Chit Chat Stocks - Netflix (NFLX) with Alex Morris

Episode Date: February 10, 2022

Netflix is a subscription streaming service and production company based out of California. The company continues to lead the streaming world when it comes to subscriber count. Listen as Brett and Ryan ask Alex Morris questions about the company, its business model, and valuation. Enjoy the show! This episode is sponsored by Stream by Mosaic, the highest quality expert network library. Sign-up here:  https://streamrg.co/CCM Subscribe to 7investing with the code "CCM" and get $10 off: https://7investing.com/subscribe/aff/4/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Interested in more of Alex's work? Follow him on Twitter here: https://twitter.com/TSOH_Investing?s=20 Contact us: [e-mail]  Timestamps Netflix | (3:00) Industry & Competition | (27:16) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chitchat Money. Today is our Thursday deep dive episode, and we're joined by Alex Morris. We talk Netflix, which has been slightly controversial at the time of this recording because they had just reported earnings, but you all will be listening to this about two weeks delayed. Anyway, we go over the business. I think it's pretty informative. Probably one of my favorite deep dives we've done so far just because there's so many different ways to look at the business. And it's timely because streaming is that it seems like streaming companies are at a pivotal moment.

We might look back at it on it and say it's not a pivotal moment, but that's stuff we get into during the interview. So if you're anyone that's interested in Netflix, interested in streaming, kind of wants to get some insight and someone who spent hours and hours researching on this, Alex was perfect for that. Yeah. And before we get to the interview, we want to talk about our friends, our sponsor stream by Mosaic.

They are an expert interview transcript library. We've used them before and we use them. We're not huge expert interview people, but we do on occasion use them whenever it's a new portfolio company or something like that, just to take a look and see what people on the inside or experts, I guess, are saying about a business. This is perfect if you're a professional investor. Yeah. Or yeah.

Even, I mean, even individuals to some extent, if you want to kind of, and if you're thinking maybe it's too pricey or maybe I'm not getting enough value potentially, they have a two-week free trial. And you can use our code. I think it's CCM. Yeah, CCM. Go to streamrg.com. And there's 8,500 plus call transcripts. They have a bunch of different industries. I think pretty much, unless it's some obscure microcap and maybe they do have one, they've probably got an expert transcript or an expert interview on that company, whatever one you're looking for. So go ahead, check them out. As I said, streamrg.com, S-T-R-E-A-M-R-G.com. Use that code. Without further ado, let's get to the interview.

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guest is not formal advice or recommendation. Now, please enjoy this episode.

Okay, welcome in. Today, we are joined by Alex Morris. i don't you know i've lost count so i'm just gonna call you a recurring guest uh and today we're talking netflix you had a write-up on them come out uh this week and we'll be sure to link to that in the show notes and they just had earnings so let's start there what were your thoughts on the earnings i guess most people probably know about netflix but uh let's just stick right into the earnings yeah thanks for having me guys i was thinking in my head how how many times it was as well. And I also do not know. So we'll just say recurring.

At a high level, I think the summary on the quarter is that it was a pretty difficult one. And the place to probably start is the subscriber data, which we really need to take a step back and look at what's happened since COVID began. So if you go back to Q419, the company had 167 million paid subs. And the pace of growth leading up to that period was right around 55 million subs on a trailing two-year basis. And that had held for the prior three or four quarters. And that number had kind of grown over time. So that gave you a good idea of what they were kind of on pace for. So if you look at this quarter, Q421, they're at 222 million paid subs, which works out to exactly 55 million. So it's right on trim with where they kind of exited 19. The problem is

those eight quarters that occurred in between there, there's a lot of variability in terms of what we got in the numbers. In first half of 20, they added 26 million subs, which was by far the best six-month period they've had in their history. They added 16 million or 15.8 million, And I think it was in Q1 of 20 alone, which by far their best quarter in their history. So they had really strong growth in the early days of the pandemic. Obviously, people were locked inside their houses, work from home, et cetera, et cetera. So it was a really nice tailwind for them. But then as you go forward from there, the experience gets a lot choppier.

They finished up 2020 pretty strongly. But then early 2021 was weak. The stock came under a lot of pressure at that point. Mid-2021 was strong again. They had Squid Game. they had other programming that really hit it out of the park. So the stock had a very nice performance. Now we're here in Q4. And the number was pretty underwhelming. And also, as we look ahead to 22, the Q1 guy was really weak. In addition, the EBIT margin target, which

people don't know, they've basically said, hey, we think we can add roughly 350 a year to margins over time. Any one year could be more or less than that, but that's kind of what we're on pace for. They've overshot that a little bit in the last, I believe, three years, but now 22, they're going to have a little bit more pressure. So it's going to basically fall back in the line. So between subscriber targets and the margin target, people are certainly a little bit more negative on Netflix's current trajectory. Okay. And as someone that follows them, are you looking for them to return to that $55 million average trend? Because I know it's supposed to dip down to what the projection would be about $42 million for the trailing

24 months, I believe the number is. Are you looking for them to return to that over time? Yes, this is the hard thing, right? So Q1 of 20 is what's going to drop out. And when they reported Q1 21, it was pretty weak. Well, yeah, you had a very tough compare from Q1 20. Now with Q1 2022 looking like it's going to be weak. Well, you know, you start you start to start asking the question, how much of this is how long will this COVID hangover basically last? And really, what was COVID? Was it a was it a pool for where our growth rate is, is just now taking a step up that we're going to build off of from there? Or is it a temporary one time influx of people? And then now you're hitting a bit of a lull on the backside of that. It's certainly looking more like the second

one at this point. But I think over a longer period of time, yeah, you're still looking for something like, let's put that 55 and a half, that's 27 and a half. I think if you're bullish on this company, you really think that over the course of the next decade or so, let's put it in round numbers, that they can add another 200 or 250 million over a decade. So that's 20 to 25 a year. So, you know, the pace that we're at right now doesn't get you there. I personally would come to the view that this is just, it's not so neat and tidy that the hangover from COVID is a one-year thing. You're dealing with the realities of operating a business. So I think you see them get back above the numbers we're at today and Q2, the trailing 24 number will go even lower as they

roll off 10 million from Q1 20. But I think we start working our way back towards kind of where they were at before the pandemic started. Okay. And I'm sure we're going to talk more about how they grow subscribers. That's the big question for them. But let's step back first. Everyone knows that Netflix is a subscription business, but I think a lot of people don't really know what's under the hood there. So can you give an overview of the unit economics and business model to give a clear view of how Netflix is making money? Sure. So the unit economics, let's start with the P&L because that's one people will certainly have an argument with it, but at least we can talk about the numbers. We can talk about the income statement versus the cash flow. If you

look at the P&L on an average subscriber basis over the past five years, the cost of goods sold line, the majority of which is their content spend, has been right around $80 per sub globally. And then below that line, as you look at operating expenses, so things like tech and development expense, marketing, etc. Those line items collectively have been right around $30 per average sub over the past five years. So between those two line items, you've been right around $110 globally, and that's an annualized number average subscriber. Now, the important thing that happened in that same period is from $16 to $21, revenues per average sub globally went from about $9.20 a month to about $11.60 a month. For an annualized basis, that's $110 to $120.

for me. So nutshell, EBIT per sub five years ago is basically zero. And then last year, it was basically 30 bucks and right around 20% margin. And again, I'm sure we'll talk about income statement versus cash flow, but that 2000 BIP improvement in the EBIT margin profile, you see a very similar trend in terms of the FCF margin profile. And so that's really how I think about the long-term business model personally. It's this combination of unrivaled scale. and then when it's paired with you know effective content investments it's the idea of driving best in class engagement churn arpus etc um and and as you start thinking about those numbers from a current base of you know 220 to 300 400 500 and then also on the arpu side of the equation

as you're starting at you know that 1160 i talked about as you think about what that looks like at 13 14 15 you start to get a clear idea of how this company over time can have you know content budgets of $20, $25, $30 billion a year. One other thing I'd add, I think it's really important to try to look at this company regionally to get a feel for how these different businesses are tracking. You look at a region like the US, obviously, the product and the subscriber base is much more established than it is in a lot of other markets outside the world. So when I look at those numbers personally, I get to... And you have to use some estimates based on what they've reported over time.

But I personally see the US slash UCAN business with something like mid-30s EBIT margins currently. And obviously, international is much lower than that given where they're at currently in their life cycle. So I think it's really important to recognize that it's kind of a mistake to view Netflix as a single business. You kind of need to think about

where these different regions are at in terms of their life cycle. Can you talk about, and this was a question we got on Twitter, and i think it's sort of a i guess a hotly debated topic it's the biggest one biggest question probably which is the content amortization portion can you kind of explain how they amortize their content and then sort of what that big discrepancy is between cash flow and uh gap earnings sure so what netflix is doing at a high level let's take a step back

people really understand this they're putting money in obviously they're paying cash up front to people who are working on a set, whatever it may be, to get a show produced. So that cash content spend is happening today. And then over, maybe that show goes live in five and six months, let's say. At that point, they start amortizing the cost of that spend through their P&L. So how they currently do it, and they lay this all out in a deck on their investor relations page. They basically tell you that the vast majority of a content asset, I mean, they say 90% plus, is amortized over the first four years of the title being on the platform now i'm sure part of the problem people have is well what is the actual life of you know is the life of a title

actually four years how fast or slow should that amortization cycle be um they tell you in that same deck and i guess people have to decide whether or not they they trust management or you know auditors whatever it may be they tell you that they look at historic viewing patterns and current viewing patterns. And they review this on a quarterly basis in order to ensure that the amortization is aligned with the viewership. So in terms of how they're accounting for this stuff, I think that's basically all you have. In terms of the discrepancy, a lot of this is the timing of a business that's currently in a major growth phase. And there's going to be a lag between the P&L costs and the cash costs as you do so.

For example, I think people forget sometimes, because a lot of us are US investors who are looking at this, this company had 10 million international subscribers seven or eight years ago. They have 150 million today. This business is still very much in a growth phase. And I think it will continue to be in a growth phase for a long time with the cash content spend likely exceeding the amortized costs that's flowing through the P&L. So I think people just have to to realize that this is part of what it takes to get to scale. And that's how it'll show up in those, you know, those different financial statements.

The other thing I'd probably add is as legacy competitors look to compete with Netflix, they are going to face a lot of the same issues in terms of how they think about spending a lot of money upfront in advance of, you know, economics that they, they hope to achieve on the backend. So I realize it's a, it can be a pretty complex issue for people, but I think when you, you know, as I mentioned in the previous answer, when you think about this idea of the income statement

having 2,000 bps of margin expansion, and you think about the FCS statement having a similar change in its trajectory over time, I think people should maybe step back and just think about what's truly going on here in terms of the economics of the business and not get too hung up on how short-term accounting is. And when I say short-term, I mean years. So I do realize it's an issue, but thinking about how the accounting issues impact apparent profitability. Do you think now this might be something that you can't get an exact number on? Do you think free cash flow and say EBITDA earnings are going to merge over time as they mature? Converge.

Converge, sorry. Yeah, over time, as the spending slows down to a pace that's more of a run rate, you'll see those two figures close. And I think, again, this is partly why it's important to look at this business regionally. If you try to break out what the UCAN content spend looks like over the past five years, what you'll notice, and it kind of surprised me actually, the pace of growth has not been that significant in the grand scheme of things. It's really international where a ton of the spend is being driven, and if you believe in their strategy and vision, rightly so.

But if you had a clean UCAN cash flow statement, you would see that the discrepancy between these two figures is not as large as it is for the business as a whole. Right. And with that amortization stuff, I want to say whenever someone says like, oh, they're amortizing over four years, they're always cherry picking either direction. So I think in general, you know, four years might be a good number. It could be three, it could be five, but like, I don't think it's a big deal. But let's move on to the next question. That's pricing power. Another big debate, I guess a lot of investors have with Netflix. What ways do you think they can increase their pricing power? And I'm going to throw it off by maybe analyzing two

really different parts of this business. Can you talk about that in the United States, which may be more in the pricing power arena? They just raised prices again, I believe. And then maybe talk about, we just learned that they lowered prices in India. Can you talk about maybe those two different strategies, international or emerging market stuff versus the UCAN pricing power? Yeah, sure. I mean, at a very high level, and obviously this is not an original answer, but it's to have a large quantity of programming that people truly desire. And let's start with the first part as you kind of laid out, because I think it's an important thing.

As you think about markets like UCAN, where they have a clear leadership position, they clearly have penetrated a large percentage of the market, they account for a significant percentage of all viewership through kind of a video-on-demand way of viewing the offering. I think Netflix really benefits from that dominant position, not only because it gives them scale and it gives them pricing power, but you can go listen to people like comedians or actors and directors, and now we're seeing with kind of like the PGA Tour is doing, these people seek out Netflix because of the reach that it gives them. So obviously, it's important that Netflix still pays something close to top dollar, if not top dollar to secure a lot of this content. But these people also recognize that their ability to monetize is not contained to just, you know, getting a check from Netflix or Paramount Plus or whatever it may be. You know, someone like Formula One very clearly has seen that their global fan base and interest in the sport has been very materially affected by the fact that their show was on Drive to Survive was on Netflix as opposed to being on, you know, name any competitive offering, basically. So I think that that's a huge part of that having the programming that people truly want equation. Other things are as simple as having simple access to the product.

having these TV remotes that everybody has with a Netflix button on and having smart TVs that have access to the product. I think they very intelligently have pushed people into these kind of family plans with concurrent streams where they obviously know, and I know this from personal experience, I don't want to text my parents and my sister and my cousin and tell them, hey, I cut off our Netflix because I just want to turn it off for a month and I'll turn it back on. Personally, I'm just going to keep paying versus doing that. So I think they rightly recognized early on that things like password sharing and family plans, when dealt with in an intelligent way could actually be a tailwind for their business. So these are some of the

things that in my mind, really give them pricing power. And of course, this isn't theoretical, we've seen them very significantly drive pricing in a market like you can. As you look to the rest the world, as you said with India, you need to take it on a country-by-country basis. As I just mentioned for UCAN, having scale is very important. Having programming that people care about is very, very important. In a market like India, they are starting from a weaker position as opposed to being the trailblazer in that market. From the data I've seen, at least, they're probably and pretty solidly behind a company like Disney or Amazon. So they need to think about how can we start to get scale?

How can we start to get content that people really must have? And that'll be a tough fight. But Netflix has done this before countries all around the world. There's a great Bloomberg article about what they had to do in order to kind of start building their presence in a place like Brazil. And I think what you see is Netflix, you know, it's funny to think about a company having a first mover advantage and that giving them a scale advantage. But I think it's also important to recognize that a first mover advantage also comes with a ton of learnings that a company

like Netflix can now apply as they go to all these other countries around the world. So yeah, just like the income statement question, I think it really is kind of a country by country basis. And some of these places will take a long time before they really drive pricing power. what does it take for netflix to enter a different market i mean because they're not like it's not like they're going there and setting up regional like sales offices right so it's do they have to get i mean what are the like barriers to going into a new country so i think part of it is and the brazil article talks about things for example and this is this is a few years ago but things as simple as how you get paid. In some countries, not everybody has a credit card.

So they needed to address fairly simple things like that. In India, another example is, my understanding is that companies like Disney and Amazon, part of their success has been because they very effectively have tied themselves to some of the telco offerings. So it was a way to basically get them distribution without them going there and throwing up billboards or other forms of in marketing. So it's stuff like that and stuff Netflix has done before. But you need to really put the pieces in place for those things to work as opposed to just, hey, Netflix.in is now live. You need to get boots on the ground and get that going in that business. I also think, as we see them doing in places like South Korea, it's also figuring out the local content and

thinking about how are we going to make this a service that in this individual country, people are really going to want to watch the programming as opposed to this idea of it being just some American company shipping us American content, which is how it can be perceived, obviously. And it's still very early in the local content story. But I think they need to have a truly local offering in every major market that they go to. Right. And now let's get the last overview question. Now we'll get to the fun ones on the second half churn at netflix and i believe correct me if i'm wrong is the lowest out of all the streaming services um which means it's the best for from a business standpoint but we always

see people talking about competitions coming online anecdotally they're like you see someone saying oh i'm turning off netflix i like hbo max now numbers haven't proven it out yet but if churn rises that's you know they're in trouble what do you think the best ways are them there for them to keep churn either stable or go down um say over the next decade yeah i think a lot of it ties into you know obviously the ability to drive prices is obviously tied to hip with with your ability to keep people on the surface so um you know as you kind of alluded to it's hard to get clean data but everything i've ever seen suggests that that netflix remains best in class in in that regard And I think the answer is a combination of programming that people really want, both in terms of the library, but also a ton of new content.

And I think management has been fairly explicit about this, that it's stuff like Red Notice, it's stuff like Squid Game, it's stuff like Don't Look Up, these new movies or new shows that can create a lot of buzz that can convince that marginal customer to sign up for the first time or to convince people to stick around. And as I think about this business and what it becomes, you need to fight for that spot as being the thing that people turn on when they sit down on their couch at night. And if you're not securing that place, unless you're running a niche strategy where you're going to have a relatively high-priced offering for a relatively small audience, you need to be fighting for that slot in people's minds. And, you know, for a number of reasons, Netflix clearly has that position today for a large number of people around the world in terms of solidifying that position. I think they need to take what they've done so far and supercharge it. And, you know, I think they've talked about this idea of, hey, a movie like Don't Look Up, which is a theater level quality movie, we're going to have dozens of those a year. And, you know, to the extent that they can deliver on that vision, and I think the numbers I discussed earlier about subs and ARPUs support that type of investment, they can deliver on that vision. I think they have a very bright future ahead.

I have one more question before we get to the second half. Do you personally like their original content? Let me think. I like Don't Look Up was a good movie. I liked it. You liked it? I liked it. Yeah.

I think there's something a little off with their films though. It's like one thing's missing compared to like Warner brothers. You know what I mean? They got to be a little different, you know? I hear you. I thought it was, I mean,

was it my favorite movie ever? No, but I liked it. Um, drive to survive, I think is a good show, but I'm not a big, I'm not a big formula one guy.

So I'll be excited to see what they do in terms of, uh, PGA and tennis when they get that out there. I think those will both be really good. Um, you know, I don't, none of there's none of there's coming to mind right now.

I'm not a big, not a huge tv guy i usually turn it on when i'm trying to go to bed and then i fall asleep like before the opening credits are even done so do you do you subscribe to any other services yeah i subscribe to netflix disney plus hbo max and paramount which of those if you had if you had to kill you could only keep one i could only keep one yeah i mean def definitely netflix among those four the you know the problem is at least the problem from my perspective i shouldn't say that definitely netflix disney would definitely be in the running only because i'm a massive sports fan and i use i use espn plus a ton right um and paramount plus i for the same reason i'm a big

soccer fan so i have it for soccer but there's but their offering's not as deep so there's times during the calendar where for me i can just turn it off because i know i'm not going to use it and this is really this really gets the problem i think that a lot of these guys are gonna have to figure out, which is, I know there's something of a narrative going around that streaming is a really tough business and it may very well be. As in a lot of things, I think this ultimately comes down to your relative competitive advantages and where you can really shine where others do not. And this is where Netflix truly separates himself for me in terms of that mindshare I talked about a moment ago, but also having a quantity and obviously the quality has to continue to improve,

but a quantity of content that gives you reason to keep coming back to the homepage. And then obviously other stuff on top of that, more of the intangibles in terms of recommendations and, you know, the like a lot of, a lot of which parallel Spotify, in my opinion, which you guys also know very well. Yeah. I think that's a good indicator that Netflix has a pretty good business when you said you don't watch it that much. And then you wouldn't even think about not subscribing, you know,

that's pretty good indicator. I think. Yeah. Yeah. well they have me also hooked because of as i said i have a family plan so i'm paying for other people who do watch it right i've never thought about that one it was like people would think at first your first principle of thinking on that would have been that's a terrible idea you're just going to let everyone share passwords what about you're never going to get that many subscribers but i think it's really turned into a long-term advantage that's very interesting now they've played that card brilliantly over time and i i i can't say this for certain because my memory might be not as good as i think it is but i think they've really expanded in terms of uh

but what that offering entailed to really make it clear that, hey, they got much stricter in terms of the concurrent streams as well. So they've really driven people into these plans. And obviously, you see what that means in terms of pricing and a large amount of money, what it means in terms of churn as well. All right, let's hit a quick break. And then we got more questions on the second half. Pluralsight, a tech workforce development company, provides the solutions high-performing engineering teams need to tackle today's biggest challenges. Whether it's building the skills individuals and teams need to tackle mission critical projects, driving cloud transformation, or helping software teams to ship reliable,

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Advanced security must be enabled in the panoramic Wi-Fi app. Restrictions apply. Okay, welcome back in. We got a whole bunch of questions from Twitter. So I'm going to try to use some of those. So, and we briefly alluded to this in the first half, but what are your thoughts on the streaming space as a whole? And then how much do you think about competition

when thinking about sort of the Netflix investment thesis? Yeah, how I think about streaming as a whole and kind of video streaming or particularly entertainment programming. In my mind, it's just so obvious that this is where the world is going. a much better product than what existed previously. You can see the data that Netflix or third parties report that just clearly suggests that the runway here is so long. We just went out on the first

half talking about Spotify, but for me, it's a very similar kind of trajectory where you hear someone like X say such a huge percentage of advertising in the category is still over terrestrial radio. I just view a lot of these developments as things that are inevitable and It may take 10, 20, 30 years for some of these things to happen, but they will happen. So that's kind of how I think about Netflix as well. As it relates to the competition, I think it's undoubtedly coming. I own a company, I own Disney, and I think they're very much on the right path. And I think they will be one of the long-term winners alongside Netflix.

When it comes to some of the other players, I think there's a lot of work left to be done. And particularly as it relates to this transition away from linear TV in the U.S., a number of them will be fighting a lot of short-term pressure on their income statement and on their cash flow statement in order to make that happen. They'll also be fighting the incentives of the people working inside these organizations. I think a good example I saw this week was an article that was talking about ViacomCBS. And it said, you know, the company has three programming executives that report to the streaming CEO, and all three of them are looking to defend their turf. So, for example, you know, one of the execs is responsible for CBS, the broadcast network. And so, you know, you can start to see how his incentives when you're talking about putting

something on CBS, what will be seen by, you know, or at least it's accessible to tens of millions of households around the country, and it's important to Nielsen ratings and advertising revenues, et cetera, et cetera, versus that content being put on Paramount Plus, it might be in terms of what he cares about at that moment and what makes sense to him. I think that is a problem that a lot of these organizations are going to have to navigate. So they not only have to get to a place where people know about their products and care about their products and don't turn off of their products, but they also need to get

their own organization to think similarly and have an all-in mindset on streaming. And this is also a scenario where a period like this quarter where people think more negatively about Netflix specifically, but maybe even streaming broadly. It's the kind of thing where I think in some ways, those internal issues that I'm talking about become even more pronounced because maybe an organization that hasn't yet gone all in on something like streaming gets a little bit more tentative about what that may mean for their business so um i just think the clarity that netflix has and the clarity that disney is starting to have and they're moving in the right direction it just it for me it's pretty evident

that both those companies are going to end up doing pretty well in the space what uh any quick thoughts on hbo max discovery that seems like they'll be the largest one at least and you can I don't know anything about international yeah you know if they get the deal done and and they'll they have they certainly have a number of positives to to the position that they'll have I think in terms of their position internationally it's much less clear to me that they they're on very strong footing David Zaslav would tell you differently but if you look at the subscriber numbers they're a relatively immaterial player they have something like 15 or 20 million paid subs I think was the latest latest number they gave and they've been at this under different

products that were not called Discovery Plus for a number of years now. So I think they have a long way of going to prove that the content that they have is enough for people to truly care about subscribing to another D2C service. And then even outside of that, WarnerMedia has a lot of deals where they've already licensed their content in international markets. So they have to navigate all these issues. And even as they navigate them, they have to deal with the P&L and cash flow pressure. So I think they could become a real player, but it's going to take a lot of work. And so in your write-up, you mentioned that because you talked about the short-term sort of headwinds that we're seeing and whether that's a long sort of a COVID hangover or whatever it is, those could potentially be a long-term benefit. Do you want to explain why you think that is?

yeah i think it's basically this idea of these organizations that are going in different directions or at least taking away from one thing to make another thing stand up i mean taking away from their linear tv offering to make their d2c streaming service stand up this type of period may make them act a little bit more tentatively or conservatively and they may not go as aggressively after the opportunity in the short term and let's say for example you're you're paramount and you you're seeing a similar impact that netflix is in terms of your your gross ads in the short term maybe that maybe that leads you to be a little bit more conservative in terms of how you think about what this market is going to look like long term i think that assessment will be proven to be

wrong i think this market is the trajectory and the long-term opportunity is unchanged from what it was a year ago but i think there's a lot of companies that have a lot of uh people internally kind of pulling them different directions in terms of what matters most to them in the short term okay let's go to a fun question this was from twitter too but i think we're going to ask it either way netflix has made and these it's immaterial right now but it's talked about because it's a big transition out of just video stuff what are your thoughts on their video game investments and what do you think is their best way to enter the video game market because it's lot different than video um honestly i don't know at this point um i think it you know i think it

clearly makes sense for them to do this as a small bet particularly particularly if the objective is kind of to ensure that netflix's share of time on mobile devices um is is strengthened a little bit i think that's partly the lens through which they're viewing this i'm not sure if they've have said that explicitly, but that's how I kind of think about it. So I think it's an interesting test in that regard. For me, it's a lot like how I think about Spotify and live audio. I'm not really sure if it's going to work, but I think it's a good idea either way to at least give us a test. And I would say as someone who's gone on Netflix and downloaded a game and played it a little bit, I'm not a big mobile gamer, but it does have a certain feel to it that's a bit different.

And the fact that there's no advertising is a pretty compelling part of what the offering is. So obviously still very, very early, but I think gaming could potentially become an important part of their future. And, you know, we talked about this a little bit before we started this call, but I think if you look at what Microsoft's doing with Activision and trying to buy that company and really thinking about what Game Pass means to them and what video games, movies, and potentially audio means in terms of the consumer subscription services down the road. i do wonder if maybe these different avenues are converging in a way um and if that is where this world is going then it's it's very smart for netflix to try to find a path forward but i don't think we're going to see a big deal of any kind in the short term yeah it's interesting what do you guys think i'm curious what you guys think you might have your finger on the pulse here a little more than i do yeah i think it's a bit of an uphill road to climb if they want to make a

big investment right away i think yeah you're right on the inching their way in with these mobile games and mobile is definitely the only way they can really succeed right now because if they try to go with any con there there's a they're stuck between a rock and a hard place if they go for anything that can't be on on a phone because you need hardware to do the console level stuff and it requires like thousands not thousands but like over a thousand developers to create anything that a gamer that's a console level would want i also think there's an uphill battle because the business models in gaming are a lot different than netflix's subscription i think they can make it work with mobile but apple arcade hasn't really succeeded that much

and effort like with a lot of sucky effort but yeah true maybe netflix will have a better effort on it but i struggle to see how it can be material unless they really crack cloud um gaming which which maybe that's in their skunk works. We have no idea. But I wonder how much they would have to spend to really make a material. And if they do, can it be all with mobile games? And then the other thing that concerns me, which I don't think is a giant deal, is that mobile gaming is pretty unsupply constrained. So maybe Netflix can have the differentiation where it's free with no ads. Well, it's not free. It's an add-on to the subscription, but there's no ads. But I struggle to see the value add of getting where basically

you can play tens of thousands of mobile games around the world for free with some advertisements how many people are going to convince get convinced to go onto netflix unless it's a pretty like expansive game um with the ip like stranger things i guess would be a number one or the well the witcher was already a game but like uh say stranger things and in-house ip if they made something like that that was immersive then you can maybe or not immersive but like you know gta level big time game but the thing is right now with they're they're kind of hamstrung because it's only mobile so that's kind of a the things that i'm fighting in my head but maybe they solve that problem over time they have a lot of time to get it solved i don't know if they partner with

anyone i kind of think they would need to acquire a studio but we'll see ryan you have any thoughts yeah it's there's a lot to think about because as brett said the idea of them trying to build a triple a studio just doesn't make a lot of sense without like uh like cloud gaming being commonplace right now so it just i don't see really how that would work i think mobile is definitely the avenue they'd have to go down for me it would be buying buying a mobile studio of some sorts whether that's and my initial thought was like making a competitive bid for uh king games away from microsoft or something like that um but then when i think about how those games are monetized it's a lot of in-game stuff so would you want to

pay in-game stuff if you're already paying a subscription like does that dilute the experience i'm just i i really don't know how they'd go about it maybe it seems like an uphill battle to try to build your own studio but i don't think they have any intention of trying to not not saying you were saying this but i don't think they have any intention of trying to monetize these directly through any in-app purchases or anything like that i think this is purely through the lens of of making this offering more compelling driving further engagement and obviously there would be some consideration in terms of how they get their ip to be a bigger part of this but i yeah i think it's i think netflix will continue to be very clear in terms of this being a a subscription

where you pay a set price a month and that's what the offering is but i do think you know they've been clear for a very long time that when they think about who their competitors are you know they're looking at people like fortnite and they're thinking about leisure time and they're thinking about entertainment in a very broad way and i and again i i get how on one level that makes sense just from a theoretical, what's the market opportunity? I am starting to wonder if we're going to see these things step on each other's toes a little more and see somebody who tries to figure out how to potentially pair these things in a way that would give them incremental scale, incremental ability to keep customers in the service. And obviously, ARPUs

are part of that question as well. So I think it's very, very early, but I think people are starting to think about that potential idea more and more do you think oh god i think a lot of people are skeptical about netflix being able to succeed in gaming i think they could actually do it um it just they're kind of taking a back door to get there i think like well here's you can't just build a studio like yeah play studio here's what do you think's the better strategy because The two big video media companies in the world, Disney and Netflix, are going about it a bit differently. Netflix seems to say, we're going to keep everything in-house. Basically, we might acquire a small studio or something like that to get the team, but we're going to keep everything in-house, keep it within the app.

Everything was in this Netflix subscription, which is kind of their holy grail of nothing we do is beyond the subscription. It's all under this big subscription. But Disney has basically said, we don't touch video games anymore. They outsource everything. The easiest one is with Lucasfilm, Star Wars stuff. They just announced a big partnership with EA again, where they're producing three games with them. Do you think Netflix would be better?

I mean, what's the better strategy? Licensing out with 100% profit margins to let EA or someone else, the established studio, make your Star Wars games or trying to build this out in-house? I don't know. Any thoughts on that? Would Netflix ever try to maybe do that if they don't succeed on this current path? The short answer is, I mean, I clearly don't know.

But I think as your idea of what your business is becomes more of Disney as a service, I think you need more of these capabilities in-house than you probably thought you did in the past. And I think, you know, Jason Kyler, who's the CEO of WarnerMedia, or at least for now is the CEO of WarnerMedia, he likely will not be once the deal closes if it does close. But he did a podcast recently where he talked about this idea of, obviously metaverse is a very loaded term, but this idea of gaming and what it means to your traditional media company, your traditional video companies. And he makes a pretty compelling argument that this is the way people are going to interact with your IP. And you don't really think about it as being the same thing as a movie. But these two things are likely on a path where they're going to converge. and if that is where the future is going i think you really need to ask yourself how much of that do you want to be in control of and the answer may be that it's really important

that you control all of it and that's going to lead to a lot of uh difficult questions that people need to answer lead to opportunities as well but it's going to to your point it's going to lead to difficult questions in terms of we don't have any of this capability internally someone like disney has gone back and forth on this idea multiple times of my understanding of correct over the past 20 years and who knows if they're even happy with what they have now but i think it's going to be a harder question and you know i i think netflix starting to ask this question of themselves is maybe indicative of where we may start heading over time yeah the it is a it's a harder it seems like it's going to be a harder task for netflix but if

they get to the light at the end of the tunnel they'll have a much more insulated position um Sorry, Ryan, do you want to go on to the next one? I was going to ask about, I guess, what you think are going to be the big growth drivers moving forward, but I think it's probably subs and pricing. Yeah, let's go to valuation. Yeah, growth drivers, everyone knows. It's the streaming. It's like everyone knows, every consumer in the world knows.

Real quick on that point, though, I think there is a fair question of what is the TAM here long term? I think one of the numbers people have hung their hat on is, which I think Netflix management was the ones who shared this, is this idea of 800 million people who are part of pay TV globally ex-China. It's the peak of where that got to. I do think it gets a little muddied because of the difference between an account and a person. As we were just talking about before with concurrent streams and the like, this math is a little bit unclear at times because you don't know how many people are in an account. But I do think as you think long-term about what the world looks like,

and let's say it's 7 billion people ex-China. And obviously, there's a very wide range of babies and people in an age where they actually be a consumer of the product and they're very old people. But I think one of the things I come away from as I think about the TAM here is it's clearly going to be measured in billions of people. And the attractiveness of the offering relative to what existed previously. Something as simple as the ability to consume it on a mobile device, right? I think that the true TAM here is going to be quite a bit larger than what anybody has in their kind of frame of mind right now. Netflix is at 220 million accounts after they've basically been at this for real for, call it a little bit over a decade.

Disney got to a place of well over 100 million subs in a very short period of time. I think when we think about what the leading services look like in this market, and maybe it won't be Netflix, but I think the leading services in kind of video on demand globally will ultimately have well over 500 million subs. No, that's a great point. I mean, and I kind of just think about it as, look, there's going to be a steady stream of everyone our age is, I don't know, at least everyone our age is streaming TVs, Rokus, whatever. Everyone older is the cable one. Slowly that'll trickle off over time. But let's move towards more of the stock and the valuation because I know a lot of people from an investing lens are

going to want to kind of hone in on that. What kind of margins do you think this business can have at maturity? And how do you think about the valuation at its current? I have no idea. You can probably, you'll have a better idea. What's its market cap right now? What do you think about the evaluation with that? Yeah. So starting with the margins, I mean, I think it's important. Again, I said it earlier, but just to reiterate, management came out a few years ago and said, we think we can have something like 300 bps of margin expansion on average for the foreseeable future. And if you look at where they were at in 2018, and you look at where they think they'll be in 2022, adjusted for FX headwinds, they're right on target. So they've had very meaningful margin

expansion over the past couple of years. And their tune on where they can get to has not changed. And as with a lot of things in investing, for me, my faith in this management team and the trust they've earned from me because of what they've said and done in the past, it's as high as it's ever been. So I have a lot of confidence in what they're selling. And by the way, you can look at an income statement for what we viewed as a scaled player in this space, kind of a legacy U.S. media company and the kind of economics that they generated from the pay TV universe and 30% plus EBIT margins was kind of within that range. So you're talking about someone now who is going to have, as opposed to 90 million subs may ultimately have, you know, four or 500 million

subs. So I think the logic for them getting to 30% plus over time is probably pretty likely. I take the over versus the under. Let's put it that way. In terms of the valuation, it depends how you start to think about, obviously, what the growth rate looks like in terms of subs and ARPUs. But we're at, call it 30 billion trailing revenues right now. If you think that 30% margin number makes sense, we're at 9 billion already. We'll be north of 10 billion shortly. And I think the market cap is, I think, 170. So if you view that as a normalized margin number, then you're paying something like 17 times EBIT for normalized EBIT for this business. And as I think about the growth trajectory and the competitive advantages that they have, I think that's a very, very

reasonable valuation. All right. That's a great overview. Last question. What's the bear case? I know there's a lot of bears out there. Netflix. Netflix. That was the thing for a while, right? Oh, it's still a thing to some people. Still a thing. Still a thing. What's the bear case? What could you see going wrong here?

You know, I think the biggest thing would, I mean, there's two big ones that probably come to mind. One is what the steady state economics look like for this business. And part of that is this discussion we've had about what gap profitability looks like relative to the cash flows. I think that's mostly a timing issue. But that is something that people would point to. You know, the other big one is, as I kind of outlined on the first question, this idea of that huge COVID tailwind that they saw, and now what we're experiencing on the back end, you know, the sub guidance is very weak.

So if this business, which has, you know, 220 million subs today, roughly, is ultimately capped at 250, 300, whatever it may be, as opposed to the 400, 500, 600 that a lot of people are expecting over a longer period of time that would clearly impact the top line of the business and it might also have reverberations in terms of what it means for competitive dynamics so um if that kind of scenario played out it would probably be a big negative for netflix relative to current expectations um i don't think that's likely given given the kind of tan discussion that we just had but that's that's probably the most compelling bear case now they have the debt stuff They have a large amount, but they've been out, you know, I think the big payout payback or whatever, when they're due is 2024 2025. Is that kind of a time period where, say things start to kind of stagnate? Would that be a worrisome at all? Or do they have kind of room on their balance sheet?

Yeah, I think it's 15 billion gross right now, I think. The cash flow profile in the short term is what it is. On EBIT, you're talking about, I guess, two and a half times for a business where that EBIT number, even if the margins stay where they are, just as revenue grows, that EBIT numbers may continue to move higher. So I personally don't think it's an issue at all. It's something I don't even focus on at all. I mean, worst comes to worst, I guess they maybe have to issue some equity. But I think people have really got tripped up in terms of where this business is trying to head to and what that means for the income statement versus the cash flow statement over a very short period of time. And they're somewhat missing where this company seems pretty clearly

where they're going to get to. And I guess another way to say that is that the equity markets and debt markets don't seem to be as confused on that point. But I guess certain investors just don't see it. But the debt market has been very clear, at least to this point, that they kind of understand where Netflix is going. I mean, management used to call this out. I don't know if they have lately, but how their debt kind of traded was just indicative of it being a higher credit quality than, I guess, how they were rated by the rating agencies. I believe that was the framing that they were coming from, but I think that's pretty evident in terms of where this business is going, but we'll just have to see. All right. Well, that's all the

questions we have, unless you have any more. No. All right. I guess for anyone that wants to find you, best place to do that, do you know your Twitter handle? I do. It's at TSOH underscore investing. And then you can check out the substack at thescienceofhitting.com. And just for anybody who doesn't know, I share research every single week, deep dives on companies, updates on names that I currently own or that I'm following, some investment philosophy discussions, and then the prior disclosure of any and all trades before they're implemented. And obviously, the disclosure of all positions and their and their weightings so basically you know i used to work on the on the buy side i've basically taken everything i did in that role and just made it completely

accessible to subscribers so right monday and thursdays right if i got it right every every monday and every other thursday and it's a lot of content yeah what's up well the focus is media right well maybe give a what are your focuses because i know it's media and retail Anything else? Yeah, I focus on media a lot. I focus on retail a lot. I've owned Microsoft for over 10 years now. So obviously, it's my largest, or I think it's my second largest position now because the stock's done a little bit poorly relative to Berkshire. But I've owned Microsoft for forever. So obviously, I focus on them and the businesses that they compete in. Berkshire, I own Allied Financial and Bank of America. So some financials. So it's a good mix of stuff.

anything i can understand i try to cover at some point but that's a little bit narrower than some people right oh and cable too i love the uh the wireless talk about the that was a great that was a great one check that out if anyone's funny yeah sorry i was just thinking as you guys as we were talking about gaming i i kind of thought of the parallels between cable and wireless and how they're they're approaching that and maybe we'll see i mean obviously they're very different in a lot of ways, but, but that idea of, of how they view their products and what they're offering is it. It'd be, I'm very interested to see what happens with all this gaming stuff. Yeah. All right. Well, that's going to do it. We want to remind our listeners that Brett and I are

not financial advisors. Anything we say or discuss here on chit chat money is not formal advice or recommendation. We are however, general partners at arch capital. So clients may have positions in the securities discussed in this podcast. Thank you once again to Alex for coming on the show and thank you all for listening. We'll see you next time. We'll see you next time.