Bill Ackman Is Wrong, Don’t Buy Netflix Stock Yet (NASDAQ:NFLX)

Stock Market


Netflix, BBC iPlayer, News, Speedtest and other Apps on iPhone screen

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Company

Business Overview

Netflix (NFLX) is a global entertainment subscription service for streaming TV series, documentaries & movies. The company’s subscribers can watch unlimited content on any internet-connected screen, all without commercials. Additionally, the Company continues to offer its DVD by mail service in the United States, and starting from 2021 the Company added mobile games to its service. Netflix mainly derives its revenues from monthly membership fees, an amount which varies according to the country and the features of the streaming membership plan, for services related to streaming content to its members.

Total Addressable Market (NYSE:TAM)

Netflix presence in the world

ir.netflix.net

The Company’s market of reference is the Subscription-based Video on Demand Services (or “SVoD”) market, which includes those companies that offer unlimited access to their content libraries for a monthly subscription fee (ad-supported & pay-per-view offerings are out of scope).

According to Statista’s estimates, global revenue (ex-China) for the SVoD market is expected to show a CAGR 2022-2026 of 7.70% which translates into a projected market volume of $91,284 million by 2026 (with most of the revenues generated in the United States) and the number of users (ex-China) is expected to reach 1,033 million users by 2026. In particular, it is worth noting that according to those estimates the user penetration rate for the United States & Canada (which together account for 43.7% of Netflix’s total revenue) is equal to 47.1% and 39.1% respectively. In my opinion, this should be seen as a yellow light (not red yet), that the adoption of such services will soon reach its peak (particularly in developed countries).

Moreover, through the first three quarters of 2021, Leichtman Research Group found that 78% of all U.S. households have a subscription video on-Demand service from at least one of the most well-known providers Netflix, Amazon Prime, and Hulu (vs 78% in 2020, 74% in 2019, and 59% in 2016). This can be read as SVOD being seen as a commodity by tens of millions of U.S. households. Nonetheless, many households are unwilling to pay for services they don’t use, and for this reason, SVoD providers are under pressure in keeping entertaining their subscribers with new and original content (or “the next big thing”) or by expanding their content library. As an example of the latter, we can take the $71.3 billion Disney’s acquisition of 21st Century Fox that provided a huge boost to its Disney+ content. In my opinion, we should expect a greater M&A activity with other content libraries being sold to SVoD providers. All of this translates into a tougher competition for Netflix, on one side fueled by companies investing more in content, and on the other driven by consolidation and mergers. For this reason, I believe that in the years ahead we will have only a few SVoD providers competing for a capped, or ex-China (China will cap the growth in this segment on a global scale), market share.

All of that said, I don’t believe the Company will adopt alternative business models such as pay-per-view or ad-supported video streaming model (thus for the streaming segment the market of reference will remain the SVoD market), however, by looking at what the Company is currently doing I believe that the potential NFLX TAM is much bigger, and it compromises a broader definition of entertainment services. For instance, I believe that in the future we will see a broader plan offering, for example, a video-streaming plan, a video-streaming & gaming experience plan, etc.

Company Valuation

Revenue Breakdown

Let’s now break down revenue by geographical regions to better understand the Company’s top-line growth.

Geographical Breakdown

Author’s Estimates

  • UCAN: In 2021, the UCAN region accounted for 43.7% (down 4.7% YoY) of the Company’s total revenue and it shows the highest monthly ARPU ($14.56 for 2021, up 9.28% YoY), however, we can also observe a slower paid memberships growth (1.73% YoY). All of that said, according to Nielsen, Netflix is still less than 10% of total US television screen time which can be read that it has still a lot of room for growth. Further, in January Netflix announced an increase across all its three plans for the US (+11% on average) and Canada (+6.8% on average) which is expected to be rolled out to customers in Q1”22. Such price increase is likely to translates into a lower-paid membership growth in the short-term, even if, we must also account for it the release of “Bridgerton S2” (Season 1 was viewed more than 625mln hours) and the release of the highly anticipated movie “The Adam Project” in Q1”22 that may drive the growth despite the price increase. Overall, UCAN is a more mature market and more penetrated than some other Netflix markets, however, I believe Netflix has still ample runway for growth.
  • EMEA: In 2021, the EMEA region accounted for 32.7% (up 5% YoY) of Company’s total revenue, with the monthly ARPU of $11.63 (up 8.35% YoY) and a paid membership growth of 11% YoY as several titles had a particularly strong impact. Overall, as for UCAN, EMEA is a more mature market, however, considering that the Company is ramping up production, and the growth in the paid net adds is strong, I don’t see the growth to decline any time soon.
  • APAC: In 2021, the APAC region accounted for 11.0% (up 15.9% YoY) of Company’s total revenue, with the monthly ARPU of $9.55 (up 4.46% YoY) and with a paid membership growth of 28.01% YoY (the second-largest contributor, after EMEA, to membership growth in 2021). APAC, and LATM, are by far the two geographical areas with the most user growth potential even if with a lower ARPU. For instance, in Q4 we saw very strong growth in Japan and India. In particular, in India, Netflix announced at the end of December a decrease in the pricing across all plans (perhaps to align to the cables’ pricing per month per household). While such a decision will decrease ARPU it will likely translate into higher paid membership growth. I believe that the true value for Netflix’s future growth lies here, and as Brazil’s experience taught us, the Company knows how to do things well.
  • LATM: In 2021, the LATM region accounted for 12.0% (down 4.6% YoY) of the Company’s total revenue, with the monthly ARPU of $7.73 (up 4.06% YoY) and a paid membership growth of 6.46% YoY. As I said before, LATM is definitely a geographical area where the most user growth lies, however, it also shows a slow paid membership growth due to different reasons among others a lower level of government funding and subsidization to fuel their economy. Nonetheless, in 2021 the Company was able to effectively increase prices in some key countries, Mexico, Brazil, Argentina at a cost of lower-paid membership growth.
  • DVD Segment (only for the domestic market): last but not least, in 2021, the DVD segment accounted for 0.5% of the Company’s total revenue. I won’t spend many words on it because I believe that it will eventually go to zero in the next 24 months.

Taking a step further, to understand where the Company’s future value could be found, we must take a broader view of the latest actions undertaken by the Company:

  • Movies: Netflix is well known for having some of the highest quality TV shows with a high share of the top IMDB shows at any given time. However, the company also understands the importance of delivering to its members also some high-quality movies, “Red Notice”, “Don’t look up” to name a few. Netflix understands to be a few years behind in the film business and to close the gap it started 3 years ago to allocate a meaningful budget to it. I believe that it is the right path to pursue since consumers usually attach a higher value to movies because to see a big movie premier they always have to pay for it. Moreover, sometimes you just prefer to watch a great movie instead of starting a new TV show. So, thinking about having every week some great movie being released is definitely an added value not only for the current users but also for the potential ones.
  • Fast Laughs: To get a high engagement on mobile devices it introduced Fast Laughs or short videos where you watch some funny moments extrapolated from Netflix’s content, and if you like there is a function that brings you directly to the content itself. Basically, what Netflix is trying to do here is to target those devices by giving a greater experience for users.
  • Content for Kids: the acquisition of the Roald Dahl Story company, which I see as a willingness to deliver high-quality content to kids (and obviously to expand its content library with existing ones), is a very well-studied decision that I believe will add significant value to Netflix.
  • Gaming Experience: The acquisition of Night School Studio is definitely a big step forward in delivering a gaming experience for users and strengthening the streaming experience. In fact, I don’t see the gaming business as a new revenue stream but more as a way to broaden the streaming experience which is good considering the high synergy those two worlds have.
  • E-Commerce site (Netflix.shop): What the company is trying to do here is to further enhance the user’s experience by making available to fans some consumer products (e.g., the necklace from The Witcher). I personally see it as a great way of doing marketing, because through it the company will be able to increase the engagement with fans that translates into greater talkability, and attracts more fans.
  • TUDUM: to further strengthen the engagement with its members, the Company launched TUDUM which is a site to fuel the fandom for the shows and movies people love. Here people can read the stories, watch behind-the-scenes videos, etc. It is definitely a good way of doing marketing.

By putting all of it together, the actions undertaken by the company are likely to translates in the future into stronger retention, lower churn rate, and higher time spent on the platform. In particular, since the Company expressed its willingness to make the gaming experience available for its users without additional costs (no ad, no in-app purchases, or another way of monetization) I see in the future the introduction of new subscription plans, those that includes the gaming experience (a sort of full experience plan) and those without.

Discounted Cash Flow Model

Let’s now understand how much the company is worth according to the assumptions I have made and that you can see represented below.

DCF

Author’s Estimates

First, I would like to start with the top-line estimates, which drives most of the projection made in the DCF. To project revenues into the future I used a top-down approach with revenues being estimates as:

Revenue = ARPU * Average Monthly Users

With that said, below you can see the numbers used in the computation (note! the users represented in the graph are end-of-period and not those used in the formula).

ARPU & Market Opportunity

Author’s Estimates

For the top-line, I assume a CAGR of 7.2% over the next 10 years and a growth rate in perpetuity that is equal to the current 10-Y treasury rate of 1.93%. Going forward, I also assume an operating margin for the next year equal to 19.8% which is in line with the margin (19%-20%) expected by the Company for 2022 (note! the operating margin is highly sensitive to the FX exchange rate) and a target operating margin of 24.2% (that I believe to be reasonable given the current and expected dynamics).

The unlevered Free Cash Flow is discounted at a WACC of 6.61%, those computations you can see below.

WACC

Author’s Estimates

In particular, the levered beta has been computed using a bottom-up approach and the company’s ERP using an implied method approach. Finally, by putting all of it together we get the implied value per share, represented below.

Implied DCF Value

Author’s Estimates

As you can see from the above estimates, the implied value per share is equal to $208.00 which means that the Company is currently trading at a premium of 88.1% (based on my assumption you can see that I assume a terminal EV/EBITDA multiple of 4.80x). To better gauge market beliefs I provide along with the implied value per share, the sensitivity analysis on two key variables: terminal growth rate and WACC. Assuming that my estimates are correct, the market is assuming a higher terminal growth rate and a lower WACC.

Scenario Analysis

The implied value per share of $208.00 is based on my “base case” scenario or based on those assumptions that I believe to be more reasonable. However, it is also worth considering the other two scenarios:

  • Bull Case Scenario ($292.00 Target Price): the bull case scenario valuation is based on higher ARPU, higher market share. Here I assume a revenue’s CAGR of 8.74% (vs 7.2% base case) over the next 10 years and a target operating margin of 26.6% (vs 24.2% base case). Under this scenario, I am assuming that Netflix effectively navigates a highly competitive environment thanks to the competitive advantage of differentiation, which translates into higher growth & margins.
  • Bear Case Scenario ($142.00 Target Price): the bear case scenario valuation is based on lower ARPU, lower market share (or the number of users) and thus it translates into lower expected revenue growth. In particular, under this scenario, I assume a revenue’s CAGR of 4.2% (vs 7.2% base case) over the next 10 years and a target operating margin of 21.8% (vs 24.2% base case). This represents a lower subscriber growth than the base case forecast due to tougher competition, especially from Disney(DIS), which translates into higher acquisition cost of additional users, thus lower margins.

Investment Risks

Risks to my target price include:

  • Missing Subscriber Estimates: past misses resulted in severe stock declines, especially if the misses were perceived to be related to tougher competition. Thus, in my opinion, subscriber net adds are a key metric for Netflix’s share price.
  • Competition: SVoD is a very complex market and if the competition will be perceived as being a key driver of slower growth, it would negatively affect Netflix’s share price.
  • FX Exchange: large foreign exchange headwinds may lead to margin compression that would negatively affect Netflix’s share price.
  • Cost of Acquiring: lower subscribers growth and higher costs of acquiring incremental subscribers will negatively affect Netflix’s share price.

Final Thoughts

Netflix enjoyed unchallenged leadership so far, however, the competition gets tougher, and growing its subscribers base gets harder. Nonetheless, I believe that the Company has a very clear path in mind that in the years ahead will give to the Company a clear edge against its peers.

However, based on my estimates the company is currently trading at a high premium (or 88% vs current share price of $391.29). In my opinion, an appropriate entry point may be closer to my bull case scenario price target of $292/share and with the strong buy point being represented by my base-case scenario of $208/share. With that said, the company’s current valuation is not justified (even after the big drop we saw some weeks ago) and a better opportunity to buy this wonderful company will be available in the near future.



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