Motley Fool Hidden Gems Investing - Netflix Plummets, Lululemon Plans

Episode Date: April 20, 2022

For the first time in over a decade, Netflix had a quarterly net-loss of subscribers and shares fell more than 35%. (0:20) Tim Beyers discusses: - The growing competition in video streaming - Shares of Roku and Disney falling as well - How investors should think about the growth prospects for Netflix - Lululemon Athletica's plan to double its annual revenue in the next five years (15:30) Ricky Mulvey talks with Motley Fool senior analyst Sanmeet Deo about Xponential Fitness, a small-cap company rising in the boutique space. Stocks discussed: NFLX, ROKU, DIS, LULU, XPOF, PLNT Host: Chris Hill Guests: Tim Beyers, Sanmeet Deo Producer: Ricky Mulvey Engineers: Dan Boyd, Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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I'm Chris Hill, joined by Motley Fool Senior Analyst Tim Byers. Thanks for being here. Thanks for having me, Chris. Fully caffeinated, ready to go. Likewise. We both need it because Netflix came out with their first quarter earnings report, and for the first time in more than a decade, Netflix lost subscribers. They also guided for a loss in subscribers in Q2. As you and I are talking in the middle of the trading day here, the stock is down more than 35%. It is now trading at a multiple that is similar to the S&P 500 itself. My question, whenever the drop is this big, is always the same, which is, how bad is this? Is the business of Netflix 35% worse than it was the day before? No, I don't think so.

Having said that, it would be wrong to say that this is a stark overreaction and we're just ignoring reality here. I don't know that it is an appropriate reaction. However, we should recognize that Netflix has clearly entered a period of transition. And so the question you want to ask if you're an investor is, can management navigate that transition? And there's a couple of schools of thought here. You could argue that the thesis is broken because what we thought Netflix was is not what it actually is. In other words, Netflix can grow at a really compounded rate, and even all of this really tough competition from streaming competitors is not going to curtail its growth. They're going to be able to keep going as they've been going and not

have to make material changes. I think we've learned from this quarter that that is not true. Now, you could take that piece of data and say, so the thesis is broken and I'm out. Or you could go, okay, well, the thesis is different now. Is the different Netflix worth owning? And the answer to that, from my perspective, is yes. The landscape has certainly shifted over the last five years, let's call it. We're now in an environment, I say we, Netflix is now in an environment where there's much greater competition.

There are at least 10 services that have at least 15 million subscribers. Netflix is the clear leader with the total number of subscribers. But I do think that the guidance for Q2 is maybe if we're rank ordering the factors of is shocking Wall Street analysts, it is the guy down. Because again, it's been a steady increase quarter-over-quarter for more than a decade, which is so impressive. But to your point, things have shifted now, and maybe that's appropriate for investors. I'll just add that shares of Disney and Roku are down as well, not 35%, but both those companies have earnings reports coming over the next few weeks. I think what we're seeing today

with those two stocks is, again, not inappropriate. It's investors saying, well, look, if the clear leader in subscribers is struggling, it stands to reason that smaller players would as well. There are a couple of things I want to get to. Something that's getting a lot of attention is the comment that Netflix is now exploring lower-priced, ad-supported tiers. Does that make sense to you? Do you look at that and think, yes, you should absolutely do that, go full steam ahead? Or do you think that would be a mistake? No, I think it's very appropriate. I think everything's on the table. And I'll give you an area. I was talking with our coworker, somebody I work with on a couple

of our real money portfolios, TJ Piggott, and we were talking this morning, and he made the point, and I think he's absolutely right about this, is an ad-supported model in some territories isn't just a nice-to-have, it is essential. So, for example, the price of cable in India is $3 a month. There is no earthly way that Netflix can deliver a meaningful service to subscribers in the Indian subcontinent without some sort of subsidy. And the easiest subsidy is advertising. It's not clear to me how ad-sensitive that part of the world is in terms of streaming consumers, but if they're not insensitive to it, that is a model that might work. You could imagine that being available in other parts of the world and even here in the U.S.

because there's some other data that we got. There's a lot of data we got during the call yesterday, Chris. I'm going to highlight just one, which is that there are 100 million roughly people who log into Netflix under somebody else's account. Netflix wants to monetize that 100 million. I think we should, as investors, presume that they're not going to be able to get all 100 million, but they will test and learn around price-sensitive consumers and see if they can convert some of them, either by getting the existing subscriber to pay a little bit more for another household, or taking that person who is freeloading on a password sharing and getting them onto a very low-priced advertising plan.

Netflix has a very good test and learn culture, and they've been through these pivots before. That's the reason I'm unwilling to throw the baby out with the bathwater here, to use a really horrible phrase, but Netflix has been here before, and you should be careful throwing out companies that have been through it before, made a successful pivot, especially with people who have been there before and done a successful pivot. it. Because when you do that, you are essentially saying, I don't believe you are capable of doing the thing you already did. One of the questions around Netflix, as they have methodically raised prices over the past decade is, well, what's the upper limit of that? As they bump up against $20 a month, that sort of thing. Certainly, an supported model at a lower price point would give them in some ways greater pricing flexibility. But the two that leap to mind are Apple and Disney, where monthly subscriptions to their

streaming services, and granted, they both have a lot less content than Netflix does, but for both of them, it's still under $10. Do you look at those two and think, boy, they've got more room to run than Netflix does. Room to run in terms of pricing or rooms to run in terms of growth? Both. Room to run in terms of we have more ability to raise prices because we're starting at a lower point. We're not bumping up against $20 a month right now. I guess in some ways, maybe that increases the pressure a little bit on Disney to increase their subs. I see where you're going with this. It is worth remembering that we don't know what the other streaming services look like

in terms of profitability. We do know that Disney+, for example, is not even remotely profitable, but we don't know about Paramount+, we don't know about Peacock, we don't know about Hulu, but But you can hear from the Netflix call that the management of that company has some real admiration for what Hulu has been able to pull off. So if I had to guess if there was another streamer who had figured out the profitability mix, I would guess that it's Hulu. And Netflix becoming more like Hulu sounds somewhat attractive to me. Now, to answer your question, I think Disney+, in particular, but also maybe less so Apple,

because they're not really relying on Apple TV being any meaningful driver for the business. But Disney+, is intended over time to actually be a material driver of that business as cable degrades. Disney Plus has no choice but to raise prices to some level where the market will bear to see if they can actually turn profits on this. It's worth remembering that Netflix has already cracked that nut. It's worth remembering right now, it's going to go down, but as of now, Netflix has better than a 20% operating margin. Please bear in mind that in a quarter where they lost subscribers, they still drove up the average revenue per subscriber. They still grew revenue. They still had enough free cash flow that they were able to pay off a cash

acquisition, pay all their capital expenditures, and almost cover. They came within $150 million of covering a $700 million payment on the debt on their balance sheet. This is a company that if we're going to ding Netflix, we should at least acknowledge that given where they are financially, this is a very sound company and they've cracked a nut that really nobody else has cracked. Before we throw them out, let's at least acknowledge that. Last thing and then we'll move on. This is a stock that within the past 12 months hit $700 a share. At the moment, it's around $220 a share, so that's a steep drop. Do you view this as a buying opportunity with the caveat that for anyone who's buying shares

of Netflix today on this drop, their expectations need to be moderated from what Netflix was? Yes. Yeah. That is exactly right. You should, boy, do I hate using this word, Chris, but this is a little bit like the next Quickster moment. Can we not use that word ever again? But it's sort of like that in the sense of Netflix has admitted, hey, you know what? we did not give our streaming competitors nearly enough credit. We need to rethink things and that's what they will do now. So if you are a buyer, and I have no objections to anybody who wants to be a buyer here, I would buy in very small amounts. This is just me. I'd buy in very small amounts. I'd be buying over the course of time and I'd be watching closely to see how the

transition goes because you are buying this for the next 10 years. And I think there is something to that. Look, they are nowhere near penetrated on a global basis what their actual subscriber base could be. They're nowhere even close to that. So if you believe that they are a global TV brand, a literal global TV brand, then yes, I can absolutely see it. But buckle up, this is not going to be a simple or easy ride. Before I let you go, Lululemon Athletica doesn't report for another month or so, but they came out this morning with some goals. Lululemon says it is aiming to double its annual revenue in the next five years. and the way they're planning to do that slash hoping to do that is with more international

expansion, growing their men's business, taking another run at a membership model. What do you think? Does any part of that stand out to you? I'll just say that the first two make perfect sense to me because that's part of how Lululemon has grown over the past five years. The membership model, I believe they tried something like that in 2018, and it did not work out well. Yeah. Retail membership is, look, we should admit that Costco is a little bit of a mutant company in this area. A Costco membership, it pays for itself almost overnight, but that is the exception, not the rule. Here's what stands out to me, Chris. When you say double revenue in the next five years. Can we just remember what that actually is? Not to get

all mathy or anything, but here's your cold cup of coffee for the morning. That's 15% annualized revenue growth, which is good. But for a company that's been growing at 40%, please understand that Lululemon just told you in the nicest way possible that our revenue growth is going to slow dramatically. We're going to expand the way we address the market, all of which is good. I'm not saying that 15% annualized growth is bad. I'm just saying that's a material slowdown. Everything in context, please. You're right. That is the nicest way possible to say our revenue growth is about to slow down. Tim Beyers, great talking to you. Thanks for being here. Thanks, Chris.

I'm a subscriber to a few streaming services, including Netflix. One industry that does not get my money on a monthly basis, however, is fitness. What can I say? Going for a run outside is free, which is one reason fitness is not an easy industry to make money yet. But one small cap company called Exponential Fitness may have found a foothold in the boutique space. With more, here's Ricky Mulvey. If you drive past a strip mall, there's a decent chance you'll see an Exponential Fitness brand. The company owns 10 boutique gym brands, including Club Pilates, Pure Bar, Yoga Six, and Cycle Bar. Exponential Fitness, ticker XPOF. It's about a $1 billion market cap company.

Followed closely by Motley Fool senior analyst Sanmeet Deo. If you're interested in the fitness industry, this may be a company to put on your watch list. Sanmeet, good to see you! Ready to pump some iron? Yeah, absolutely! Thanks for having me, Ricky! I found out about this company because you did an interview with the CEO, Anthony Geisler. It made me start looking into it. I do not own the stock yet. But why is Exponential an interesting company to you? Well, I've been following Club Pilates and Exponential for a while now. I own a boutique fitness brand myself. And Club Pilates was unfortunately not the one that I selected

to do a franchise in. But since then, it's become the largest global franchisor in a $20 billion boutique fitness industry. And this boutique fitness industry is the fastest growing segment of the broader $97 billion global health and fitness industry. And it's projected to grow about 24 and a half percent CAGR from 2020 through 2025. Like you said, they have a platform of 10 fitness brands. You listed off a bunch of them. It's class-based programming. They have strong community type environment, delivering the classes through in-person boutiques, small footprint studios, and also online channels, which they've really ramped up since COVID hit and recently. I mean, one of the things I really liked about it is they grew and gained share through COVID

with nearly a third of boutique studios closing. It shows to their strength and how they've kind of been able to sustain such an immense blow to that industry throughout that period of time. You mentioned their competitors closing. What was Exponential Fitness doing differently throughout the pandemic, especially with regard to their relationship with franchisees? One of the things that I was impressed with, um, and Anthony mentioned this on our interview is, you know, he fought for, they fought for their franchisees to get through, through rent relief, um, negotiations with landlords, with fighting the government to try to get funding, even though that wasn't as successful as they had hoped. Um, I think they offered some, um, royalty relief for the studios.

They also, what was impressive was now this was a bit of timing and also, um, good, good planning, but, um, they, they had already started launched a studio to, to broadcast digital classes right before the pandemic, uh, had started. So they're already in the position to do so. And because they were, they were able to launch it right away once the pandemic hit and their franchisees were able to get a ton of content that they could deliver to their customers online and really keep that membership base active and engaged and moving. Talking about the franchisee relationship, what's it mean for stock investors that these studios

are not company-owned and that it's a franchise model? A lot of attractive features of a franchisor model for investors is it's an asset-light model. They have predictable recurring revenue. They're getting paid these fees every month based on the revenues that the franchisees, um, make no matter what, um, they have, and the franchisor is able to have high gross margins and strong free cashflow present potential because they're not taking on the ongoing capital requirements of, of building out the studios, um, um, repairing equipment and taking on a lot of those expenses. They're very capital light in that sense. So, and also one advantage is they could rapidly scale with this franchise business model. They currently have about 2,100 global studios open and they have

4,400 plus global licenses sold. So those are studios waiting to be kind of, or working on to be open. So you can scale a business model very quickly as a franchisor versus having to open all of those yourself. I mean, you've owned a boutique fitness studio, on me. What are some ways that you monitor Exponential's relationship with franchisees? This is one of those things that's more art than science because it's not going to be really listed in their financial documents as a public market investor. But a few of the things to keep an eye on is, are their franchisees owning multiple units? In Exponential's case, some of these franchisees own multiple brands across the platform. So they might own a Club Pilates

and a rumble and a stretch bar. So the more of these franchisees are willing to invest more into the brands and open more units and take on that, that, that risk, um, is it's a good thing. It means they're, they're, they're invested in the, in the franchise and they're, you know, obviously they're there. If they're going to invest more than they're positive on the business. Um, one of the things you could actually do is a bit of scuttlebutt is talk to owners. If you go to a studio club Pilates, try to see if you can talk to the manager or the owner and get a feel for what's it like working for this franchise? Are they supporting you through things? And get a little bit of feel for what their sense is in terms of that relationship. And then also just

monitor the growth of the franchise. So monitor the staff at the corporate level with the growth of the franchisee units. If it looks like the corporate level staff is not growing enough to support those franchisees, you know, may want to question that, um, to, to the company and say, well, Hey, do you have enough support staff to support these, you know, 2100 studios they have opened and potentially 4,400 studios open. So a lot of key things there to kind of watch out for fitness is one of those industries that is notoriously difficult to grow in. Uh, this company has done a good job at it so far, but, um, you know, going forward, where do you see the meaningful growth for exponential fitness? Is it expanding internationally? Is it

focusing on their existing brands? Is it adding more brands into the fold? What are you looking for as an investor? You hit on all of those. One of the main ways they've grown thus far is from 2017 through 2021, their global studios have grown at a CAGR of about 27%. That's primarily from acquiring a ton of key boutique fitness verticals, businesses and gyms that are in a little different types of fitness categories. And you have yoga, you have stretching, you have bar, um, boxing Pilates. Those are all very different brands that, that they, that the franchisees can have access to as well. So they will look to acquire new brands. They're always looking. Um, the CEO mentioned that they're always on the lookout, um, obviously grow their current

studio base. You know, it's estimated that they could grow to potentially about 7,900 locations in the U S alone. Um, whether that's being very ambitious or not was, is yet to see what's the baseline for that. Oh, so they have about 2,100 global studios, about 1800 U S studios or so. So it's a huge growth, but you know, these are very small four print stores. So it's like 1500 to 2000 square feet. So it's at these big box gyms that you're thinking of that have massive locations. Um, internationally is definitely something they have about 175 open now, 956 contractually obligated to open. They acquired, uh, a brand called BFT, which gave them a foothold in Australia, New Zealand, and Singapore. Um, and then they're doing some

innovative things in terms of driving kind of system-wide sales and growing their AUVs, um, X-Pass, which is similar to ClassPass, where you can try out different offerings across the exponential brand portfolio. And then X-Plus, which they recently just revamped and launched recently, where it's basically a digital-only platform. So you can have digital access to all their brands on that one app or on that website. What are some of the major risks you're continuing to watch with this company. I actually think the customers are more fickle with fitness than they are with things like maybe restaurants or fashion. You know, there's always like a new type of fitness brand or, or, or class or something out there that people could try products that they

could try to kind of get in shape. Um, and they tend to want to have that quick fix and they don't stick to something. So it can be hard to retain customers and churn is definitely a huge issue with gym concepts, particularly boutique fitness concepts, because they can run a little more expensive than some other typical big box chain. Sunmeet Deo, appreciate your time. And thanks for coming by the show. Yeah, thanks for having me. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against,

So don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.