Important disclosures appear on the last page of this report. The Henry Fund Henry B. Tippie College of Business Jacob Kammerer [[email protected]] Netflix, Inc. (NFLX) April 20, 2021 Communication Services – Entertainment Stock Rating Buy Investment Thesis Target Price $605-610 We recommend a BUY rating on Netflix, Inc., driven by low cost of content per subscriber and a projected 35.3% compound annual growth rate in memberships in the Asia-Pacific region. Netflix is the dominant video streaming firm, boasting the most paid memberships worldwide. We believe Netflix will experience beneficial scaled economics given the vast scale of its operations. We project an upside of 11.0%, and recommend a buy rating. Drivers of Thesis • Projected 35.3% compound annual growth rate in memberships in the Asia- Pacific region, driven by low subscriber penetration rates per capita. • Strong scaled economics driving down costs due to Netflix’s vast scale, with a projected 90% increase in gross margin between 2020 and 2030. • Netflix has the most subscribers and distributes content at near-zero marginal cost, so Netflix can simultaneously be the highest bidder for content and achieve the lowest content cost per subscriber. Risks to Thesis • Increased competition cannibalizing Netflix’s subscriber growth, potentially lowering our projected 15.6% compound annual growth in total revenue. • Lower than expected revenue per membership growth, especially in Latin America where we project a 3.0% compound annual growth rate. • High content acquisition costs as a result of increased competition, lowering our projected 90% increase in gross margin. Henry Fund DCF $608 Relative PEG 2021 $573 Henry Fund DDM $509 Relative P/E 2021 $331 Price Data Current Price $549.57 52wk Range $393.60 – 593.29 Consensus 1yr Target $619.43 Key Statistics Market Cap (B) $243.4 Shares Outstanding (M) 442.9 Institutional Ownership 81.5% Beta 0.83 Dividend Yield 0.0% Price/Earnings (TTM) 90.4 Price/Earnings (FY1) 50.8 Price/Sales (TTM) 10.0 Profitability Gross Margin 38.9% Operating Margin 10.6% Net Margin 18.3% Return on Equity (TTM) 23.9% Earnings Estimates Year 2018 2019 2020 2021E 2022E 2023E EPS HF est. $2.78 $4.26 $6.26 $10.10 $9.86 $13.04 $12.71 $17.12 $16.99 growth 115.5% 53.2% 46.9% 57.5% 28.9% 33.7% Source: FactSet [1] , Yahoo! Finance [2] 12 Month Performance Company Description Netflix is an international entertainment firm that enables members to watch as much video content as they want, where they want, and when they want. Netflix operates the popular Netflix application, which can be accessed on any platform with an internet connection. Netflix derives 99% of its revenues from streaming services, and boasts a paying membership base of 204 million users. [3] Netflix is expected to maintain their streaming dominance moving forward, even given the influx of streaming competitors. 88.7 9.8 16.4 89.8 5.7 64.8 27.0 3.8 13.1 0 20 40 60 80 100 P/E P/Sales EV/EBITDA NFLX DIS Industry -10% 0% 10% 20% 30% 40% 50% A M J J A S O N D J F M NFLX S&P 500 Source: Yahoo! Finance [4]
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NFLX Report - Spring 2021Apr 20, 2021 · Netflix, Inc. (NFLX) April 20, 2021 Communication Services – Stock RatingEntertainment Buy Investment Thesis Target Price $605-610 We recommend
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Important disclosures appear on the last page of this report.
The Henry Fund
Henry B. Tippie College of Business Jacob Kammerer [[email protected]] Netflix, Inc. (NFLX) April 20, 2021 Communication Services – Entertainment Stock Rating Buy
Investment Thesis Target Price $605-610 We recommend a BUY rating on Netflix, Inc., driven by low cost of content per subscriber and a projected 35.3% compound annual growth rate in memberships in the Asia-Pacific region. Netflix is the dominant video streaming firm, boasting the most paid memberships worldwide. We believe Netflix will experience beneficial scaled economics given the vast scale of its operations. We project an upside of 11.0%, and recommend a buy rating. Drivers of Thesis • Projected 35.3% compound annual growth rate in memberships in the Asia-
Pacific region, driven by low subscriber penetration rates per capita. • Strong scaled economics driving down costs due to Netflix’s vast scale, with
a projected 90% increase in gross margin between 2020 and 2030.
• Netflix has the most subscribers and distributes content at near-zero marginal cost, so Netflix can simultaneously be the highest bidder for content and achieve the lowest content cost per subscriber.
Netflix is an international entertainment firm that enables members to watch as much video content as they want, where they want, and when they want. Netflix operates the popular Netflix application, which can be accessed on any platform with an internet connection. Netflix derives 99% of its revenues from streaming services, and boasts a paying membership base of 204 million users.[3] Netflix is expected to maintain their streaming dominance moving forward, even given the influx of streaming competitors.
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COMPANY DESCRIPTION
Netflix is an streaming video on demand (SVOD) company with operations worldwide. Its mission is to “entertain the world.” [5] It operates via two distinct segments: streaming services and DVD-by-mail services. It derives 99% of its revenues from streaming, with the remaining 1% of revenue coming from DVD-by-mail services. Netflix is available in every country except China, North Korea, Syria, and Crimea, due to a challenging regulatory environment. Current company initiatives include “growing [its] ecosystem of users and rapid innovation.” [6]
Revenues have been broken down geographically, below. The most profitable region is the U.S. & Canada (UCAN), where the average revenue per membership is much higher relative to other regions. The UCAN has the largest subscriber base, comprising 34% of total subscribers in 2020. We expect lower relative growth in monthly memberships in the UCAN region in years to come due to market saturation, with the highest growth in the Asia-Pacific (APAC) and Latin America (LATAM) regions.
Source: NFLX 10-K [7]
DVD-by-mail Service
Netflix’s DVD-by-mail segment is the smaller of Netflix’s two operating segments, and accounts for 1% of total revenue. This service is only offered in the United States, and is a remnant of its past business model. “In 1999, Netflix began offering an online subscription service through the Internet. Subscribers chose movie and television titles from the Netflix website; the shows were then mailed to customers in the form of DVDs.” [8] Revenues from this segment consists of membership fees associated with subscribing to the Netflix DVD-by-mail
program. This was Netflix’s primary revenue driver prior to the mass adoption of streaming, but its revenue share has continuously declined since 2011. We forecast continued decline of 20% in this revenue segment, based on year-over-year decline in the previous three years. Netflix does not provide any additional details on segment profitability versus cost or when they plan to fully discontinue the segment. As of FYE 2019, “over two million members in the U.S. subscribe to [the] DVD-by-mail legacy service.” [9]
Source: NFLX 10-K, [10] Henry Fund Model
Streaming Service
Streaming services account for 99% of Netflix’s total revenue. This service is offered worldwide, and can be used by anyone with a broadband internet connection of at least 0.5 Mbps. Streaming revenues are dependent upon two factors: total average paying memberships and monthly revenue per paying membership.
Average Paying Memberships
Netflix boasts the most paying memberships of any streaming platform, with an estimated 204 million persons subscribing to its platform as of FYE 2020.[11] This represents membership growth of 21.9% year-over-year from 2019 to 2020. We expect robust membership growth in the next five years, especially in the APAC and EMEA regions, where we project a 35.1% and 16.5% CAGR, respectively. We expect lower growth in the UCAN region, due to market saturation and limited growth opportunity.
The graph below plots growth in memberships in the APAC region versus growth in total revenue. The APAC and LATAM regions remain largely untapped, with low membership penetration levels relative to the total population. However, LATAM countries have smaller library content sizes so we expect lower growth in memberships due to less engagement. We expect membership growth in the APAC and EMEA markets will drive revenues over our forecast horizon.
Source: NFLX 10-K, [13] Henry Fund Model
Monthly Revenue per Paying Membership
Netflix boasts the highest revenue per membership of any SVOD platform, with a global average revenue per membership of $10.91.[14] Revenue per membership varies significantly by region, as shown in the table below. We expect membership fees to increase most significantly in the LATAM and EMEA regions, which in turn will boost revenue per paying membership. Currently, revenue per membership in the UCAN is much larger than the other three regions. As such, we expect minimal growth in membership fees within this region, and expect fees to keep pace with inflation. We forecast low terminal growth in average revenue per membership of just 1.5% for each region, given that Netflix has limited ability to increase price drastically due to high elasticity of demand. These terminal growth values simply capture the effects of inflation.
In the U.S., there are three distinct subscription plans that determine membership fees: basic, standard, and premium. Each subscription comes with unlimited access to movies and TV shows on any device. However, the choice of subscription plan directly effects which additional features are available. The table below shows the monthly cost for a U.S. membership, and the total number of screens that can play Netflix content simultaneously. Netflix does not offer any additional information on which subscription plans are most popular. Further analysis of competitors pricing plans can be found under the “markets and competition” subheading.
Basic Standard Premium Monthly Cost $8.99 $13.99 $17.99 # of screens 1 2 4 # of devices with downloads
1 2 4
Source: Netflix Plans and Pricing [16]
Total Revenue
Streaming service revenue has seen tremendous growth over the past eight years, once accounting for only “60.5% of [Netflix’s] total revenues in 2012.” [17] The graph below shows total revenue by region. We expect revenue in the EMEA region to overtake U.S. revenues, especially as broadband internet connectivity increases in this area (this is covered more fully in digital trends, below). We also expect APAC revenues to overtake LATAM revenues, with high growth in the India and Indonesia markets. The primary driver of this is a push toward producing original content in languages native to APAC countries.
Source: NFLX 10-K,[18] Henry Fund Model Projections
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Cost Structure Analysis
We forecasted the majority of Netflix’s expenses as a percentage of sales, with the exception of cost of revenue. We forecasted cost of revenue based on beginning content assets and content amortization, since “amortization of content assets makes up the majority of cost of revenues.” [19] The underlying assumption is that accumulated content amortization cannot exceed content expenditures. Below, the graph shows the historical and forecasted cost of revenue. We expect Netflix will experience economies of scale while growing operations, with cost of revenue (as a percentage of sales) gradually decreasing and settling at 44.9% of sales.
Source: NFLX 10-K [20]
We expect general & administrative (G&A) and marketing expenses to decrease over time, as Netflix experiences economies of scale while growing revenues. However, we technology & development (T&D) expenses to increase slightly due to their integral nature in helping Netflix produce engaging and relevant content. Expenses are summarized, below.
Netflix has increased gross and net margins, year-over-year, from 2016-2020. We expect gross and net margins will continue to increase over the next ten years, driven by low cost of content relative to its subscriber base. We project an increase in gross and net margins of 6.9% and 11.5% CAGR, respectively.
Source: NFLX 10-K, [22] Henry Fund Model
Target Market Analysis
Netflix has no primary target market, and markets its services to anyone who desires ease-of-access to entertainment. Netflix plans to continue expanding into untapped markets as broadband connectivity increases. The graph below shows content library size by country. We expect Netflix to continue growing its library size in the EMEA and APAC regions, where growth potential is highest due to low membership penetration levels.
Source: Comparitech [23]
In recent years Netflix has made a tremendous effort to produce content that engages a wide array of audience groups, regardless of age, gender, sexual orientation, or culture. Netflix has also made efforts to produce content in other languages, and content that is inclusive of a variety of cultures. The company launched “the Lunar New Year Premium Collection” [24] in January 2021, which “showcases mandarin-language premium titles.”[24] Netflix has strategically positioned themselves to continue growing organically in emerging markets.
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Debt Maturity Analysis
Netflix has taken on a large amount debt in recent years. This has had benefits such as lowering their weighted average cost of capital, but it has also required increasing dependence on revenue growth and generating free cash flow. We do not expect Netflix will need to refinance debt in the next 10 years due to their positive free cash flows. Management does not give any guidance on target capital structure, but historically has maintained no more than 10% debt relative to total enterprise value. We expect this to remain the case, barring any materially adverse effects. In January 2021, Netflix was upgraded by S&P “to BB+ on strong video streaming trends and positive free cash flow.”[25] This rating has been trending upward over the past year, with Netflix’s credit rating being raised twice.
Netflix reported 2021 Q1 earnings on April 20, 2021. It beat analyst expectations in revenue growth and EPS, but fell below estimates for subscriber additions. Specifically, Netflix reported the following metrics relative to analyst expectations:
Expectation Reported EPS 3.75 2.97 Revenue 7.1 B 7.2 B Subscriber additions 6.2 M 4.0 M
Source: CNBC Netflix Earnings Report [27]
Netflix stock fell 8.7% in after-hours trading on April 20th [28] in reaction to the company reporting significantly lower subscriber additions. Management indicated the reason for the slowdown in membership growth was from “a lighter content slate in the first half of this year, due to Covid-19 production delays.” [27] We are not worried by the
lower than expected subscriber growth. Netflix is maturing as a firm, and lower growth in total paying memberships is to be expected. Q1 revenues fell in line with analyst expectations. Netflix beat EPS expectations by 26%, likely due to lower than expected costs.
Looking forward, management gives the following guidance: [27]
• 17 billion in content spending this year • Higher content release in second half of 2021 • Initiating a share buyback program in 2021 • Continued testing of password crackdown
We expect EPS to dramatically increase in the next three years, given that Netflix is initiating a share buyback program. Netflix is maturing as a firm, and has the profitability to return wealth to shareholders via buybacks. We also expect restrictions will be eased such that Netflix can fulfill its goal of spending 17 billion on content. This will likely bolster membership growth in the second half of the year, and enable Netflix to achieve a projected 226 million memberships by FYE 2021.
COVID-19 Impact
Netflix has benefited from the Covid-19 pandemic; and that may be the understatement of the year. It achieved positive free cash flow for the first time in its 2020 fiscal year, and added 36.5 million subscribers for a total year-over-year growth of 21.9%. The company did this while simultaneously “raising the prices on its standard and premium plans for U.S. customers.”[29] This has only further solidified its dominance in streaming.
Netflix will likely retain this user base moving forward. We have factored this assumption into our model through continuous subscriber growth. We do not expect a mass exodus from the platform even when restrictions are lifted, and see a permanent change in the way people consume video media. However, we forecast conservative growth in memberships in 2021 due to the easing of Covid-19 restrictions. We expect people will spend less time at home, whether it be due to work or outdoor leisure activities, which will decrease time spent streaming. This has the possibility of eating into Netflix’s subscriber base, as pent up demand results in a shift in budget allocation from streaming to travel. However, we see this as unlikely given that streaming is seen a staple.
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Password Sharing Crackdown
In early March, Netflix said it has “started testing a feature that could prod users who are borrowing a password from someone outside their household to buy a subscription.” [30] Password sharing has been a common practice among friends and extended family for years. This feature attempts to curb this behavior by prompting users to verify the account via an email or text code if the company detects the person is not the account owner. If Netflix decides to implement this feature universally, it could yield large organic subscription growth for Netflix in years to come.
We expect Netflix will roll out this system on a broader basis, assuming this system is a successful deterrent to password sharing. This will help boost average paying memberships, and also ensure better security measures are in place. However, it is important to note that we do not think the company will risk its current user base through a heavily-enforced password crackdown; they merely are reminding users of a breach in the terms of use agreement.
INDUSTRY TRENDS
The mass adoption of streaming has changed how people consume video media. From cord cutting to increased broadband connection, people can stream from almost anywhere and at any time. And the adoption of mobile technology has only further solidified this shift in consumption. It gives consumers the ability to consume media where they want, when they want. This trend has enabled firms such as Netflix to capture tremendous market share, and grow operations aggressively.
Cord Cutting
Pay TV has experienced what is known as the “cord cutting” trend over the past 10-12 years. This correlates with when Netflix introduced video streaming, which provided an alternative to basic cable television. Cord cutting has directly benefited Netflix, whose service is much cheaper than traditional cable television. The graph, below, shows DirecTV’s total subscribers from FYE 2014 through 2020. Subscriber growth has trended downward, as internet connectivity speeds increase and more people desire the convenience of streaming. We expect a continued trend in cord cutting, and expect this is one way Netflix will continue to grow its membership base.
Source: Statista [31]
Broadband Access
Broadband access is essential to streaming video content via Netflix. A minimum broadband connectivity speed of 0.5 Mbps is required to stream Netflix’s content. As such, total broadband penetration is one of the foremost indicators of potential growth. The graph below shows mobile broadband subscriptions worldwide, from 2015 to 2020. Broadband subscriptions have rapidly been increasing as this technology becomes widely available to most of the world population. However, this growth has slowed in the past four years, as we reach the upper bound of potential broadband subscribers.
Source: Statista [32]
Broadband connection speed is a crucial factor in the quality of video streaming. Higher connection speeds allow for seamless streaming capability, which enhances viewer experience. As such, we have broken down fixed broadband connection speeds by select country in the table below, with data presented as of March 2021.
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Country Connection Speed (Mbps) Thailand 230.6 Romania 210.8 France 193.5 South Korea 185.0 U.S. 182.7 Chile 170.0 China 168.0
Source: SpeedTest Global Index [33]
Original Content
Original content is any content that is exclusive to a platform. “Netflix has been releasing movies and TV Series under the label “Netflix Original” since 2013.” [34] This is an example of original content, which can only be watched on the Netflix platform. Netflix’s debut of original content has proved to be a master-stroke in forward thinking; as content contracts expire and the licensed content is returned to its rightful owner, Netflix is left with a wonderful library of original content. Below, the table shows Netflix content spending and year-over-year growth in spending. This spending goes toward producing original content, which in turn retains and grows Netflix’s large userbase.
2017 2018 2019 2020 Content Spending
$8.9 B $12.0 B $15.3 B $17.3 B
YoY growth 34.8% 27.5% 13.1%
Source: Statista [35]
Firms saw the success of original content and tried to replicate it. Amazon began debuting original content in 2015, and now almost every major platform produces some form original content. This has changed the landscape of streaming, enabling firms to retain a loyal customer base due to the various shows and movies they simply cannot find anywhere else. We expect Netflix to remain the industry leader in original content, because it spends so aggressively in this area. Netflix also has access to large amounts of user data, which can be used to generate engaging content.
Higher Screen Times
On average, adults in the U.S. spent 3.75 hours browsing or in apps on their smartphone per day. Furthermore, total screen time among all digital devices increased to 7.5
hours in the U.S. during the pandemic. These higher screen times have directly translated into higher revenues for firms within the video streaming space. Screen times are expected to continue trending higher as we enmesh ourselves more fully with the digital world. We believe the companies that are most advantaged by this trend are streaming platforms. Netflix, Disney, Amazon, AT&T, and NBCUniversal are all poised to continue growing streaming revenues as a result of our digital appetites.
The graph below shows the trend in time spent with traditional media versus digital media in the U.S. The term “traditional media” refers to media such as television, radio, newspapers, and magazines. This trend toward greater digitalization is likely here to stay, and will continue growing rapidly both the U.S. and abroad. This large increase in screen time provides digital advertising firms with the opportunity to reach an audience that numbers in the billions, and take full advantage of monetizing this trend.
Source: eMarketer [36]
Passion Brand
Netflix has followed many successful predecessors in developing what is known as a passion brand. A passion brand focuses on doing one or two things well, rather than attempting to perfect multiple, different types of operations. Examples include “Starbucks, not 7-Eleven; Southwest, not United; HBO, not Dish.” [37] This focus has enabled Netflix to remain the leader in streaming, and continually produce content that is critically-acclaimed, popular, and highly engaging. We expect Netflix will keep this as its central focus in the coming years, and would see any deviation from this vision as an indication of poor future outlook.
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MARKETS AND COMPETITION
The entertainment industry is filled with large companies that vie for viewer attention and interaction. This is especially true of video streaming, with the advent of the so-called “streaming wars”. In recent years, large companies have observed the success of Netflix and debuted their own streaming platforms. This has come at a cost to Netflix, who previously enjoyed unfettered control of the streaming market. Currently, the main players within this market include Netflix, Disney (Disney+ and Hulu), and Amazon Prime. Along with these main players, other notable participants include AT&T (HBO Max), Comcast (NBCUniversal’s Peacock), Apple TV+, Google (YouTube TV), and ViacomCBS (Pararmount+).
The market dominance these select few companies is expected moving forward, especially for Netflix. The company has been very active in producing and acquiring original content since 2013, giving it an advantage as other companies try to simultaneously create new content and retrieve content that was licensed. However, we expect smaller platforms like HBO Max to gain a large subscriber base due to its broad library of legacy content.
The graphic below shows the percentage of consumers surveyed who purchased streaming services from these providers, as of April 2020. Netflix exhibits clear dominance in membership penetration, and is only rivaled in size by Amazon Prime and the Disney suite of products (Hulu and Disney+). It is important to note this survey only included U.S. consumers. Abroad, large SVOD providers include Tencent Video, iQIYI, and Youku, which boast a 120M, 119M, and 90M subscribers, respectively, as of FYE 2020. We do not use these companies in our comparison, since they derive a large portion of revenue from China.
Source: Statista [38]
Peer Comparisons
The companies we have chosen to focus on for peer comparison all operate video streaming platforms, and together account for a significant portion of market share. Below, each of these companies is compared via total subscribers, subscription pricing tier, and 2020 content spending.
Total Subscribers
Ticker 2019 Subscribers
2020 Subscribers
YoY growth
NFLX 152 M 204 M 34% AMZN 75 150 100 DIS 33 165 400 CMCSA - 33 - GOOGL 15 30 100 VIAC 8 18 124 T 8 17 115 AAPL - 10 -
Source: FIPP, Company Annual/Quarterly Filings [39]
NFLX is best positioned in terms of total subscribers. NFLX has the advantage of being the first mover, and is the most mature of the streaming companies in terms of years providing streaming services. However, DIS and T are both exhibiting tremendous growth in subscribers. This is a result of these platforms being in their early-growth years; we expect growth in both to level off as they raise prices and reach a point of user saturation in the United States. These companies are still developing their subscriber base, do not expect these platforms will experience any meaningful saturation for the next couple years.
The key to future subscriber growth lies internationally, and especially in the Asia-Pacific and Latin America regions. We believe NFLX is best positioned to maintain and grow subscribers, even with the fierce competition and higher competitor subscription growth. This is due to a push toward producing international content, and an active presence in many of these markets. NFLX also has the ability to spend almost twice as much on content as its competitors, due to its large subscriber base, which helps solidify its dominance within the industry. We expect NFLX will not be surpassed by any of its peers in total subscribers over our projection period.
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Subscription Pricing Tiers
Ticker Basic Plan Cost Ad Supported? YouTube TV $64.99 No HBO Max 14.99 No Netflix 8.99 No Prime Video 8.99 No Disney+ 7.99 No Hulu 5.99 Yes Paramount+ 5.99 Yes Peacock 4.99 Yes Apple TV+ 4.99 No
Source: Platform Pricing Plans [40]
The table above shows the cost of the most basic subscription plan that each service offers, as of April 2021. The table also indicates which platforms operate an ad-supported service built upon the basic plan. The competitors most similar to Netflix will offer all content for a fixed monthly cost, with no ad-supported streaming. Given that Netflix is the largest player within the streaming industry, they can command one of the highest basic plan costs. We Netflix will remain a price-setter within the industry, and smaller streaming companies will follow.
2020 Content Expenditures
Ticker Estimated Expenditure Percent Netflix Netflix 16 B 100% Prime Video 7 44 Apple TV+ 6 38 Hulu 3 19 Disney+ 1.75 11 HBO Max 1.5 9 Peacock 1 6
Source: Forbes [41]
Netflix spends much more on content than its peers. This is illustrated in the table above, which shows 2020 estimated expenditures and the expenditures as a percent of Netflix’s total expenditures. Content expenditure can be seen as an investment, which will both retain membership base and attract new subscribers. Netflix’s high content spending is an attempt to bolster its content library, as licensing agreements for past content lapse and competitors retain the rights to stream content. We expect Netflix will remain the highest spender on content, since it has the ability to spend much more on content given its large subscriber base.
A Comparison Story
Lastly, we feel the streaming industry is experiencing what many industries have experienced in the past:
1. The success of a select few, first mover companies 2. An onslaught of new competitors 3. Merger-mania and consolidation
We feel that this is important to understand because history often repeats itself. Ford debuted the first, large-scale production of its Model-T. Soon afterward, many companies were trying to replicate this success, each with its own style, filling a niche within the market. After it became obvious that not all of these companies would become profitable, due to an upper-bound on total market size, the industry experienced large consolidation. What remained: the largest and most adaptable within the industry.
We feel the same will be true within the streaming industry. Netflix has a first mover advantage, and a proven ability to be adaptable. It has grown organically for years with no merger or acquisition activity, and has an uncanny ability to mirror competitor success. Even if Netflix will need to acquire competing firms, it will have the financial means to do so and will maintain its dominance.
COMPARABLE ESG ANALYSIS
The chart below shows ESG scores of Netflix’s major streaming competitors. We chose to focus on DIS, T, CMCSA, and AMZN since they all operate competitive streaming platforms.
Netflix has a low environmental score relative to peers, which bodes well for the company. This low score is driven in large part by the low energy usage required of its business model: energy consumption associated with operating corporate offices, data centers, and travel associated with filming. Netflix utilizes Amazon servers as
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the backbone of its streaming platform, which helps keep its environmental score low and in turn artificially elevates Amazon’s environmental score.
Netflix currently has a number of initiatives in place to lower its environment score, and as such decrease its effects on our climate. The primary company initiatives are:
1. Reducing emission by 45% in 2030 [43] 2. Investing in the regeneration of critical natural
ecosystems [43] 3. Fully neutralizing emissions that can’t be avoided
internally by investing in carbon prevention projects [43]
We believe these initiatives will help position Netflix to operate more efficiently, from a climate change perspective, and help bolster public perception of the company.
Social & Governance
Netflix has a relatively high governance score of 10 [44], driven by limited shareholder rights of lesser-stake holders in the company. We expect the company to take initiatives toward creating a more equitable and transparent governance structure. Netflix has a low social score, in part due to diversity initiatives and limited company controversy.
RISKS TO GROWTH
The primary risks facing Netflix are increased competition and streaming saturation. Netflix no longer operates unperturbed and with limited competition; as indicated above, Netflix is facing fierce competition from a variety of large companies, all of whom are well-equipped to capture streaming market share. Netflix also is dealing with the effects of limited growth prospects in the U.S. and Canada, which is showing signs of market saturation. These two issues must be closely monitored in the coming months and years, and any acquisitions within the streaming space must be closely monitored.
Streaming Wars
The streaming wars are in full swing, and it is not to the benefit of the first mover: Netflix. The company has maintained its competitive edge as other companies debut streaming platforms, and Netflix has even grown its user
base in the process, but there is an upper bound to the amount of money consumers are willing to allocate toward streaming entertainment. We do not anticipate Netflix will be adversely effected, since the company spends about twice as much on content as its competitors. However, these competitors have legacy content, such as cult classics like “Friends” or “The Office”, and will grow memberships as a result. We do not anticipate that Netflix will engage in any acquisition activity to drive growth.
Streaming Saturation
Movie and television streaming has seen explosive growth since first gaining wide adoption in 2007. However, it seems that we are nearing the upper bound of individuals willing to pay for one or more streaming memberships, especially in developed markets like the U.S & Canada. International growth will be a crucial aspect of future growth prospects, as well as any merger and acquisition activity within the streaming industry. We expect Netflix will utilize its strong cash reserves, user data, and international recognition to grow operations internationally, especially in the Asia-Pacific region.
ECONOMIC OUTLOOK
Netflix’s revenues are strongly correlated with personal disposable income, with a correlation coefficient of 0.87 based on regression analysis of data from 2014 through 2020. And since personal income is driven in part by strong GDP growth, we have chosen to examine these two economic indicators in concert with inflation. Netflix must keep membership price growth consistent with inflation expectations to maintain stable growth.
Personal Disposable Income
We see personal disposable income as the foremost economic indicator of Netflix’s outlook. The entertainment industry competes for a consumer’s personal disposable income. The U.S., and many parts of the world, are currently in a period of elevated disposable income, largely driven by continued stimulus. This has directly benefited streaming firms, who can charge more for subscriptions and maintain their consumer base. However, it is hard to predict the amount of disposable income people are willing to allocate to streaming, since “consumers’ preferences are currently unknown.” [45]
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As this industry matures, we expect to gain deeper insight into the maximum percentage of disposable income that a consumer is willing to allocate for streaming entertainment. We expect people continue to treat streaming more as a staple than discretionary, which will lower subscription price elasticity. Below, historical year-over-year annual growth in personal disposable income is shown. We see disposable income trending upward, with less volatility in the years to come. This assumption is driven by a broad push toward pay equity, which will increase average disposable income.
Source: FRED – Disposable Personal Income (3/26/21) [46]
GDP Expectations
We see GDP as the second most important economic indicator of Netflix’s performance. Prior to the Covid-19 pandemic, we saw strong year-over-year growth in GDP, and Netflix benefited (both in share price and subscription growth). The graph to the right shows estimates for the U.S. and world 2021 GDP forecast. Consensus expectations for 2021 real GDP growth in the U.S. have increased from 3.9% in January to 6.2% in mid-April.[47] This growth outpaces world GDP expectations, which rose from 5.2% to 5.8% in the same time period. [47] We expect a robust economic recovery as a result:
• seamless vaccine distribution • pent-up consumer demand • higher disposable income
While we expect a robust economic recovery, it is important to note our recession fears. We expect the stock market might enter a small correction in the next six months, which would drive down Netflix’s share price.
Source: FRED – Gross Domestic Product (3/25/2021) [47]
Inflation & Interest Rates
Our biggest worry right now is inflation. The Fed is slowly bringing interest rates back up to 2%, but this is still well below the historical average. Furthermore, the money supply is increasing due to Covid-19 relief bills. This is setting the stage for hyper-inflation in years to come. We expect inflation to continue rising as the Fed maintains its quantitative easing policy. However, we do not expect the Fed to raise the Federal Funds rate in the next year, since Fed Chair Powell has been adamant about maintaining low rates for as long as it takes the economy to recover.
We also see interest rate risk as a large threat to Netflix. The company has a large amount of debt, which is used to fund content expenditures. And while Netflix has upgraded its credit rating twice in the past year, we still see rising interest rates as a threat.
VALUATION
Revenue Decomposition
The revenue decomposition breaks down revenue based on the average number of paying memberships and the average revenue per membership for the following regions: U.S. & Canada (UCAN), Europe & Middle East (EMEA), Latin America (LATAM), and Asia-Pacific (APAC). The number of monthly memberships is a key metric used to gauge popularity of streaming platforms. Our projections for growth in memberships, by region, is shown below. The most aggressive growth is projected in the Asia-Pacific region due to increasing internet accessibility and lower levels of market saturation.
0%
2%
4%
6%
8%
10%
12%
14%
16%
2018-01 2019-01 2020-01 2021-01
Personal Disposable Income (Annual YoY %)
01234567
Apr-
20
May
-20
Jun-
20
Jul-2
0
Aug-
20
Sep-
20
Oct
-20
Nov
-20
Dec
-20
Jan-
21
Feb-
21
Mar
-21
Apr-
21
US and World 2021 GDP Forecast (Annual YoY %)
US GDP 2021 Forecast World GDP 2021 Forecast
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Source: Henry Fund Model – Revenue Decomposition
Income Statement
Income statement items were forecasted as a percentage of sales, with the exception of cost of revenue, depreciation & amortization, interest income, and interest expense.
• COR was forecasted using projected content expenditures, content amortization, and beginning content assets
• D&A was forecasted using an average of the implied historical depreciation rate of the previous two year: 18.00%.
• Interest income was forecasted using the return on investment based on the 5 year average of the one-year Treasury Bill: 1.40%
• Interest expense was forecasted using the pre-tax cost of debt: 2.68%
A breakdown of historical operating expenses can be found in the Cost Structure Analysis subsection on Page 3. Our key operating expense assumption is that Netflix will experience economies of scale and cost of revenue (as a percent of sales) will decrease.
Balance Sheet
The main assumptions in our balance sheet projections are:
• No acquisitions • No debt refinancing • No public issuance of additional stock • No repurchasing of stock • Content assets with be fully amortized
Netflix has historically maintained debt levels of no more than 10% of total enterprise value. We forecasted this by modelling long-term debt as a percent of total assets. Netflix has a $750 million revolving credit facility, and as of December 31, 2020, no amounts had been borrowed.” [9] It is also important to note that Netflix currently has $8.2 billion in cash & cash equivalents, which makes them well-poised to handle any debt-related obligations in the years to come.
Netflix has made no acquisitions in its operating history. Rather, Netflix copies a competitor’s successes to expand business operations. We have projected no acquisitions in the future, and expect company growth to be organic. We also do not forecast any additional issuance of stock in the next ten years, other than through the employee stock option plan. Netflix currently has no share buyback program, but has stated initiating a program as they turn free cash flow positive.
Capital Expenditures
Netflix is continually growing its business, and this growth is sustained through adequate capex. In recent years, Netflix has increased their capex by 50% or more (with the exception of 2018). We expect significantly lower capex in the coming years, as Netflix scales their business model. However, we expect increased content spending, which can viewed similar to capex. Content spending has increased tremendously year-over-year, largely due to the streaming wars. We anticipate Netflix will spend even more in 2021, and attempt to stay ahead of competition via robust original content.
Risk-Free Rate & WACC
Our team is bullish on interest rates in the near-term. We have chosen the 20-year Treasury rate as our risk free rate, which is a break from the tradition of using the 10-year in the past. This is primarily driven by unprecedented, low interest rates that will only rise in the coming months and years. Sensitivity analysis was used to test plus-or-minus 15 basis points of the current risk free rate, and yielded a share price range between $587-631 per share. We believe this captures Netflix’s true value, as this is likely where the 10-year interest rate will settle in the long-term according to the Fed. Federal reserve guidance on interest rates should be monitored closely to account for any fundamental changes in our model.
0.0%
20.0%
40.0%
60.0%
80.0%
2020 2021E 2022E 2023E 2024E 2025E
Average Paying Membership Growth by Region
UCAN growth EMEA growth LATAM growth APAC growth
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The weighted average cost of capital has a dramatic effect on the target share price for DCF analysis. Sensitivity testing yielded a share price range of $573-675 per share based on a 30 basis point change in the WACC. The inputs used in the calculation of our 5.99% WACC are extremely sensitive to changes in the risk-free rate, equity risk premium, and beta. We chose to use an equity risk premium of 4.90%, which is similar to the historical geometric average of 4.88%. This decision was largely based on our long-term investment horizon, and the idea that market conditions repeat themselves.
Valuation Model
Discounted cash flow (DCF) analysis, dividend discount modelling (DDM), and relative valuation (RV) were used to obtain a target price range of $605-610 per share. This target price range was largely derived from the DCF model, as it is the most practical valuation method for Netflix. The model outputs are summarized in the table, below, and an analysis and commentary of each model is provided.
The discounted cash flow analysis model is the most practical for valuing a company such as Netflix. Our model predicted a share price of $608.43 per share, representing a 10.7% upside from the trading price as of 4/20/2021. We believe this model adequately represents Netflix’s financial outlook, and that Netflix is trading largely on a DCF basis. We forecasted a continuing value growth in NOPLAT of 1.17%, which is conservative but captures how Netflix is maturing as a firm. We forecasted a continuing value growth in ROIC of 31.69%, which is higher than historical averages but captures Netflix’s large growth opportunity from past content expenditures. Ultimately, this model captures a conservative share price and we believe NFLX is a strong buy.
The relative valuation method is the next most practical method for valuating a company such as Netflix. Our model predicted a share price of $572.52 per share using 1-year forward PEG, which represents a 4.2% upside to the current share price. Our model also suggests a share price of $331.01 using the 1-year forward P/E. We believe
Netflix’s high concentration in streaming revenues relative to peers yields a lower share price on a relative valuation basis. As such, we find these prices to be too low relative to Netflix’s true value. The companies we used to estimate Netflix’s share price on a relative valuation basis are Disney, Amazon, Comcast, AT&T, Apple, ViacomCBS, and Alphabet. These companies all have share buyback programs in place to bolster earnings, so it is understandable that Netflix is trading at a premium based on a price-to-earnings valuation. However, Netflix is trading at a discount on a PEG basis due to the continued high-growth state of the company. We ultimately decided this model only captures a small portion of Netflix’s projected share price.
The dividend discount model is the least effective in estimating Netflix’s value, since Netflix does not pay dividends. This model is most applicable for companies that pay dividends and are in a stable-growth phase; Netflix is neither. The DDM projected a share price of $509.45 per share, which is much lower than the other methods of analysis, and a discount to its current share price. We did not use this model to determine our target price for Netflix.
KEYS TO MONITOR
Netflix has captured tremendous market share as a result of being the first mover. Netflix will face challenges maintaining this market share, especially as more competitors debut streaming services. Keys to monitor in the coming months and years include:
• Percent disposable income allocated to streaming • Competitor year-over-year growth in subscribers • Netflix membership growth in APAC region • Original content production and popularity • Effectiveness of password sharing crackdown
We believe any material changes in the above bullet points will require an adjusted model to accurately reflect Netflix’s intrinsic equity value. We believe Netflix is currently trading below its intrinsic value, and recommend a buy rating.
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REFERENCES 1. FactSet: Snapshot
2. Yahoo! Finance: Analysis
3. Netflix 10-K (FYE 2020 filing, see page 22) 4. Yahoo! Finance: NFLX Historical Data
43. Netflix – Environmental, Social, and Governance 2020
44. Yahoo! Finance – Sustainability
45. Berkeley Economic Review – The economics driving the streaming
industry (10/21/2019)
46. FRED: Disposable personal income (as of 03/26/2021)
47. Bloomberg Database: U.S. and World GDP Forecast 2021
DISCLAIMER
Henry Fund reports are created by graduate students in the Applied Securities Management program at the University of Iowa’s Tippie College of Business. These reports provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of our students. Henry Fund analysts are not registered investment advisors, brokers or licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold an investment position in the companies mentioned in this report.
Netflix, Inc.Revenue Decomposition - in millions, except per membership
Netflix, Inc.Weighted Average Cost of Capital (WACC) Estimation
Cost of Equity: ASSUMPTIONS:Risk-Free Rate 2.25% 20-year Treasury BondBeta 0.82 5-year monthly betaEquity Risk Premium 4.90% Henry Fund ERP based on geometric averageCost of Equity 6.29%
Cost of Debt:Risk-Free Rate 2.25% 20-year Treasury BondImplied Default Premium 0.43%Pre-Tax Cost of Debt 2.68% YTM on NFLX 10-year bondMarginal Tax Rate 24%After-Tax Cost of Debt 2.05%
Market Value of Common Equity: MV WeightsTotal Shares Outstanding 441Current Stock Price $514.00MV of Equity 226,634 92.43%
Market Value of Debt:Short-Term Debt 500Current Portion of LTD -Long-Term Debt 15809PV of Operating Leases 2262MV of Total Debt 18,571 7.57%
Shares Outstanding (beginning of the year) 441 444 448 451 454 458 460 460 460 460Plus: Shares Issued Through ESOP 3 3 3 3 3 2 0 0 0 0Less: Shares Repurchased in Treasury - - - - - - - - - - Shares Outstanding (end of the year) 444 448 451 454 458 460 460 460 460 460
Netflix, Inc.Valuation of Options Granted under ESOP
Current Stock Price $514.00
Risk Free Rate 2.25%
Current Dividend Yield 0.00%
Annualized St. Dev. of Stock Returns 34.93% 5Y average
Average Average B-S ValueRange of Number Exercise Remaining Option of OptionsOutstanding Options of Shares (M) Price Life (yrs) Price GrantedRange 1 18.68 170.23 5.55 370.14$ 6,913$