Is Netflix a good investment?
Opdateret: 6. jun. 2022
This is my fourth post about the FAANG stocks. N stands for Netflix and in this analysis, I will investigate the company and determine if it should be part of your portfolio, and at what price.
This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and briefly go through why the company has meaning to me. I have changed the format of the analysis a bit to try to make it shorter and with less numbers. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.
For full disclosure, I should mention that I don't own shares in Netflix, and never have. I really like Netflix as customer though and I have been a customer for many years but recently cancelled the subscriptions due to price hikes. It used to be my favorite of the streaming services as I like that they have movies and series from all over the world, but I have since switched to HBO as it is cheaper. However, even though I like the company, I will stay objective in this analysis.
Netflix is defined as an over-the-top content platform and production platform. It was founded in 1997 by Reed Hastings and Marc Randolph and is located in California. I believe most people know about Netflix, so I see no reason to go deeper into what the company does, instead we will look at the moat. Netflix is a well-known brand, which is so well-known that it is even used as part of a euphemism for sexual activity being "Netflix and chill". It gives Netflix some sort of brand moat, however I would argue that the brand moat is relatively weak. It is so easy to switch from one streaming company to another, and if the company does not provide the content you like, most customers won't stay because of the brand itself. Meaning I don't think it has as strong as a moat as I would usually like.
Their CEO is Reed Hastings. Besides being the CEO, he is also the cofounder of Netflix. His educational background is a master's degree in computer science from Stanford University. He doesn't credit his educational background for his entrepreneurial spirit though, instead he credits his time in the Peace Corps for that, as he believes it gave him a combination of service and adventure. During his time in the Peace Corps, he went to teach math in rural Swaziland for two years and regarding to his entrepreneurial spirit he has stated "Once you have hitchhiked across Africa with ten bucks in your pocket, starting a business doesn't seem too intimidating". Prior to founding Netflix, he founded Pure Software, while the company was successful, he did have some managerial challenges. Once Pure Software (then Pure Atria due to a merger) was acquired by Rational Software, he left soon after, and spent two years thinking about avoid similar problems in his next start up. Those years were very beneficial for him as his way of leadership is now considered transformational. His approach to personal time off, travel policies, formal reviews and compensation packages are far from mainstream corporate America. You can read much more about his management style in the book "No Rules Rules". I really like his managerial style and I believe his results speak for themselves and it is safe to say that his is a very good CEO that you can trust
I believe that Netflix has a brand moat albeit a bit weaker than we would like. However, I really like the management. Now let us investigate the numbers to see if Netflix does live up to our requirements for a strong moat. In case you want an explanation about what the numbers are, you can have a look at "MY STRATEGY" on the website.
The first number I will investigate is the return on investment capital, also known as ROIC. Ideally, you would like to see a ROIC above 10 % in all years. Historically, Netflix has an underwhelming ROIC. However, they have moved in the right direction since 2016, and does live up to the 10 % ROIC in the last two years. Hopefully, this trend will continue moving forward.
The next numbers are the book value + dividend. In my old format this was known as the equity growth rate. It was the most important of the four growth rates I used to use in my analyses, which is why I will continue to use it moving forward. As you are used to see the numbers in percentage, I have decided to share both the numbers and the percentage growth year over year. Netflix has managed to deliver some very nice numbers and is well above the required 10 % growth a year. Like with the ROIC, the numbers are getting better from 2016 and forward.
Finally, we investigate the free cash flow. In short, free cash flow is the cash a company generates after it has paid for operating expenses and capital expenditures. Netflix hasn't delivered the free cash flow that you would like to see from a company you invest in. In the last ten years, Netflix only managed to deliver positive free cash flow in one year. Management has stated though that they expect to be cash flow positive in 2022 and beyond.
Another important thing to investigate is debt, and we want to see if a business has a reasonable debt that can be paid off within 3 years. Doing the calculation on Netflix, I can see that Netflix has 2,87 years earnings in debt, which is acceptable. It is quite a positive number as Netflix used to have a lot more debt.
Like every other company, Netflix is facing some risks. The most obvious risks come from competitors such as HBO (AT&T), Amazon Prime and Disney+. As I wrote in the paragraph about the moat, I believe the streaming industry is very competitive and it is hard to keep competitors away, as you don't a have such a strong moat that keeps your customers from changing from one company to another. During 2021 Netflix has 222 million paying customers compared to 179 million on Disney+, however, Disney is narrowing the gap. Netflix has determined that they have 800-900 million households around the world as potential customers. India is the largest potential market, but Netflix cannot seem to get a footing in India. To try to get more Indian customers aboard, Netflix has lowered the subscription fee in India. Macroeconomic factors. In their latest letter to shareholders, management mentioned inflation, sluggish economic growth and geopolitical events as things that could have an impact on their business. Right now, all of this is reality with high inflation, underwhelming economic growth and a war in Europe. The question is how long it will last.
It isn't all bad for Netflix. A market analysis report from Grand View Research projects the global video streaming market size to grow by a compounded annual growth rate (CAGR) of 20,4 % from 2020 to 2027. Obviously, Netflix will take their share of the growth, but it might also be worth looking into other video streaming companies Furthermore, Netflix entered the world of mobile gaming in November 2021. The world's mobile gaming market is expected to grow by a CAGR of 12,6 % until 2026, and so far, Netflix has only released 10 games, and they are expected to expand their portfolio in 2022. Finally, Netflix is expected to become free cash flow positive for the full year of 2022 and beyond and reinvest that that cash in their core business and fund new growth opportunities as we have seen with gaming. Monetizing shared accounts. Management believes that there are over 100 million households that watched Netflix through a shared account. Hence, management hopes to monetize these households through different subscriptions in which shares account will be needed to pay more.
All right, we have gone through the numbers, potential and risk regarding Netflix, and now it is time for us to calculate a price for Netflix. To calculate price, we will need numbers that I have explained in the "MY STRATEGY" section of the website. I do not want to go through the whole calculation here. I chose to use an EPS at 8, which is between the EPS from 2020 and 2021. I chose a Estimated future EPS growth rate of 15 (which is usually the highest possible growth rate I use, and one Netflix expects to grow with), Estimated future PE 30 (which the double of the growth rate, as the historically PE for Netflix has been higher) and we already have the minimum acceptable return rate on 15 %. Doing the calculations by using the formula I described in "MY STRATEGY", we come up with the sticker price (some call it fair value or intrinsic value) of $240, and we want to have a margin of safety on 50 % , so we will divide it by 2 meaning that we want to buy Netflix at price of $120 (or lower obviously), if we use the Margin of Safety price.
Our second way to calculate a buy price is the TEN CAP price, which is also explained at "MY STRATEGY". To do so, we need some numbers from their financial statements, keep in mind that all numbers are in millions. The operating Cash Flow last year was 392,61. The Capital Expenditures was 524,58. I tried to look through their annual report to see, how much of the capital expenditures were used on maintenance. I couldn't find it though, so as a rule of thumb, you expect 70 % of the capital expenditures to be used on maintenance, meaning we will use 367,21 in our further calculations. The Tax Provision was 723,88. We have 443,1 outstanding shares. Hence, the calculation will be like this: (392,61 - 367,21 + 723,88) / 443,1 x 10 = $16,9 in TEN CAP price.
The last calculation is the PAYBACK TIME. It is also described in "MY STRATEGY". However, with the Free Cash Flow Per Share that is negative, it is not possible to make this calculation.
I do believe that Netflix is good company and I really like the management. However, competition is ramping up, which has hurt the growth of the company. I don't like that the company has a negative free cash flow, o hopefully management will be able to deliver on their promise and be free cash flow positive from 2022 and beyond. Nevertheless, the streaming sector is interesting, especially if it can grow by 20,4 % a year. If management is successful in monetizing these 100 million households, it will be another growth catalyst for Netflix. Personally, I'm not completely sold on the investment case of Netflix, but should it reach the margin of safety price of $120, I might reconsider. Until then, Netflix will not be part of my portfolio.
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