Netflix (Stock exchange: NFLX)

Netflix (Stock exchange: NFLX)

Partners: Mallory M. Craig- Karim, mmc2nk@virginia.edu Patrick W. Leugers, pwl2vc@virginia.edu EQUITY ANALYSIS: Buy RIVANNA INVESTMENTS April 8 2016 I. Company Overview Netflix is the world s leading Internet television network with over 75 million members in over 190 countries enjoying more than 125 million hours of TV shows and movies per day, including original series, documentaries and feature films. Members can watch as much as they want, anytime, anywhere, on nearly any Internet- connected screen. Members can play, pause and resume watching, all without commercials or commitments. II. Thesis Netflix has rewarded its investors over the past 14 years with a truly spectacular 6,000% gain. Though this pitch does not rest upon the notion that Rivanna s potential investment in Netflix will produce this level of return, it suggests that the company will continue to be one of the more valuable long- term growth plays on the market, especially so if investors are willing to withstand some volatility. Netflix s growth trajectory is robust. It continues to hit its targets for subscriber growth in the U.S. and in global markets. At the end of 2015, Netflix was serving 190 countries. Even while spending heavily on expansion and content, it excels at growing revenues and expanding profit margins. The international markets in particular will be a source of continued subscriber growth. III. Variant Perception The market is underestimating the realistic international growth potential. Too much focus is on the domestic subscribership growth numbers, which have been slowing. Domestic growth will continue to shrink as the market in on- demand streaming matures and becomes a battle for market share. However, the international market is nascent and has far greater potential than the domestic market. The low cost of the average subscription internationally, aprox. $7.50 and massive expansion of high quality broadband that can deliver HD video over the internet creates huge potential markets in middle income Asian, 2 of 11

Partners: Mallory M. Craig- Karim, mmc2nk@virginia.edu Patrick W. Leugers, pwl2vc@virginia.edu Latin American counties (excluding China). Furthermore, European markets lack a dominant streaming provider and Netflix is a prime position to take advantage. Netflix has started to create original content in foreign languages aimed at these markets. IV. Positives International Growth o Another big plus from January was the continued growth of Netflix abroad. o Specifically, NFLX reported 4.04 million more international subscribers in Q4, blowing away expectations for 3.51 million in international growth and up from a rate of 2.43 million in the year prior. o With 27.4 million paid customers abroad and a rapid growth rate around 15% annually for this segment, Netflix is diversifying well between its international subscribers and its mature domestic Original Programming Power o Content is king: Netflix is becoming a content creator rather than merely a content distributor o Netflix originals from House of Cards to Orange is the New Black have loyal followings, and more recent titles like the Making a Murderer documentary series continue to connect with viewers and critics alike. o Furthermore, Netflix has created original programming in French, Portuguese, Japanese, Spanish and has future programming planned in Italian and German. o This is not only good for the NFLX brand, but also good at keeping down content costs. Consider that the cost of revenue for its streaming business was 69.6% of total revenue in fiscal 2015, but 70.8% in the year prior. o The lower cost of hit originals has helped contribute to that trend and boost profitability. Network Effects/ Barriers to Entry o Subscription models create network effects that are barriers to entry to new competitors o Any company that wishes to enter market must have large amounts of cash to create a variety original programming or obtain licenses for significant content o People won t subscribe to company that only has one or two shows 3 of 11

Partners: Mallory M. Craig- Karim, mmc2nk@virginia.edu Patrick W. Leugers, pwl2vc@virginia.edu N E T F L I X I S G R O W I N G W I T H G O O D M A R G I N S Comcast Amazon NeDlix 69.70% Gross Margin 33.00% 32.30% 8.34% Revenue Growth 20.25% 23.16% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% N E T F L I X I S W E L L F I N A N C E D Comcast Amazon NeDlix 0.68 Current RaIo 1.08 1.54 3.19 4.89 Financial Leverage 4.51 0 1 2 3 4 of 11 4 5 6

Partners: Mallory M. Craig- Karim, mmc2nk@virginia.edu Patrick W. Leugers, pwl2vc@virginia.edu Management team Netflix s expense policy is five words long: Act in Netflix s best interests. The company hires only those deemed A players, and it turn lets go of people whose skills no longer fit. Other companies spend endless time and money writing and enforcing HR policies to deal with problems caused by B players, while Netflix does not. Examples of how this reduces costs: o Expense accounts are unrestricted, unless alerted to be abusing this privilege For example, many large companies use travel agents (and pay their fees) to book trips, as a way to enforce travel policies. Netflix saves money by letting employees book their own trips online. o No formal reviews Managers and employees have conversations about performance as an organic part of their work. In many functions sales, engineering, product development it is clear how well people are doing. (As companies develop better analytics to measure performance, this becomes even truer.) They save money on HR proposals for poor performers. V. Risks If Netflix s efforts to attract and retain members are not successful, its business will be adversely affected. Its ability to continue to attract members will depend on its ability to consistently provide its members with compelling content choices, as well as a quality experience for selecting and viewing TV shows and movies. Furthermore, the relative service levels, content offerings, pricing and related features of competitors to Netflix s service may adversely impact our ability to attract and retain memberships.. If growth rates slow faster than expected, given, in particular that Netflix s content costs are largely fixed in nature and contracted over several years, it may not be able to adjust its expenditures or increase its (per membership) revenues commensurate with the lowered growth rate such that its margins, liquidity and results of operation may be adversely impacted. Changes in competitive offerings for entertainment video, including the potential rapid adoption of piracy- based video offerings, could adversely impact Netflix. The market for entertainment video is intensely competitive and subject to rapid change. Through new and existing distribution channels, consumers have increasing options to access entertainment video. The various economic models underlying these channels include subscription, transactional, ad- supported and piracy- based models. All of these have the 5 of 11

Partners: Mallory M. Craig- Karim, mmc2nk@virginia.edu Patrick W. Leugers, pwl2vc@virginia.edu potential to capture meaningful segments of the entertainment video market. Piracy, in particular, threatens to damage Netflix s business, as its fundamental proposition to consumers is so compelling and difficult to compete against: virtually all content for free. New entrants may enter the market or existing providers may adjust their services with unique offerings or approaches to providing entertainment video. Companies also may enter into business combinations or alliances that strengthen their competitive positions. If Netflix is unable to successfully or profitably compete with current and new competitors, its business will be adversely affected, and it may not be able to increase or maintain market share, revenues or profitability. The long- term and fixed cost nature of Netflix s content commitments may limit its operating flexibility and could adversely affect its liquidity and results of operations. In connection with obtaining streaming content, Netflix typically enters into multi- year commitments with studios and other content providers, the payment terms of which are not tied to member usage or the size of its membership base ( fixed cost ) but which may be tied to such factors as titles licensed and/or theatrical exhibition receipts. Given the multiple- year duration and largely fixed cost nature of content commitments, if membership acquisition and retention do not meet expectations, Netflix s margins may be adversely affected. It could be subject to economic, political, regulatory and other risks arising from its international operations. Operating in international markets requires significant resources and management attention and will subject us to regulatory, economic and political risks that may be different from or incremental to those in the U.S. Risks include those of censorship, currency fluctuations, availability of reliable broadband capability, etc. If studios, content providers or other rights holders refuse to license streaming content or other rights upon terms acceptable to Netflix, its business could be adversely affected. Netflix s ability to provide its members with content they can watch depends on studios, content providers and other rights holders licensing rights to distribute such content and certain related elements thereof, such as the public performance of music contained within the content we distribute. The license periods and the terms and conditions of such licenses vary. If the studios, content providers and other rights holders are not or are no longer willing or able to license Netflix content upon terms acceptable to the company, its ability to stream content to its members will be adversely affected and/or our costs could increase. 6 of 11

Partners: Mallory M. Craig- Karim, mmc2nk@virginia.edu Patrick W. Leugers, pwl2vc@virginia.edu Many of the licenses for content provide for the studios or other content providers to withdraw content from Netflix s service relatively quickly. Because of these provisions, content available through Netflix can be withdrawn on short notice. As competition increases, Netflix may see the cost of programming increase. As it seeks to differentiate its service, Netflix is increasingly focused on securing certain exclusive rights when obtaining content, including original content. Competitors and Competition While Netflix has a clear first- mover advantage, that advantage counts for less as rivals including Hulu and Prime Instant Video from Amazon.com, Inc. (NASDAQ:AMZN) continue to gather customers. Three Primary Competitors: 1. Streaming Services: Amazon a. Consider a January report from Consumer Intelligence Research that estimated Prime customers are up 35% year- over- year to 54 million U.S. members in 2015. While streaming is not the sole draw, the fact that AMZN may have more customers than the domestic business of NFLX stock is certainly noteworthy. b. Netflix relies upon Amazon Web Services (AWS) for its cloud computing needs. While the retail side of Amazon competes with Netflix, we do not believe that Amazon will use the AWS operation in such a manner as to gain competitive advantage against our service. 2. Cable Networks a. A significant number of Netflix s streaming content has consisted of older seasons of popular cable TV shows. And these shows are licensed from traditional media companies that are increasingly seen as direct competitors to Netflix. It is only a matter of time before cable companies realize that they are indirectly hurting their own business through the forging of licensing deals with Netflix. b. Some cable networks have begun signing licensing deals with other streaming services, like Hulu, or putting more episodes on- demand using pay- TV distributors. c. Case example of Fox and Hulu i. Fox has partnered with Hulu, a Netflix competitor that Fox owns part of and which lets Fox control the advertising. Fox has given Hulu exclusive rights to shows on one of its cable channels, FX. 7 of 11

Partners: Mallory M. Craig- Karim, mmc2nk@virginia.edu Patrick W. Leugers, pwl2vc@virginia.edu 3. Broadcast Networks a. To compete with Netflix, Broadcast networks are adding more original hours, increasing their production costs, favoring in- house production, and introducing big name actors. VI. Legal Analysis From time to time, in the normal course of its operations, the Company is a party to litigation matters and claims. Most of these matters relate to patent infringement lawsuits. Class Action Lawsuit Alleging Violations of Securities Laws: In re Netflix, Inc. On January 13, 2012, the first of three purported shareholder class action lawsuits was filed in the United States District Court for the Northern District of California against the Company and certain of its officers and directors. Two additional purported shareholder class action lawsuits were filed in the same court on January 27, 2012 and February 29, 2012 alleging substantially similar claims. On June 26, 2012, lead plaintiffs filed a consolidated complaint, which alleged violations of the federal securities laws. The Court dismissed the consolidated complaint with leave to amend on February 13, 2013. Lead plaintiffs filed a first amended consolidated complaint on March 22, 2013. The Court dismissed the first amended consolidated complaint with prejudice on August 20, 2013, and judgment was entered on September 27, 2013. Lead plaintiffs filed a motion to alter or amend the judgment and requested leave to file a second amended complaint on October 25, 2013. On January 17, 2014, the Court denied that motion. On February 18, 2014, lead plaintiffs appealed that decision to the United States Court of Appeals for the Ninth Circuit. Management has determined a potential loss is reasonably possible however, based on its current knowledge, management does not believe that the amount of such possible loss or a range of potential loss is reasonably estimable. VII. Valuation 1. Future mature market a. What is the potential of the market? i. Average price of Netflix subscription internationally 1. $7.48 per month ii. Broadband Connections Worldwide Exclusive of China & United States 1. ~450 million (2014) 2. ~600 million (2020) 8 of 11

Partners: Mallory M. Craig- Karim, mmc2nk@virginia.edu Patrick W. Leugers, pwl2vc@virginia.edu Broadband ConnecIons Worldwide Excluding China & US 700000 600000 455,773 422,762 392,650 359,760 500000 400000 290,342 300000 200000 210,954 131,333 100000 0 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 b. Estimate of Netflix market share using current market share in U.S. (2015) i. 104,655,600 million households with broadband access ii. 44,380,000 million Netflix subscribers iii. 42.4% of households have Netflix 2. Current Growth of International Subscribers a. Number of subscribers (in millions) 35,000 30,024 30,000 25,000 20,000 18,277 15,000 10,000 10,930 5,000 0 2012.5 2013 2013.5 2014 9 of 11 2014.5 2015 2015.5

Partners: Mallory M. Craig- Karim, mmc2nk@virginia.edu Patrick W. Leugers, pwl2vc@virginia.edu b. Estimated International Market Share i. 2013: 2.6% ii. 2014: 4.0% iii. 2015: 6.1% 3. Assuming 25% penetration of international market and 60% of domestic markets by 2020 a. International Projected Subscribers i. 2020 Est. of 605,000,000 broadband connections 1. x 25% Market Share = 151, 250,000 subscribers b. International Revenues i. 151,250,000 x $7.48 x 12 months = 13.576 billion (2020) 1.952 billion (2015) c. Domestic Projected Subscribers i. 2020 Est. of 125,000,000 broadband connections 1. 60% Market Share = 75,000,000 subscribers d. Domestic Revenues i. 75,000,000 x $8.50 x 12 months = 7.65 billion (2020) 4.18 billion (2015) e. Gross Margin i. Estimate of gross margin of business in the future ~30% Gross Margin over Time 40 35 37.24 36.34 30 25 27.25 29.52 31.83 32.27 2014 2015 20 15 10 5 0 2009 2010 2011 2012 2013 10 of 11 2016

Partners: Mallory M. Craig- Karim, mmc2nk@virginia.edu Patrick W. Leugers, pwl2vc@virginia.edu o Gross Income: $2.36 Billion o Tax Rate: 30% o Net Income: $1.625 Billion Estimated 2020 Revenue: $21.226 Billion Estimated 2020 Gross Margin: $6.36 Billion o Estimated R&D Cost: $2.1 Billion o Estimates G&A Cost: $1.5 Billion o Estimated Interest: $400 Million Assuming 500 Million Outstanding Shares in 2020 (428 Million 2015) o 2020 EPS = $3.25 o Current Price per Share: 104.45 o 2020 Calculated P/E Ration = 32.14 4. Conservative Estimate a. Large Chinese market is not included because of current exclusion and political factors i. House of Cards is one of the most pirated shows in China 11 of 11