Motley Fool Hidden Gems Investing - Understanding Subscription Businesses, Value Investing's Bad Rap

Episode Date: January 31, 2022

There are a lot of reasons we love to invest in subscription businesses and high on that list is the recurring revenue model. The Wall Street Journal reports that streaming-video services are losing half of their new subscribers after just a few months. Jason Moser analyzes the challenges of the consumer-facing subscription model and how services like Netflix, Apple+, HBO Max, Disney+ and others are combatting them (to varying levels of success). He also responds to a Motley Fool member's question about whether to focus on buying shares of larger, profitable businesses at the expense of currently-unprofitable companies with potential. Plus, John Rotonti and Jim Gillies discuss value investing and a sleeping tech giant that appears to be getting back on track. Our free Investing Starter Kit includes 15 stocks and 5 ETFs. For a copy just go to http://fool.com/StarterKit Stocks: DIS, AAPL, T, NFLX, CMCSA, SPOT, AMZN, NET, V, AI, INTC Host: Chris Hill Guests: Jason Moser, John Rotonti, Jim Gillies Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Chris Hill. Today on Motley Fool Money, it's time to wrap a bow on January and get a variant perspective on a sleeping tech giant that's getting back on the right track. That and more coming up right now. I'm Chris Hill, joined by Motley Fool senior analyst, Jason Moser. Thanks for being here. Jason Moser. Happy Monday. Thanks for having Happy Monday. Happy last day of January. We will get to that, but I want to start with the business of subscriptions. We see this in B2B all the time with software and Cloud services. I want to go to the consumer side because the Wall Street Journal has a story about streaming video services and how they get a big surge of new subscribers

when they've got a big movie coming out, and then over the next few months, those people, about 50% of them, just drop off of the service altogether. HBO Max, Apple+, Disney+, and by the way, none of these companies commented on the story. A subscriber measurement company called Antenna provided this data to The Wall Street Journal. As someone who enjoys movies and streaming television and is also a shareholder of a couple of these companies, let me start with this. When we think about subscription churn, how worried should shareholders be about this? Because it was pretty damning to look at these charts and see, look, in the case of Disney+, when Hamilton, the movie version of Hamilton came out, huge spike in subscribers. For HBO Max,

it was the Wonder Woman sequel. For some reason, I was surprised by this. For Apple+, it was the Tom Hanks World War II drama Greyhound, which I wouldn't have necessarily put it in I wouldn't have assumed that was the thing. I would have guessed Ted Lasso. But in terms of this type of drop-off, how concerning is it? I feel like it's a situation that would have been a bigger deal a time ago for smaller companies. I think going forward, it's going to start to become more of an issue for all companies because there are so many more substitutes out there today than there were before. If you go back, let's just use Netflix as the example. That's the company that probably most

people are familiar with. But back in 2010, 2011, where they discontinued reporting churn altogether, they thought, well, this just isn't really a metric that matters. It's not something that indicates success or failure in our business at this point. Let's be clear what churn is. When we're talking about churn, we're ultimately talking about the number of folks leaving a service. Companies can calculate a couple of different ways. They may calculate where they divide the folks who quit by the total number of subscribers, or maybe they divide the folks who quit by how many folks signed up. Know exactly what they're defining there, how they're calculating it. But ultimately, it's a metric that's telling you how many people are headed for the exits over

any given period of time. I think for a long time, it wasn't really a big deal for Netflix, because Netflix was the only game in town. A lot of people, it had not really lost its novelty, to a degree, it still hasn't. But churn just wasn't really that big of an issue. Now, it's going to become a bigger issue, I think, going forward. But when you look at a company like Netflix, and I'll throw Disney in there as well, because they've reached these subscriber bases that are so big that even any small period of elevated churn, it's not going to really impact that business quite as significantly as a newer streaming service that's trying to grow their subscriber base. You look at something like a Peacock or you look at something like an HBO,

HBO Max situation where they have good offerings, they're a little bit late to the game though, so they just inherently have smaller subscriber bases and the churn is going to be something that could be more material for those businesses going forward. But I think when you look at companies like Disney and Netflix, they're big enough to where they can at least weather the impacts of this as it ebbs and flows. Is part of this just the cost of doing business? If you have a consumer-facing subscription business, you could throw streaming music in there as well with businesses like Spotify. Because if Amazon Web Services had this type of customer churn, I think we'd all be surprised, or any SaaS company for that matter,

just by virtue of the fact that the number of accounts that you have is just going to be in the tens of millions as opposed to the number of accounts that Amazon Web Services has. Yeah. You're right in the nature of the offering, I think, changes where this comes into play. Someone who maybe built their business on Amazon Web Services might not necessarily want to switch willy-nilly. You got to have a little bit more of a reason, a bank account, another good example, a bank account, you're just so enmeshed, It's more work to switch for really what you would consider not much in the way of savings, because you're going to have to have that account one way or the other. You're going to have to bank

some way or another. Music, I think, is far different than video because we, of course, enjoy the same songs and the same albums and the same artists over and over again throughout our entire life. I think music is a little bit more interesting in that it's a bit more protected in that regard. Video, absolutely unique in that regard, though, I think, particularly as we move to over-the-top distribution. Again, you look at all of the substitutes that are out there today, I think we're going to have a tiered system here. I think you're going to have some core offerings that households are always going to have, and that's probably the Netflixes and Disneys of of the world. Amazon, to the extent that you already have Amazon Prime, then you're getting

that video offering. Then you're going to see people start to maybe jump in and out of things like Peacock or HBO Max, depending on what hits are released. I definitely think it is a cost of doing business. I think that these businesses, as it pertains to video, I think the most difficult part of this is that it's always going to be something they have to keep in mind. Not only do they have to keep in mind how much they're spending on content, but also when they're releasing it. That's always a bit of a strategic call right there as well. But when you look at the actual numbers, the amount that these businesses are spending on content today, it's really astounding. If you look at Netflix,

go back to Q4 2015, streaming content obligations were listed at $10.9 billion. Sounds like a lot because it is. Today, it's $23 billion. Disney, they noted in their most recent 10K that the fiscal 2022 spend on produced and licensed content, this includes sports rights, along with all of the other content they're distributing over the top, it's going to be $33 billion, about $8 billion more than the previous year. You look at these companies with the scale and the resources, they obviously had to leg up because not only can they produce more content and more good content, but they can spread it out over longer periods of time throughout the year. They can create interest, they can create buzz. Yeah, it is one of those

things where it puts bigger companies in a bit of a better position, and that churn rate is going to be something that impacts those smaller businesses more so than those bigger businesses, I think. Last thing I want to touch on is the pricing. Let me quote directly from this article. Streamers' challenges are exacerbated by the fact that most services are available through a monthly subscription, making it easy for viewers to cancel when they are done binge-watching a specific show. Which leads me to this question, do these businesses need to start making a bigger gap between the monthly and the annual subscription fee? Do they need to start making the monthly fee

significantly higher and thereby making the annual fee more attractive? I think that's probably the easiest lever to pull in regard to this. If you look to your wireless phone subscription, typically there are contracts that we've had to sign historically, and I know we're trying to steer away from that stuff now. Look at your cable provider, for those of you out there with cable subscriptions. Anything where you have the option to get a discount by signing up for a full year. If they want to reduce that churn number, that's the easiest way to go about it, is to say, hey, pay us upfront for a full year and we'll really make it worth your while. I think that's where a newer entrant to the space is going to

benefit from something like that more. I don't know that Netflix necessarily is going to benefit from it. I don't know that that would materially reduce the churn of something like a Netflix or a Disney. Again, going back to me, those are the platforms with the most content and the most content for the masses. But when you start getting to smaller platforms with a little bit more niche offering, Paramount+, another good example, I think, particularly as they're new, as you're trying to build up that subscriber base, I think one of the easiest levers they can pull is to offer that full year discount. That can give them a lot more predictability as far as the revenue they're going to get for a longer period of time. It's going to give them a lot more, I think this

is the most important part, you've locked in a viewer for at least a year. Think about the data that you can get just from locking those viewers in. We've talked about how Netflix has benefited from that through the years. Any streamer is going to be able to benefit from that if they just have the wherewithal to parse that data out. Certainly, I could see that being one way to go about it. Our e-mail address is podcast.fool.com. Got a note from a long-time listener and member of a number of Motley Fool services, Vince. A lengthy note, so I'm not going to read the entire e-mail, but Vince touched on something that we have heard from a number of people, particularly over the last few months. He's looking at his portfolio, he's a little closer

to retirement, so he's doing some selling, but he still has that long-term mindset, which we love to see. Quoting from his e-mail, should I be looking to buy shares of sound businesses like Netflix, Amazon, Microsoft, etc., at the expense of potentially future profitable companies that are still wildly unprofitable? Recognizing, of course, that we all need some of those in strategic areas like AI and the Cloud and the metaverse, whatever thing my grandkids are talking about. I would just throw cybersecurity in there, as you and I have talked about before, as being such a critical area for investment, and some of those businesses aren't profitable. This is a drumbeat we've heard a lot recently, just the whole flight to quality,

that sort of thing, where it's like, okay, my portfolio is taking some hits, I'm going to be looking for companies making some profits. Yeah. Well, I think this is a reminder that you should always be looking to have those profitable and stable companies in your portfolio. That's first and foremost, I think these are the times that are great reminders that we want to make sure we're well diversified. That is the point of diversification. I look at my portfolio and I think for every Cloudflare, I've got a Visa, or for every C3 AI, I've got an Amazon. I feel like when you start seeing the masses flowing away from these speculative names, or at least the unprofitable

names, the ones that Vince is talking about there, that's when my interest starts to peak up a little bit because I feel like as everybody's headed for the exits, that's where opportunities oftentimes are created, in that fear and that selling. But with that said, it certainly depends on the investor and where they are in their life. Knowing Vince, and as he stated in his email there, getting a little bit closer to retirement, he wants to be a bit more focused on protecting that wealth as opposed to growing that wealth. I think that's something always to keep in mind. I think when you look at what the market has done this year alone writ large, you look at the Nasdaq down 10% year-to-date already, that clearly hurts. I think a lot of folks, we're all feeling that

pinch to an extent. But there are clearly a lot of companies that are a part of that calculus that are down considerably more. I was just looking at some interesting data here. By mid-year 2021, last year, the NASDAQ had accommodated 70% of all the SPACs that went public. You've got an index there on the NASDAQ that's very SPAC-heavy. How's that going? Exactly. That's a rhetorical question, folks. He knows, I know, and you know, they're just not working out so well right now. I think when you have these wild bull markets, they create wild speculation, that creates wild valuations, which then encourages that wild bull market to keep on running. Now, with that said, we're seeing a lot of these valuations start to

pull back. For a long time, we talked about this 30-40 times sales being the new 30-40 times earnings. We kept on talking, it was on these shows. You go back and listen, we're talking, this just doesn't feel like it makes a whole heck of a lot of sense, but that's what it is right now. That's what investors are chasing. That party eventually ends and things start to pull back, but now you're seeing a lot of these businesses that, yeah, they're not profitable yet, but there are some really good quality businesses out there that have a very plausible path to profitability and we're a lot closer to it now than we were back then. If you're seeing these businesses now 10, 11, 12 times sales, that starts to look a little bit more reasonable if you have that

five-year time horizon. If you're looking to keep that growth dynamic in your portfolio, even if you're getting closer to retirement, number one, obviously focus on protecting that wealth. Make sure you're always focused on getting those high-quality businesses in there. Always try to offset one of those high flyers with a nice stalwart idea. But I don't know that I would necessarily go chasing those profitable, stable companies at the expense of all of those high-flyer companies like Vince was talking about. I think the key is to look at those high-flyers and try to understand the story, try to understand the long-term trend that's going to get that company to where you think it can go. If you can still

answer that question today, then I think it makes sense to keep them. But by the same token, use this volatility as a time to shore up that portfolio and maybe give yourself a little bit more exposure to those high-quality profitable names, particularly if you're feeling a little stressed during times like these. Jason Moser, thanks so much for being here. Thank you. Value investing is dead. Value investing is struggling to remain relevant. That's not my opinion. Those are just the first two results you get if you go onto Google and type in the phrase value investing is. But as best as I can tell, value investing gets a bad

rap. Like a lot of things in life, it's more complicated than it appears on the surface. To explore this further and provide a couple of stock ideas with Motley Fool Canada's Jim Gillies, here's Motley Fool Senior Analyst, John Rotonti. Thanks, Chris. This is our primer on value investing. Maybe we'll start with Jim. What is your definition of value investing? John, very broadly, my definition of value investing is paying less for any security, any stock than I think it is objectively worth. The way you get to a point of deciding what something is worth, that's where a lot of the argument goes in when you're talking about valuation and value investing. It does

tend to be fairly selective. There's not one approved method for all stocks. That's why I bristle when I hear people talk about value investors just do things like screen for low P-E ratios or low price-to-book ratios. That is not how I do it. I believe in looking for things off the beaten path, things where people have a variant perception, if you will, of what valuation is, because I think that therein lies opportunity. I love that you just brought up variant perception. I just interviewed, for a Fool.com article, Michael Mobison and Al Rappaport, the authors of Expectations Investing. I asked them, what is a variant perception, and what is your definition of an attractive investment thesis?

Here's the answer. I think, Jim, you're going to love this. I imagine I will, actually. So, a variant perception is holding a well-founded view about a company's financial prospects that are not priced into the stock. In other words, your expectations and the expectations implied by the market are different and noteworthy. What's an example of a company in the past maybe that you've looked at or in the past maybe that you've invested in that you think was a good value investment? This is a company that is below its all-time high, which was set over 20 years ago during the tech bubble. At one point in time,

it was perceived as one half of the duopoly that controlled essentially every desktop computer. Of course, I'm talking about Intel. Intel and Microsoft Windows were basically the PC market. Intel, again today, is below where it was 20 years ago at the height of the tech bubble. And a part of that, frankly, is people just got too excited about buying Intel back then. It was over a half a billion dollar market cap. People were paying 15 times sales, 50 times free cash flow. And that's hard when you're starting at that level. But today, John, so we want to talk about variant perception, we want to talk about why you would want to look at this today, because the market has decided that Intel is a tired, old story. Yes, they're

in chips, but they're behind AMD, and they really haven't done anything terribly good in mobile, at least on smartphone chips. They probably did a little bit better on Wi-Fi and data center chips. But here's what's happening. First of all, you start with Intel is a cash flow engine. From the dot-com era to today, they've produced hundreds of billions of dollars in cash flow, and they've returned all of it to shareholders, dividend and share buybacks. They bought back 40% of their stock over the past two decades. That includes, they give a lot of stock to insiders. They've had meaningful over and above getting rid of dilution, buying back stock. They also pay a 3% dividend yield right now. So, first off, cash flow engine.

Second off, low valuation today. As I speak, the stock is trading at about 2.5 times revenue. It's trading at about 6 times, trading at about 10 times earnings. So, this is kind of a classic heads I win, tails I don't lose much. You're not buying at the elevated price that the dot-com era people were doing. Here's the catalyst I think that's going to happen. I think it's already happened, market hasn't noticed yet. And that is, the CEO is Pat Gelsinger. He was with Intel until about 2009. He was in the running to take over as CEO. He leaves, goes to EMC when it's clear he's not the favorite to take over from then-CEO Paul Ottolini. He was the first CEO of Intel who was not a tech guy, so he's not Andy Grove-like, whatever. And so, basically, he runs

it focused on business metrics rather than the tech metrics that make Intel this dominant special company? Finally, a year ago, John, Pat Gelsinger is coming back. He's back from VMware and where he'd been hanging out. He is basically a tech guy, a chip designer. He is dedicated to bringing Intel back to the tech leadership place where it is, and He's willing to spend money to do so. There's very clearly a plan to invest money to try to recapture leadership. There's a lot of stories right now about how Intel is currently building two new chip foundry plants, I believe in Ohio, going to spend as much as $20 billion. Sounds like a lot of money, until you realize that Intel, when it's not investing for growth,

can do $20 billion a year in free cash flow pretty easily. They are also planning on IPO-ing Mobileye. They own Mobileye, which they bought in 2015. They paid $15 billion for it. Mobileye is, I believe, roughly within Intel, quadrupled their revenue. I might be overestimating a little bit, but I believe that's the rough number. They're going to IPO Mobileye. They're going to keep majority stake, but let's say they sell a third, they could probably get $5 billion for that third. They are already producing a lot of cash. And heck, the company's got $35 billion almost in cash on the balance sheet anyway. So, they are going to reinvest. They're partnering with some of the heavy

players in the chip space. And they are going to, under Gelsinger's leadership, seek to reclaim that previous leadership spot. And they have the research to do so. The current free cash flow that they produced last year is about $11 billion, but that's lower than it will be because they've been spending on these new capex investments. You're buying a company today that the market is short-sightedly looking at and saying, this is worth 10X earnings. I'm saying, in three years, earnings will be meaningfully higher, cash flow will be meaningfully higher. We will know if Pat Gelsinger's strategy is working to return Intel to its former tech leadership, or at least trying to reclaim some of that tech leadership, and

and you get paid to wait, you pay a 3% dividend almost today to wait, they're going to raise the dividend every year as they do. I'll bet you they have less shares, and I'll bet you they have higher financial metrics across the board because Gelsinger is investing in the business. I have another example. I know you and I were both buying Apple in 2018, but I was also buying in 2014 when it was at 10X free cash flow. And so, what happened with Apple was, every once in a while, the market would get fixated on the iPhone cycle. And they lost track of the fact that Apple was growing into more than just the iPhone. It was growing into an ecosystem, it was growing into a services company.

You had the greatest free cash flow generating machine the world has ever seen, Jim. Literally. Everyone in the U.S. almost had an iPhone in their pocket. We looked at the thing 50 times a day. You only brush your teeth two or three times a day. You look at your iPhone 50 times a day. And this traded at a 10% free cash flow yield. Price to free cash flow is enterprise value divided by free cash flow. If you invert that, you do free cash flow divided by enterprise value, you get something called the free cash flow yield. What that is, Fools, is think about it like this. The dividend yield is what a company actually pays you out as a dividend every year. The free cash flow yield is what the company could

potentially pay you out as a dividend if it paid all of its cash to you as a dividend. In other words, think of it like this also. If you own the business outright, the free cash flow yield is how much of the cash you could pull out of the business every single year for yourself. 10% free cash flow yield, Jim, for the greatest business the world has ever seen. My point is, you can also find value investing opportunities on the high-quality growth end of the business spectrum. Absolutely. I very fondly remember, and like yourself, I bought Apple a few times over the years. But then, in Q4 of 2018, I wrote repeated articles about it, recommended it in one service I was in front of at the time.

Did it myself. You were buying the greatest, as you call it, John, and I agree 100% here, You were buying the greatest cash flow generating story of our lifetimes, as if it would never grow again and paying 10X cash flow. There you have it, Fools, two value investing ideas from Jim Gillies and myself. That's value investing, Fools. That's value investing. Thank you. Thanks, guys. That's all for today, but coming up tomorrow, Alison Southwick and Robert Brokamp share some thoughts on the financial goal that guides so many of us, saving for retirement. As always, people on the program may have interest 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.