Netflix: Amazing Growth But At A High Price

Netflix: Amazing Growth But At A High Price Mar. 17, 2018 5:27 AM ET8 comments by: Jonathan Cooper Summary Amazing user growth, projected to accelerate into Q1'18. Contribution profit per subscriber continues to expand, especially in the nowprofitable international segment. Netflix offers great value to customers; I am a long-time and happy customer. As a value investor, I won't invest at current lofty prices, but I would also not short Netflix. NFLX data by YCharts Page 1 of 10

Netflix (NFLX) is an exceptionally strong business. Through strong management, it has grown from a small distributor of DVDs by mail to spending more on content than anyone else on the Internet. Netflix's shows are winning critical and widespread acclaim. This year, Netflix also garnered eight Academy Award nominations, winning its first Oscar for a full-length feature for Icarus. I have been a cord-cutting millennial for years, and Netflix is a subscription that I would not consider cutting. Its value per dollar is unparalleled, and it continues to add entertaining new content every month. During the past year, Netflix blew past 100 million subscribers and is profitable. Estimates of how large Netflix may get vary, but it is possible it could eventually hit 400 million, or more, subscribers. Netflix is a well-run, growing, profitable company that is producing content that is loved both by subscribers and by critics. However, despite all that, valuation remains a question mark - shares in Netflix are richly valued, sporting a market cap over $135 billion, and up over 100% in the past year. Growth Netflix is a rapidly growing company, with international subscribers only recently passing domestic subscribers. Netflix divides subscribers into two categories - the United States, and International subscribers, which include all other countries. All subscribers described in this article refer to streaming subscribers. Netflix also continues to run a declining DVD subscriber business. That business is profitable but operates at a much lower volume than the streaming business, and subscriber figures are declining each year. (In 000s) 2011 A 2012 A 2013 A 2014 A 2015 A 2016 A 2017 A Paid Subs 21,600 30,363 41,434 54,476 70,839 89,090 110,644 US 20,153 25,471 31,712 37,698 43,401 47,905 52,810 Int'l 1,447 4,892 9,722 16,778 27,438 41,185 57,834 Page 2 of 10

During 2017, Netflix added over 21 million new subscribers - its strongest net addition to date, after having added 18 million in 2016. In numeric terms, Netflix is growing faster than it has ever grown. In percentage terms, Netflix sports double-digit subscriber growth in both the United States and Internationally. In both cases, growth is slowing down, but remains very robust. 2012 A 2013 A 2014 A 2015 A 2016 A 2017 A Paid Subs y/y 41% 36% 31% 30% 26% 24% US 26% 25% 19% 15% 10% 10% Int'l 238% 99% 73% 64% 50% 40% Subscriber growth in the United States has declined from 26% in 2012 to 10% in 2017. This decline can be attributed to Netflix's massive size and to the company's nearing market saturation in the United States. There were about 106 million broadband households in the United States in 2016, indicating that Netflix is nearing 50% market saturation (and potentially higher than 50%, including accounts shared between friends and family). Q1'17 A q/q y/y Q1'18 E q/q y/y Paid Subs 94.36 M 6% 21% 118.49 M 7% 26% US 49.38 M 3% 8% 54.71 M 4% 11% Int'l 44.99 M 9% 41% 63.78 M 10% 42% Page 3 of 10

Source: Netflix Q1'18 Forecast & Q1'17 Results Rather than slowing down, Netflix is projecting that growth will accelerate in its first quarter of 2018. Netflix is projecting quarterly subscriber growth of 7% in the next quarter and annual growth of 26% (comps of 6% and 21%). Growth is expected to accelerate both in the United States and in the International segment. This is especially impressive in the International segment, given that growth in that segment is already above 40% annually. Netflix is an amazing growth story, and that story continues to unfold. Profitability - Operating and Net Income Unlike many growing Internet companies, Netflix has been profitable throughout its rapid growth. (In millions) 2011 A 2012 A 2013 A 2014 A 2015 A 2016 A 2017 A Revenue $3,205 $3,609 $4,375 $5,505 $6,780 $8,831 $11,693 Operating Income $376 $50 $228 $403 $306 $380 $839 Net Income $226 $17 $112 $267 $123 $187 $559 Company-wide margins during this period have shrunk - Netflix had an EBIT margin of 12% and a profit margin of 7% in 2011, but those compressed to 6% and 5% by 2017. 2011 A 2012 A 2013 A 2014 A 2015 A 2016 A 2017 A Operating Margin 12% 1% 5% 7% 5% 4% 7% Net Margin 7% 0% 3% 5% 2% 2% 5% Page 4 of 10

Netflix's business has changed rather dramatically during that time. Back in 2011, DVDsby-mail was a much larger part of its business, and its streaming business was heavily dependent on content that was produced for parties other than Netflix, such as television shows and movies for which Netflix had purchased rights to show on its platform. Today, DVDs are a tiny part of Netflix's overall business, and its streaming business is driven by the original content like Stranger Things (which was great) and Bright (which wasn't great). Profitability - Contribution Profit While company-wide margins are not impressive (although 2017 was better than 2016), Netflix has made dramatic improvements on profitability for each subscriber. In its quarterly reports, Netflix tracks a figure that it calls contribution profit. In my opinion, contribution profit is one of Netflix's most important metrics. Contribution profit is tracked for both domestic and international streaming subscriptions separately and for DVD subscriptions (which I will continue to ignore). Contribution profit includes the revenues from each given segment, the cost of revenues for that segment, and also the marketing spend for that segment: "We define contribution profit (loss) as revenues less cost of revenues and marketing expenses incurred by the segment. We believe this is an important measure of our operating segment performance as it represents each segment's performance before global corporate costs. As markets within our International streaming segment become profitable, we increasingly focus on our global operating margin as a measure of profitability." - Netflix 2017 10-K/A (In millions) 2012 A 2013 A 2014 A 2015 A 2016 A 2017 A Streaming Revenue $2,472 $3,464 $4,739 $6,134 $8,288 $11,222 US $2,185 $2,751 $3,431 $4,180 $5,077 $6,153 Page 5 of 10

Int'l $288 $712 $1,308 $1,953 $3,211 $5,069 Netflix's streaming revenue has grown dramatically, alongside subscriber numbers. Streaming revenue has grown ~4.5x since 2012, jumping from $2.5 billion to $11.2 billion. 2012 A 2013 A 2014 A 2015 A 2016 A 2017 A Revenue/Sub $95.2 $96.5 $98.8 $97.9 $103.7 $112.4 US $95.8 $96.2 $98.9 $103.1 $111.2 $122.2 Int'l $90.7 $97.5 $98.7 $88.4 $93.6 $102.4 Source: Author's calculations based on Netflix SEC filings. Based on annual revenue divided by the average of subscribers at year-end and at the prior-year-end. Similarly, revenue per subscriber has continued to grow, both domestically and internationally, over the last two years. International revenue per subscriber itself took a dip in 2015, as Netflix rolled out into more international markets and often with lower prices, but has risen since then, and it is currently at its highest ever level. Revenue per subscriber is expected to continue to rise - Netflix's Q1'18 Forecast implies 5% higher revenue per sub in Q1'18 compared to Q4'17. Costs per subscriber (including cost of revenue and marketing) have also increased during this time span. However, costs per sub are not rising as quickly as revenue per subscriber. As a result, contribution profit has increased, and contribution profit per subscriber has increased. (In millions) 2012 A 2013 A 2014 A 2015 A 2016 A 2017 A Contribution Profits ($20) $348 $776 $1,042 $1,530 $2,490 Page 6 of 10

US $369 $623 $936 $1,376 $1,839 $2,283 Int'l ($389) ($274) ($160) ($333) ($309) $207 2012 A 2013 A 2014 A 2015 A 2016 A 2017 A Contribution Profits/Sub ($1) $10 $16 $17 $19 $25 US $16 $22 $27 $34 $40 $45 Int'l ($123) ($38) ($12) ($15) ($9) $4 Source: Author's calculations based on Netflix's SEC filings. Based on annual contribution profits divided by the average of subscribers at year-end and at the prior-year-end. In my view, this figure is one of the most promising figures for Netflix's future success, as these rising contribution profits per subscriber show that Netflix can scale successfully, and its success will increase as it scales up. Netflix operates in an economy of scale, much like many Internet and software companies. Stranger Things does not get more expensive to produce regardless of whether you have 50, 100, or 200 million subscribers. Supporting a higher number of subscribers will require more content, but that increase is less than linear - doubling subscribers is unlikely to require twice as much content budget. During this period, Netflix's domestic contribution margins have increased from 17% to 37%, while international contribution margins have increased from well below -100% up to 4% in the past year. Netflix is forecasting continued growth in its international contribution margins: The Q1'18 forecast implies international contribution margins of 13%, up from 9% last quarter and 4% one year ago. Page 7 of 10

Over the next five to ten years, I expect Netflix's international contribution profit per subscriber to grow nearer to its domestic figures. This growth will again be made possible by economies of scale. On a per-user basis, producing foreign-language content on Netflix will be made substantially cheaper as the international audience grows, especially if it can maintain its current 40%+ growth rate internationally. This will improve Netflix's companywide margins appreciably and will occur as the company's growth continues both domestically and abroad. Risks Netflix trades at very high prices. According to YCharts, Netflix's forward PE ratio is 117 and forward EV/EBITDA is 74. It is very unlikely that those multiples will be sustainable for years to come. Netflix will need to rapidly grow its earnings and EBITDA to maintain (and improve) its current share prices. I believe that Netflix is an extremely attractive business from a growth point of view, but its prices may scare off many value investors. Market corrections could hit Netflix hard. Netflix's current multiples are supported by market optimism, both about the company's future and about the current state of the economy. If either story falters, Netflix could fall dramatically. During a downturn, Netflix is very unlikely to trade at a PE ratio of 117. The danger of slowing growth. Netflix's price is likely based on investor perception that the company can ultimately reach ~400 million or more subscribers globally. If that perception changes, such as if Netflix forecasts lower user growth in a coming quarter or year, its price could fall hard. Current subscriber figures might support a PE ratio of ~30, at the high end, with PE ratios higher than that attributable to future growth. I expect Netflix to continue to grow and to hit 400 million subscribers in the next decade, but if forecasts stumble, share prices could fall dramatically. Increasing competition could hurt Netflix. Netflix is the leader in paid streaming services, but it is not the only such service. Other services could potentially hurt Netflix by taking customers away from the company. The primary competitor here could be Disney's (DIS) upcoming streaming service. Disney owns a huge library of valuable content, from animated movies to Pixar to Star Wars to Marvel. I expect Disney's entry into streaming to be successful, and for its service to gain millions of subscribers. I do Page 8 of 10

not expect this service to be bad for Netflix - I anticipate that most consumers will simply add the Disney service on top of the Netflix service. It may even be a positive for Netflix: Consumers may be attracted to online streaming through Disney, and then also add other online streaming services like Netflix once they have begun to use a streaming device (be it a smart television or an OTT device). Netflix has negative cash flow and has had negative cash flow for the past six years. I have frequently seen commenters bring up Netflix's negative free cash flow in discussions about the company. Despite being profitable, Netflix suffers from negative free cash flow as its content budget is growing rapidly. I do not consider this problematic. Netflix's spending on content is necessary as the company expands, especially adding foreign content to attract foreign subscribers. Spending on content can take months and years to show rewards, given the timelines for television and movie production. Netflix's spending on content ultimately all flows through its income statement, as that content is amortized. I don't have any reason to suspect that Netflix's D&A on its content spending is incorrect, nor any reason to suspect that the company will run out of available content now or in the future. Therefore, I believe that Netflix's growth and profitability are more meaningful than its free cash flow during this time of growth. Conclusion From a growth perspective, I love Netflix. I am a happy Netflix customer, and have been a customer on and off since having a DVD plan over 10 years ago. Netflix has shown tremendous growth over the past five years, both in adding new subscribers and in increasing its profits (contribution profits) from each added subscriber. Beginning its streaming service was not inexpensive, and Netflix invested heavily in these efforts. It is being repaid for those investments domestically, and the international investments are also beginning to show fruit. I expect Netflix to continue to grow subscriber counts over the next five to ten years. I expect that it will also continue to make more money per subscriber than it did before through charging higher prices to new subscribers and through raising prices. Netflix can also raise prices by charging for additional services, such as by charging more for the switch to 4K content and other future additions to its service. Page 9 of 10

Additionally, Netflix has great optionality in the sense that it has the option to profitably add new offerings. For example, Netflix could one day add live sports to its offerings - for an added fee. This could also open new revenue and growth opportunities for the company. Netflix's management has been amazing for the past 10 years - profitably guiding the company from a Redbox/Blockbuster competitor to a $135+ billion company. I expect that management will continue to make great choices, and its option to expand into other areas will be exercised profitably in the future. Despite this, from a value perspective, I don't consider Netflix a "Buy" at its current prices. The company trades at very lofty prices which reflect a huge amount of optimism about the future of the company. I share much of this optimism, but still prefer to invest in value stocks rather than long-term growth stocks. I will be extremely interested in investing in Netflix if the market turns downwards, but its current price is too rich for me. I would not consider shorting Netflix, however, regardless of what Citron Research might tweet. In the meantime, I will sit on the sidelines and continue to enjoy Netflix as a customer. Thanks for reading! ** Author's note: If you enjoyed this article, please hit "Follow" next to my name at the top of the page. This helps me build my readership and increases my visibility on Seeking Alpha. Please also leave questions, comments, feedback, and suggestions below. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Like this article Page 10 of 10