Chit Chat Stocks - Fundamental Analysis: Netflix (NFLX)

Episode Date: April 23, 2020

On this show we talk Netflix. Find out why Brett gave it a rating of 7.3 and Ryan a rating of 7.5 --- Support this podcast: https://anchor.fm/chit-chat-money/support Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Hello and welcome. This is the Fundamental Analysis Show on Chitchat Money. My name is Brett Schaefer and I'm here with Ryan Henderson, my co-host. Ryan, how's it going? Going good. Going good. We just recorded our interview that'll be coming out, I think, later than this episode, but it was with Justin Costelli. We had a good interview and now we are ready to talk Netflix. Yeah, talking Netflix. So you want to get into what they do and then the history of the company. We've gone over them before, so maybe skip a minute if you know the whole backstory have you read the story before but ryan you want to give a little deep dive uh for the listeners yeah so netflix is and most people definitely a lot of people know what they

do but they're a streaming service that allows members to watch a wide variety of tv shows movies documentaries and uh more you know beyond that through their different internet connected devices because you can do it through connected tvs laptops ipads whatever iphones um so a whole bunch of different ways you can watch um they run a subscription-based business model with three different pricing plans so they have their basic standard and their premium offerings those range from $8.99 a month to $15.99 a month and while netflix is profitable on a net income basis they have negative cash flow historically that changed this quarter which we'll talk about um due to their upfront due to the upfront cash that they pay for licensing content and producing their own

original content so due to the amortization structure a lot of the content costs for netflix are realized early so they're paid up front and as they've increased the content spend their negative cash flow has grown so if that all makes sense they're earning money on a net income basis but then they drop down their cost structure for original content and licensing content to a cashflow basis, which gives them negative cashflow. They are also making money through DVD rentals, which was small, small amount, small amount. Yeah. They don't even put it on the earnings anymore. They just say it's included in revenue, but interesting that that is still a thing. And that does exist. I'll dive into the history though. Netflix was apparently founded

after Blockbuster gave founder and CEO Reed Hastings a late fee for not returning his Apollo 13 on time he was outraged and embarrassed at a 40 late fee i know that's crazy and he just has happened to have a 200 billion dollar epiphany um which i don't know it sounds too good to be true almost it's probably is true but basically he came up with this idea that you should let people rent out dvds by mail and so that's how he started netflix so you'd rent the video online it would get delivered to your door and then once you finished watching it you put it back in the red envelope which they ship to you you put it in the mail and once the post office got it they would ship the next movie from your list and eventually this evolved to a subscription

offering of basically the same thing it was dvd delivery still and then in 2007 they went a step further and began offering a subscription streaming service which was only via the internet so it was only via computer at the time the incumbent player blockbuster was always sort of one step behind they kept launching like they would just repeat what netflix was doing like two years later which obviously ended up hindering them interesting note though blockbuster turned down the chance to buy netflix for 50 million dollars in 2000 and netflix ipo'd in 2002 i think i've told that story before but you just know what blockbuster could have been yeah they made a great mistake there uh and the story on netflix there is a biography of the business itself not just reed

hastings or anything like that and they were very scrappy at the beginning uh like they didn't even have a mail ordering system they were just piling up dvds in the offices and stuff like that so they were you know like that classic startup uh but i guess whatever read the book if you actually want to go over that's not what the show is about i'll go through the valuation here they have a market cap of 185 billion dollars ticker of nflx and a price of 421 dollars and 42 cents and that is a 422 2020 earth day um while we're recording this they have ev to sales of 9.64 pe is of about 100 although you do as ryan mentioned you have to look at the amortization table uh if you want to judge the earnings because you have to look at what uh they do when they actually are spending

money versus how they accrue that because they realize their content costs over 10 years on the earnings line, but they're actually paying all those costs upfront or typically. So cashflow is probably the better metric or one you want to use in tandem. It has been pretty bad lately at 15% negative margin. Although this quarter they showed that if they slow the content spend, they will be cashflow positive. No dividend as you probably will expect. Shares outstanding have only gone up from 407 to 437 million since 2013. So see, you can get good talent, the best in the industry without overpaying on stock-based compensation. There's a lesson to all those stocks that I do not like or that I like the business, but I get really mad every time they're

diluting shares by five to 10% every year, I guess. And then lastly, they have net debt of $9.7 billion. And the company said this should increase over time. Although we've gone over this before, I think on a different fundamental analysis show on Netflix, this stuff is not due till 2024 is some of it, but mainly 2025, 2026. So they have a few years there and then they have negative working capital. But again, they do have that recurring revenue model. So if they do run into cash troubles, I think with the steadiness of the subscription, they should be okay. Although I don't want to make any conclusions there. Yeah. And also they do not have a hard time borrowing money. They've been able to do it at will. And that's what they've done. That's powered

their business. And with low interest rates, it's been easier for them to do that. I'll get into the earnings though. And by the way, I think everyone should go read their shareholder letters. They write good shareholder letters. Even if you're not interested in the business, it's nice to see good management write good letters like that it's a good read it's well worth it um revenue for the first quarter of 2020 was 5.8 billion up 28 percent year over year and just for reference they released earnings like two days ago as of the time you're listening to this so it's relevant information um they added 15.8 million new paid memberships this quarter so they now have a total count of 183 million paid memberships roughly

Memberships grew 23% year over year. They had $958 million in operating income this quarter, up 109% year over year. $709 million in net income, up 106% year over year. Had $162 million in positive free cash flow this quarter versus almost negative half a billion in free cash flow last year. So this is the first time being cash flow positive since the second quarter of 2014. now it should be noted that they paused production so well they said they were going to be free cash flow positive before um any of this new uh whatever the new the coronavirus impacts hit where everything got all jumbled so i think that was going to happen but they just said quarter

or yeah just for the year for the quarter uh but they're still guiding for negative 1 billion in free cash flow this year okay interesting um and then their operating margin was 16.6 percent versus 10.2 last year apparently it would have been 20.4 if it weren't for a 200 million dollars in incremental content costs because they had to do something like up front because of coronavirus and then they had hardship fund commitments is what they said so probably donating basically to the cause or trying to you know make one-time expenses to kind of salvage any aspects of the business that might be hurt um despite higher than expected paid net additions revenue was in line due to the sharp increase of the u.s dollar versus foreign currency so i didn't know about

this but the u.s dollar its value increased in in relation to other currencies because i throughout the coronavirus and this wasn't expected i guess um and so that if if you think the net additions were higher however when you have to exchange the rates to the u.s dollar revenue actually it kind of came down if that kind of makes sense so revenue ended up being in line with expectations even though net additions were higher excluding foreign exchange arpu would have increased eight percent year over year that's globally they finished the quarter with $5.2 billion in cash. They have an undrawn $750 million credit facility with roughly $500 million due in short-term debt. Not to mention free cash flow outlook is a little better than

they expected at negative $1 billion for 2020. They stated they have more than 12 months of liquidity with flexible financial options. you welcome back let's hit the second half of the show and first up as always digging trenches and that is the moat rating and we did some well ryan did some preparation for this one uh so you want to talk what the crowdsource moat rating was yeah i did a little bit of um kind of preemptive research here for this and i'm going to pull it up on twitter because it ended with 911 votes i basically i asked on a scale from zero to three what would you rate netflix's moat just like we

do and um it gave everyone an option there were polls it was a poll 911 votes and 52 percent of people said they'd give it a two a strong moat 12 said it was impenetrable one said it was weak or 30 said one week but exists and then six percent said zero no moat so most people gave them a two and i would have to agree i'm i'm borderline three though i think it's developing my only thing right now is the value of their ip versus the incumbents that's and so when you say that i think disney typically um and then just generally there is a lot of competition however they have proved time and again that incumbents can't just enter it and automatically be successful apple amazon um i'm trying to think of other ones uh it's not guaranteed that you're going to do

well and then on top of it it's super capital intensive for a startup to just enter it so maybe you've got the ip but you don't have the production abilities that netflix has you don't have the recommendation algorithms that kind of thing it's a lot it's a much more difficult business than people think so i'm going to go with a solid two i'm gonna i think i'm going to give it a three just because if you've seen three of the largest businesses in the world and i guess You can count Comcast in there as well, going to hop on this, and AT&T. So you got Amazon, Apple, and Disney all launching stuff after Netflix has started. And Netflix has continued to accelerate their lead and just shown that they've been able

to prove they have a moat basically against anyone unless someone else wants to spend $20 billion a year on the streaming service, which no one is doing right now. So I think I'm going to give it a three, although I'm not invested in the company. uh, but I guess we'll move on to the next section and that is further reading. So what do you want to look up if you were interested in investing? So contracts with the actors is something that I'm looking at actors, actresses. Um, I know they're different. It's like a set salary. So obviously, um, so that structure is different than what studios do. Cause I know studios, you get basically bonuses here and there if the like box office does well. So, and obviously

there's no box office when you go with netflix so a lot of it's structured i'm curious which the uh which style the actors actually prefer and then what are the nature of those contracts do they go exclusive i know they signed ryan reynolds um and i'm not sure if that means he's not doing any other stuff right now how does that work can you sign actors exclusively to your platform right i don't know exactly i can give a little light on that but all i know is that say they sign a big name for like two to three years and it's like a hundred million dollar deal something like that that means that they have a set amount of commitments they have to make to netflix whether it's like eight things or three things or something like that but i don't think it stops them from

working from someone else i could be wrong on that though but i do believe what i've heard not from any individual sources just from reading things uh obviously i don't know any actors or anything but they uh like it because it gives them a lot more flexibility so you get like a three-year contract and you get all this money and you could basically do i mean you have to stay within your niche but you basically like do what you want they give you a ton of flexibility which i think a lot of the creators do like okay um what are you looking at for further reading so it's tough because this business is so simple and it's kind of ironic that it gets so much time on twitter cnbc and the like just because it's really is a basic business at its heart

but i do want to know what their plan is to do next within streaming or without do is it the next five years just the same trying to feed the flywheel of content subscribers you know just whatever all that raising prices stuff like that or is there something outside of streaming that they're going to go to next because it will not the growth in streaming will not last forever although it should last for the next few years at least. But they do play close to the chest, so I'm not sure there's going to be anything out there. I would just want to know, like, is it going to be cloud gaming eventually?

Stuff like that. Okay, future growth opportunities, what do you have? Okay, mine's simple. Again, very simple business, but it is raising prices. So right now, premium, which is four screens, super high definition, and you can watch from anywhere, is $16 a month in the United States. So that's basically $16 for a family or any sort of family structure. I believe, and I'll try to convince the listeners if they don't believe this, that people would

easily pay 20 bucks for this right now and eventually will be willing to pay 25 bucks for this. It's basically like one movie plus TV show a month, which is what Netflix gives you, whether the movie is a film, like a fiction film or a documentary. They've proven that they can give you that once a month. and then if you don't like regular scripted shows they have a lot of the unscripted stuff which people call garbage uh you know like the the too hot to handle things like that that but that's some of the most popular uh content for a lot of the demographics in the

united states and it is still going to cost less per month than what it would cost to go to the theater or and have the cable bill so the theater and cable structure which is what you'd have before if you wanted to see movies um and watch television shows so that's why i think they have a lot of pricing power yeah and okay so let me give you a scenario if you had if you could only pay for one streaming service you it's $30 or let's go $25 you get one streaming service only I think most Americans would choose Netflix oh you have I mean unless you're just you have to choose Netflix unless you really like an individual show or if you have like kids under the age of eight maybe disney i mean i don't like disney plus but then again i'm not under the eight i

don't know what kind of original content they're putting out in terms of like really audience size but even netflix has that stuff um for younger kids so yeah i agree with you i think there's definitely room to raise prices i think they know that um and at least having a good blend of price raising because you don't want to see prices immediately in some of those emerging markets um i'll get into mine though i think they should hedge foreign currency exposure and make so they must they must know something i don't in terms of why they're not doing this but as international growth continues to outpace the u.s and canada more and more that top line is going to come from other areas around the world and they stated in their earnings and it's starting to

you know i mean it's starting to show because revenue was less than they would have projected with the net additions that they had this quarter. They said, as a reminder, more than half of our revenue is not denominated in U.S. dollars, and we don't hedge our foreign currency exchange exposure. Given the volatility of foreign currencies, particularly in emerging markets like Latin America, maybe some of the Asian Pacific areas,

don't you think it seems valuable to protect that downside? They stated if the value of the U.S. dollar stays where it's at, like in relation to the foreign currencies they'll simply adjust their models but they are expecting a decrease in operating margin if it stays this way so why not hedge yeah i think it should yeah it's kind of like an airline uh with oil it's going to impact your business a lot um and i i mean there is a good case for i definitely it's kind of like the airlines with oil um i know i know they're spending tons uh their capex is probably going elsewhere um and maybe there is some simple adjustment they can make to their models but it it seems like a no-brainer especially

right now like in the you know no one knows how a lot of these emerging market governments are going to be affected um because of coronavirus they're taking a little they're taking a little bit of a risk there um but that's what they've always done so i guess i don't i do not think they're gonna change that i mean we could play executive all we want but we you know we're not probably yeah i mean they probably know they probably they've probably looked it over before it's not like oh well that happened um anyway all right highlights and low lights what uh what do you have okay i'll put down pricing power i know a lot of people disagree on the pricing power thing but I think it's clear. And I don't know, we're not going to convince anyone with just going over

the show though. I think they have the best UI slash business practices slash technology in their industry. They have basically also, they have basically all of their 2020 content in post production. They mentioned that on the earnings letter or the call. This is a lot different than other things. So they mentioned that the crown, which is one of their most popular shows is going to be coming out in the fourth quarter of 2020 and that is already in post-production so they have a lot more running room than say a movie studio or things like that and they're also going to have a benefit if the studio if the theaters are closed for a lot longer and uh other things that are related to that i think a lot of the studios are going to want to bring back their

content to netflix just because that's the best and cheapest way to get some cash flow and netflix will pay for and then it'll centralize where people want to watch um you know you know what i mean like if things aren't going to the theaters they're going to want people to watch their movies no matter what and then low lights for me debt levels are obvious there's uncertainty on the cash flow and the pricing power may disappear in a long-term recession there are some decent arguments on that although i don't really believe that just because i think the cable bill the bundle goes first yeah okay so one of the things you stated there is kind of my low light which is that pause in production um but you brought up a good point so i'll hit my highlights first i think

the business model that they've been preaching for so long is beginning to unravel we're starting to see that start working your way from the top to the bottom and you you mean sorry you mean unravel in a good way yeah yeah no we're starting to see that um and you're if you look at it from the income statement from the top to the bottom you're beginning to realize that profitability is coming in droves it's there's a lot i mean 106 percent profitability on the net income side obviously the cash flow is another story but as that content spend i mean they proved if they stopped spending con if they stopped spending on content obviously there's still stuff coming out right now they're profitable on a cash flow basis um or they could be right but my problem here

is that there will be the pause in production. I know that they have tons of content that was basically finished and waiting for release or in the post-production process. So they should be fine for the coming quarters. But with the current halt in production all around the world, it's likely going to translate to slower membership growth

when that production was set to be released. So whether that was a year and a half from now, unless, like you said, they signed kind of interim two-year deals with some of these other producers and have it come out on their platform, which is probably a good idea. I think that's the best way to do it

because there's going to be a whole block of area where there isn't a lot of original content coming out because there was no production. Another one here, I think that with the current halt in production, it might provide some of those incumbent players, so like Disney and even Comcast with their new, what is it, Peacock, is that what it's called?

Um, I think that might give them a chance to flex their existing IP. If, if Netflix at the time, isn't coming out with a lot of good original content, uh, Peacock and Disney plus might be able to say, all right, we've got more value here for what we're offering. Yeah. I mean, you can make that argument, but I don't really, I don't really believe it. Friends, Seinfeld, the office. I think a lot of people would be willing to watch that if Netflix was

struggling to produce original content. Yeah. But you have to remember they do get, it's just one show. They do get Seinfeld in 2021. They do lose the office though. I don't know where that, I think that's going on Peacock.

But I mean, it's such like you would think, all right, there are some negatives to the slowdown for Netflix, but net overall on the entire industry, they're definitely getting a benefit. uh from this yeah i mean they're taking market share yeah and they've proved they proved that uh you know but by the slight bump and they talked about it on the earnings uh the the i don't know

if it's the earnings call but on the earnings release they said we saw an increase in growth in the net additions when the stay-at-home orders went into effect yeah and you can see that i mean the subscriber numbers were giant 16 million all right uh last up rating what do you got i'm going a solid 7.5 and so here's my thing i think the business model is sound i and they do have a mo and and i talked about this with uh one of the investment analysts from ensemble capital and he talked about it a lot and he said basically business is worth its future cash flows is essentially what he's saying and i think they can charge air i don't see why they couldn't grow at 20 percent top line for the next 10 years whether that's arpu or international growth

and that's i mean but then there's the part of me that says i don't know if i want a company that's fringe 200 billion dollars trading at earnings multiple above yes yeah and i'll go into why my rating will be very similar to yours but yeah they are too popular for my taste which puts it into the too hard pile for me and they are the law of large numbers which also puts into the too hard pile where i think a lot of the growth is priced in i do not believe and there are a lot of people that think netflix is going to fail i don't believe they're going to fail would i be surprised yes but they do have the capital structure and the negative cash flow that you know you could say like oh things went wrong so it's not going into my portfolio i don't think

ever unless we see a huge drop in the share price and the business still continues to climb which it's talked about so much i really don't see that happening so i'm gonna give like a seven three right around yours um it's it's on my watch list it's been on my watch list but i mean it's just it's too efficiently priced right that we both agree on that yeah i don't i think this could be a market outperformer for the next five to 10 years um like i don't think you're gonna go wrong like i don't think you're risking all your money by putting into this but it doesn't like this isn't i'm not buying it because there is one it feels like too many people know about it there's no um you you have no advantage there and it the law of large numbers eventually comes into play

Yeah, I'd rather try to find the companies that are in the Netflix phase what they were before 2010. I know that's a lot harder, but that's what we're trying to go here for. All right, that's going to do it for this episode. Thank you guys for listening. Make sure to follow us as always on Twitter at chitchatmoney and email us show suggestions at chitchatmoneypodcast at gmail.com. Remember, we are not financial advisors. Anything we say on this show is not formal advice or recommendation. Thank you guys for listening to this episode. We'll see you guys next time. Do you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad.

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