growing king of content rental it was. Not only are subscriber additions slowing, but also high content costs are likely to permanently pressure margins. That impacts earnings and ultimately cash flow. NFLX is now a lower margin, slower growing ex-momentum stock with a future that is not guaranteed to reflect its past. The biggest asset they have is Reed Hastings who has shown prescience and adaptability in a changing market.
The legacy DVD business
The DVD business is in decline and Netflix has no plans to either resurrect it or try to compete with other DVD rental businesses. They will keep what they have. DVDs create cash flow and investments in titles (capital spending) are minimal. Continued integration with streaming will affect gross margins with high shipping and handling costs. Distributing streaming content allows better economies of scale. DVD shipping and handling does benefit from some scale and gross margins will feel the impact of DVD costs spread over a smaller subscriber base and less volume as the service continues to lose subscribers.
Reed Hastings has conceded growth in DVD rentals to kiosks—good news for Coinstar.
If Blockbuster liquidates this year, like Movie Gallery did last year, we may see a modest boost in shipments, but we think the bulk of the remaining video store customers will tend to visit kiosks for $1-a-day DVDs, and they will get streaming from Netflix. Even though we expect DVD shipments to decline this year, we want to be clear that we intend to continue to offer great DVD-by-mail service for many years to come.
While not predicting the death of the DVD business for Netflix, Hastings has consigned it to a reliable source of cash, albeit a static one. Costs to ship and handle are still material but it pays its way.
The DVD Business
The fee structure has undergone changes over the years and that was a tool NFLX was able to use to increase revenue/and or customers. The flat fee streaming business is rigid. Until recently Netflix had 9 separate plans for subscribers to choose from.
A brief recap of the company’s history:
The first plan was a limited plan at $15.95 for 4 DVDs with no late fees per month in 1999. It was the no late fee that was the hook for subscribers. Later, unlimited rentals capped only by the turnaround in shipping brought in more subscribers.
In 2007, Netflix began offering streaming content bundled with the DVD plans and again kept numbers growing.
November 2010, the company introduced streaming only for $7.99 unbundled from DVDs.
From Netflix November 2010:
We are now offering a new $7.99 a month plan, which lets you instantly watch unlimited TV episodes and movies streamed to your computer or TV. This plan does not include any DVDs. All the titles you can watch instantly on your current plan are also available on this new plan, and as a reminder, not all titles on DVD are available to watch instantly. This new plan is available immediately
Second, we are increasing the prices on our unlimited plans that offer both watching instantly and DVDs by mail. On our two most popular unlimited plans – the 1 DVD out at a time and 2 DVDs out at a time – the price is increasing by $1 a month. We’ve also included below the changes on all the plans.
Why the changes? Our selection of TV episodes and movies available to stream has grown dramatically, and as a result most members want us to deliver unlimited TV episodes and movies two ways: streaming instantly over the internet plus DVDs by mail. The price increase will allow us to continue to offer the popular plan choice of unlimited TV episodes and movies streaming instantly along with unlimited DVDs. The new plan, which does not include DVDs, is a great option for the increasing number of members who only want to watch instantly. The $7.99 a month price reflects no DVD shipping costs on this plan.
You might also wonder why we haven’t introduced a new plan that includes only DVDs by mail. The fact is that Netflix members are already watching more TV episodes and movies streamed instantly over the Internet than on DVDs, and we expect that trend to continue. Creating the best user experience that we can around watching instantly is how we’re spending the vast majority of our time and resources. Because of this, we are not creating any plans that are focused solely on DVDs by mail.
That lasted about one year. The separation into two services in 2011 did not go over well and for the first time in its short history, Netflix lost subscribers.
[See Post for Tables]
Since it was possible to get movie plans with unlimited streaming at $1 more in 2010 over 2009 prices, it’s easy to see why subscribers reacted ferociously when the price increases were announced in July 2011--$7.98 for streaming and $7.98 for 1 unlimited DVD with no streaming. Customers would be paying $16 for what had cost them $10.
In September 2011 Hastings only made matters worse with a planned separation of business names, billing and physical structures with Netflix DVD becoming a wholly owned subsidiary called Qwikster. Netflix lost an estimated 800,000 subscribers by raising prices and then announcing the DVD service would be a separate business, Qwikster. Qwikster was quickly shelved, but the price increases and the physical separation remain. Streaming has become the company’s focus and gets most of the attention and investment dollars. Reed Hastings’ nightmare scenario is getting left behind in the streaming content wars and going the way of Borders – irrelevant and out of business. It may have blinded him to the remaining value of the Netflix DVD service even in a streaming content world. Netflix will keep the DVD business, but will not invest heavily in it to create growth. Those days are over.
Coinstar is thriving:
April 12: Coinstar Inc. raises its first-quarter and full-year revenue guidance on the popularity of its Redbox movie business. Coinstar says recent price hikes didn't dampen movie rentals during the period as much as it thought they might. And consumer demand jumped on the popularity of movies such as "Moneyball" and "Puss and Boots."
Subscription numbers and revenue increases
The increase in paid subscribers is not an accurate indicator at a 1:1 ratio for predicting increased amounts in revenue. The two rates often diverge.
Netflix can grow revenue two ways – more subscribers and/or raise prices. Before streaming, Netflix had tiered pricing that could be adjusted to raise revenue or build a subscriber base. When Netflix cut prices in 2005 to boost subscriber growth, revenue lagged in 2005 and 2006, but subscriber increases were some of their highest.
Churn makes it difficult to predict revenue growth as a function of subscriber increases. When customer’s leave and new customers are counted is important. Losing a customer the first month of the quarter and adding a customer the last month is not equivalent to keeping a subscriber all three months—one month of revenue has been lost but customer count remains unchanged. High churn can decrease revenue,but subscriber growth can and does increase.
Subscriber growth will be mainly streaming content. The price at present is fixed at $7.99 and pricing increases to raise revenue will not be used to increase revenue. Revenue and profit growth will be based almost completely on expanding the subscriber base.
[See Post for Tables]
This same trend applies to Q1 2012 -— average number of subscriber’s increased 21% and domestic revenue grew 17%. International subscribers increased by 257%, revenue increased 252%. While it’s tempting to try to predict revenue using subscriber numbers, it’s not practicable and that makes estimating future revenue numbers difficult even if the company estimates new subscribers.
Paid subscriber growth hit a 5-year high in 2010 and was a response to the free bundled streaming deal. It only lasted a year and by 2011 paid subscriber growth was dropping. Before streaming content, DVD subscriber adds climbed between 2004-2006 and then slowed by 2007 indicating some saturation. Streaming returned Netflix to high growth and record prices per share and explains Hastings’ preoccupation with becoming the streaming king and DVD’s demotion to second-class citizen.
In July 2011, DVD and streaming were separated into DVD-only and streaming-only payment plans. Customers have opted out of paying for both over the last three quarters and most of the new subscribers are streaming only.
Subscribers that paid for two separate accounts—DVD and streaming:
[See Post for Tables]
Streaming-only continues to expand while DVD numbers are shrinking. DVD is expected to continue to lose members but at a slower rate of decline. Unfortunately, domestic streaming appears to be decelerating and international may be the best chance for Netflix to resume high growth. International is not a proven business plan and Netflix is entering unknown territory. Case in point—difficulties finding an easy way to get paid in Latin America since credit cards are not as ubiquitous a payment method as in the states.
The DVD business still generates profits even with high shipping and handling costs. The future of DVD has been conceded to the competition and at some point if numbers drop enough, shipping and handling will not be cost effective.
From Netflix 2010
While streaming is much bigger for us than DVD, in hours of entertainment delivered, and streaming is growing much faster than DVD, our DVD shipment and content costs are still very material. Fortunately, disc shipments in the quarter increased only modestly over Q4 2009, and we expect year-over-year shipments to decline in the coming quarters. If Blockbuster liquidates this year, like Movie Gallery did last year, we may see a modest boost in shipments, but we think the bulk of the remaining video store customers will tend to visit kiosks for $1-a-day DVDs, and they will get streaming from Netflix.
DVD rentals accounted for 37% of Q1 2012 revenue and contributed 45% adjusted operating margins (only cost of sales and marketing deducted)
The high cost of streaming
Streaming content has a high price tag. In 2008, Netflix was able to buy 2500 titles from Starz for $30 million per year. Starz and Netflix parted ways in February 2012 when a deal could not be reached for renewal. Rumor has it Starz wanted at least $200 million per year. Starz was important to Netflix for its catalog of more current programming including movies and original content. Workaround deals with Disney and other studios directly are costly and have not replaced all titles. Even older programming on second tier networks like CW (going bankrupt before the Netflix deal) is premium priced. Netflix is reportedly paying $1 billion for 4 years of older episodes of Vampire Diaries and Gossip Girl among others.
The battle for exclusivity and new movies and television has made it a seller’s market.
Over the last five years, acquisition of streaming content has gone from $48.3 million in 2008 to $2.3 billion in 2011. Additions to the streaming content library were $765 million in Q1 2012. The total gross streaming library is now at $3.2 billion with $3.7 billion in obligations not included on the balance sheet.
In 2007, Netflix invested record capital expenditure of $223 million for DVDs (not including revenue sharing). In 2011, they spent only $85 million for DVDs. The gross DVD library is $581 million and is now largely depreciated. DVDs are largely paid for and do not consume much in investment dollars. With the cash flow from DVDs, it is a business segment worth keeping for now.
Compared to the DVD investment and gross library, streaming content is expensive and completely transforms the business model decreasing both cash flow and free cash flow. Looking at the cost of content/revenue shows how much revenue is “consumed” by the cash cost of content acquisition and is a rough measure of the efficiency of streaming vs DVD. Cost is cash cost and not additions to the streaming content library. Cash cost includes amounts found on the cash flow statement as well as a “hidden” cost in the cost of subscription from the profit and loss statement.
To get cash cost of streaming, change in liabilities is subtracted from additions to streaming content on the cash flow statement and streaming content costs from the above table are then included. The result is a higher cash cost than we find either through using amortization as a proxy or simply the cash flow statement number.
The costs have risen impressively over the past three years and the estimated Q1 cost was $445.3 million for just three months. The costs will increase sequentially every quarter according to management and 2012 spending for streaming will be a record high. It will continue to pressure margins although NFLX expects an increase in the streaming content operating margin at 2% in Q2 and 1% Q3 and Q4. I am not convinced it’s going to increase by 4% by 2013 and it should be tracked.
In Q1 2012, streaming cash cost rose to 51% of revenue. As content costs become a bigger percentage of revenue, profit becomes more elusive turning to negative profits in Q1 2012.
Domestic subscription additions and revenue growth slowed in Q1 even as operating expenses grew. International expansion is strong but subscriber numbers are still low and the revenue generated does not support the cost of content and marketing. Netflix earnings were in the red for Q1 and the stock price suffered an extreme and entirely logical correction.
In addition to the expense of streaming content found on the financial statements (profit and loss, balance sheet and cash flow statement), there is a substantial obligation coming due that does not meet the criteria for library content found in the footnotes only.
Cash flow from operations was only $19 million in Q1 2012 compared to $$116.3 million in Q1 2011. Free cash flow dropped to $780,000 from $78 million in 2011. Most of the decrease was due to the increase in additions to streaming content.
The bulk is due 2012-2015 and will be in addition to any newly acquired content. As streaming costs continue to climb and are unlikely to either flatten or decline through 2015, higher subscriber growth is the only strategy that will increase gross margins. There are no plans to tier or increase pricing.
Margins through 2011 were relatively stable. The higher spending for content was partially offset by decreased spending in shipping and handling of DVDs. Revenue and subscriber increases were high enough to maintain margins even with escalating streaming costs. That changed in Q1 2012 as margins disintegrated.
Part of the problem was slowing subscriber adds and revenue on top of rising streaming content costs.
Year over year growth has slowed even at the top and gross on down are suffering from higher content and marketing costs.
The other hit to margins was an increase in marketing spending the last two quarters to push NFLX growth internationally. It’s easy to see why the company reached a peak share price between May-September of 2011 with the remarkable numbers it was turning in. Success now is going require international expansion. In March 2012, domestic streaming increased only 9% to 22 million subscribers and international was up 257% to 2.4 million. There is very little chance higher/tiered pricing will help revenue at least in the near term.
Netflix has beat challengers into obsolescence in the past. Blockbuster folded, as did Wal-Mart’s attempt to enter the rental DVD business. The content wars are different -– bidding for programming puts the owners of content in control. Prices for premium content are subject to demand –demand is high. DVD prices were cheap and negotiable.
HBO (part of Time/Warner) will not let go of premium content at any price and has set up their own streaming service for original content like the enormously popular Game of Thrones. Comcast has launched Xfinity for $4.99. Starz and Netflix could not reach a deal after Starz discovered its content was worth a great deal more than $30 million per year. The new world of streaming content is more treacherous and more expensive than the rental of DVDs where Netflix was the undisputed leader.
As we move up in the content buying economic strata, you start off with kind of a low-end nonexclusive content and then as you want to get shows like Mad Men, you have to outcompete with other cable networks that get those shows in syndication and those are exclusive licenses, and so we started giving more and more of those. As we want to do direct deals with movie studios like DreamWorks Automation, the other bidders will not take that content if we also have it. So those are de facto exclusive. So this exclusive trend has been going on towards more and more exclusive and will continue as we climb the economic strata and have better and better content. It's a natural outcome of us being a network like other cable networks, all of which are exclusive against each other. I don't think we'll have all of our content and really at any point in time, because we'll continue to also have a broad range of non-exclusive content, but certainly will be more and more that is exclusive.
Outlook - Increased Seasonality in Net Adds
Netflix expects to see 15% streaming margins in Q2. They were 13.1% in Q1 (compared to 45% for DVDs). For Q3 and Q4 they are looking for 1% improvement each quarter and possibly extending it into 2013. In order for that to happen, streaming costs have to grow more slowly than revenue.
The company guided to 7 million net subscriber additions. The gross adds are projected at around 11 million. Taking seasonality into account and adjusting for the churn, revenue increases by an estimated $535.9 million to $3.7 billion for 2012. The growth would be 17%.
Streaming content library additions were $2.3 billion in 2011 and would need to come in below $2.7 billion if Hastings is using 17% growth as a cap. Netflix already spent $765 million in Q1 leaving less than $1.9 billion in the budget for the remainder of 2012.
If cash costs are used, $926 million is the upper limit of cash left for content Q2-Q4. Using either figure does not allow for the aggressive content acquisition strategy Netflix has been using over the past year to attract customers.
If they can stay within budget, even at the high end, streaming costs/revenue would moderate to 35% and allow for the margin expansion they are looking for. I’m betting they will overspend. Popular programs and movies are expensive and they need great content to compete.
Netflix plans to continue spending on original content and that will come out of the streaming content budget leaving even less to buy premium movies and TV. They have targeted 5% spending. A high value/quality production like Game of Thrones costs $5 million per episode. For a season of 9 episodes that’s $45 million. The costs are high but well within the budget even for high quality work. Netflix may be aiming for a lower budget and less expensive production at least at first. It’s not a bad investment if they can locate good directors and quality scripts.
At 29% subscriber growth and 17% revenue growth estimated for 2012, Netflix is not the company it was. These growth rates may be the best we can expect and returns to historic numbers at 40%-60% are unlikely. The new normal may not make Netflix much of a momentum stock, but if it can continue to move along in the teens and combine that with meaningful margin expansion, $65 per share could prove a reasonable entry. Ultimate success depends on acquiring the great and often expensive programs needed to attract subscribers with a disciplined acquisition strategy that won’t destroy margins in profits. The new reality is that content owners are in control and there will be bidding up of the best movies and TV as competitors scramble for exclusivity and quality that snares subscribers.
Hulu launched its first original series, and has continued its platform (Wii) and country (Japan) expansion. While we have ten times more domestic paid members, and we added over three times more domestic net additions than Hulu in Q1, we do watch them carefully. Most of their viewing, we believe, is from current-season broadcast-network content.
Amazon continues to grow its U.S. video content library available through Amazon Prime. We think they are still substantially behind Hulu in viewing hours. Given Amazon's size and ambitions, we continue to track their progress carefully as well.
A discounted cash flow is not an exact science but can give a rough idea of value under a reasonable set of circumstances.
For Netflix the subscriber number growth can be used as a reality check when looking at what number of subscribers it takes to support a certain level of revenue.
If Netflix could grow at a compounded annual growth rate over 10 years of 10%, revenue would reach $8.7 billion and would require 86 million subscribers paying $7.99 per month. The company has guided to as many as 90 million subscribers—they do not mention a time frame. This is what it would take to get to almost $9 billion in revenue. To put that into some context, Netflix has grown from $272 million in 2003 to an estimated $3.8 billion by the end of 2012 – a 14-fold increase. The discounted cash flow requires a 2.7X increase in revenue and a 3-fold increase in subscribers in 10 years. It seems conservative, but the super-charged growth of the past decade will be hard to replicate under current conditions. The expenses are escalating and the competition is unrelenting.
Netflix has substantial off balance sheet streaming obligations. I decided to treat that as debt and it lowered the value just as any debt would in a DCF. It seems a fair treatment of this expense that is not captured in the current capex estimates or net income.
The value at 10% CAGR accounting for 86 million subscribers and $8.7 billion in revenue in year ten gives Netflix a value of $75 and is close to where the company trades today. It’s a long way from $300.
The streaming content obligations treated as debt decrease the value and if they are not included, the price per share climbs to $136. IMO, it is necessary to put them in somewhere. If they are ignored, the company gets this future spending for free. It is not included in either capital spending or as part of cost of sales i.e. subscription costs.
In the end, Netflix is worth what the market will pay. If the high growth story of the past resumes, $75 is low. There is nothing like momentum for taking a stock to stratospheric levels. If current conditions prevail and bidding for programming continues drive costs and subscribers are fractured across different services, then growth will moderate and $65 represents only a slight undervaluation.
I would be surprised if Netflix in 10 years looks even remotely similar to Netfix 2012. The streaming middleman model could be replaced or at least supplemented by a Netflix that becomes part of a cable/satellite package. They could also become a heavy weight in original content if they can find financial success and a knack for creating popular programming. A model that holds them static as subscriber-only at $7.99 is conceptually flawed and waits to see what the company does next.
Caps on use--bandwidth hogs beware