Netflix continues to grow and generate cash while its competitors struggle not to lose money. With an extraordinary culture and a huge opportunity to further expand its market through advertisements, the company has everything we look for in an investment. Despite today’s all-time high thanks to a very strong outcome, we believe the stock still has the potential to yield returns above the S&P500.
Some companies always had an easy life. That’s not the case for Netflix.
Less than three years after its founding as a DVD rental business by mail in 1997, the company faced the bursting of the internet bubble, which prevented its IPO. In a desperate move, founder Reed Hastings tried to sell Netflix to Blockbuster for $50 million – luckily for him, unsuccessfully.
Ironically, in the following years, the next major battle for the company would be fought with Blockbuster, under very adverse conditions: in 2001, Netflix had only 500 thousand subscribers, while Blockbuster had 65 million members in the US alone. Nevertheless, within five years, Blockbuster would be on the ropes.
One of the factors that helped Netflix was its superior culture. The Netflix Culture Slide Deck, available on the Internet since 2009, remains current and thought-provoking. You may disagree with some points, but it is undeniable that this culture was well thought out, refined over the years, and actually implemented in practice, unlike what happens in most companies, where culture presentations end up becoming empty slogans.
In the book No Rules Rules, Reed Hastings and Erin Meyer highlight pillars of this culture: hiring only the best people, paying them well, giving them freedom and responsibilities, and guiding them by context rather than processes.
It’s impressive how the preselection of a group of elite, well-aligned collaborators allows for a reduction of bureaucratic management/control mechanisms (processes and policies) that scare off talents and stiffen the decision-making process.
This culture allowed the company to be agile and take calculated risks through many experiments carried out in a decentralized way. Unlike its stagnant competitor, Netflix was able to adapt and react quickly to market transformations.
Analyzing the company’s history, two qualities that we greatly appreciate become evident: resilience and a culture of “delayed gratification.” Regarding the latter, we note that in network effect businesses, the optimal long-term strategy is to maximize engagement before monetization.
Netflix executed this recipe to the letter, prioritizing having more subscribers over short-term profits. It was only in October 2017 that the standard plan in the US started costing more than $10, a price clearly “subsidized” when compared to similar entertainment options, especially with the value of a cable TV subscription.
In other words, we are talking about a 20-year-old company that was still in “delayed gratification” mode. How many companies can withstand the Marshmallow Test for 20 years? Only when the growth in the number of subscribers in North America began to slow down did prices start increasing more rapidly.
In this context, in a company in “delayed gratification” mode, current accounting profit does not reflect the true profitability potential of the business. We believe that current margins are far from the margins we will see when the service reaches maturity, with a scale of at least 400-500 million subscribers (currently 283 million).
There is still a lot of audience for streaming to gain from broadcast TV and cable TV, and plenty of room to grow in emerging countries. The AVOD model (ad-based plan) is still in its early stages and significantly expands the addressable streaming market by reducing the monthly fee.
Just as we have seen the internet evolve in the last 20 years from generic banners to personalized ads, we can imagine a future where Netflix ads become highly individualized. In this scenario, ad revenue would increase significantly and push up the price of ad-free subscriptions.
Even with higher monthly fees, the company should continue to deliver value to subscribers. This is because Netflix has created network effects – more subscribers enable a larger and higher-quality content library, which in turn attracts more subscribers. Examples include Netflix’s internally-produced Korean series, initially aimed at the local market but ended up being successful in various countries.
Behind our optimism is also another more current but extremely important aspect.
The capital cycle of the industry has changed, and the competitive environment has softened. In 2019-20, we witnessed a horror movie in the industry, with several content holders launching streaming services.
Concerns about revenue decline from traditional television motivated this supposedly strategic move. However, in an industry where scale is essential, and where the leader has over 280 million subscribers, competitors with only 20 or 30 million subscribers should struggle to reach profitability.
And indeed, since 2022, we have observed a rationalization of competition, with price increases, budget cuts for new productions, and a trend of “rebundling” where smaller streaming services combine their content into a joint offering.
The industry mindset is shifting from “grow at all costs” to “profitability first.” We believe this trend has not yet run its course.
Finally, the impact of artificial intelligence cannot be ignored.
In a 3 to 5-year window, scenarios can be envisioned where small studios, with minimal budgets, are able to produce blockbusters. Ultimately, even individuals could produce movies and series with the help of AI, flooding the world with content that is currently relatively scarce.
The pessimistic thesis would suggest that people would no longer see value in paying for Netflix because there would be thousands of good series on YouTube, for example. However, there are mitigating factors for this concern. The main one is that Netflix itself is likely to benefit greatly from the fall in production costs. It is very likely that we will see the positive effects of AI on margins by 2025 or 2026, long before we see concrete signs of the pessimistic scenario.
We have held a significant position in Netflix since 2022. Although the stock price may not seem like a bargain at first glance, we project revenue growth of over 10% in the coming years and the continuation of operational margin gains (which evolved from 4% in 2016 to 18% in 2020 and is expected to end this year at 27%).
In this scenario, we can see annual earnings per share growth of over 25% between 2024 and 2028, more than supporting the current multiples. The tough battles seem to be in the past, and now Netflix is moving towards consolidating its streaming empire.
Source
Arwen Volkov, A graduate of the University of St. Gallen in Switzerland with a degree in International Finance, Arwen specializes in sustainable finance and green investments. She began her career at an investment bank in London, where she developed financing models for environmentally friendly projects. Known for her analytical and strategic thinking skills, Arwen is a sought-after financial consultant. In her spare time, she mentors fintech startups, contributing to their growth strategies. She is also a nature enthusiast and an amateur photographer.
