Netflix is an internet media company focused on streaming on demand of movies and TV series. The company offers both licensed and in-house-produced video content.
The firm has subscribers across the world, and lately numbers from outside the U.S. have overtaken those from the domestic market. This has happened thanks to a successful international expansion strategy.
The crossover point occurred in the second quarter of 2017, when international memberships exceeded 52 million.
This has been possible thanks to the higher growth rate of international memberships compared to domestic memberships.
The streaming segment is by far the largest by revenues. In fact, the “Domestic DVD” segment has suffered a continuous decline over time, and has been penalized by the growth of the streaming segment. This has benefitted from a humongous increase in demand due to its steadily growing and high-quality content library.
Overall, total memberships keep soaring, even though many analysts have questioned their growth over the long term. So far, every doubt has been crushed quarter after quarter.
The firm was founded in 1997, during the so-called “new economy”, by Reed Hastings and Marc Randolph in Scotts Valley, California. (1)
Initially, Netflix was a DVD-by-mail service, but in ’99 the company shifted to a monthly subscription model. The first difficulties for the firm were due to the scarce distribution, at the time, of DVD players and the strong competition of Blockbuster and other home video rental companies.
In 2000, Netflix proposed that it be acquired by Blockbuster in order to create synergies that could benefit both companies. But Blockbuster declined the offer. (2)
In 2001, memberships increased thanks to the diffusion of low-priced DVD players across the U.S. In 2002, the firm went public to raise capital because it wasn’t able to self-finance its business with profits. In 2007 came the revolution: Netflix launched video on demand and inflicted the mortal hit on Blockbuster. In 2011, the home video rental firm filed for bankruptcy.(3)
In February 2013, Netflix launched its first TV series: House of Cards. All the episodes were released in one day. It was a bold move that paid off. The series about the cynical politician Frank Underwood has received 33 Emmy Award nominations over the years.
How to deal with disruptors
The fight between Netflix and Blockbuster was similar to that of David against Goliath. Despite the initial difficulties, Netflix managed to overthrow its giant enemy.
In fact, as in the metaphor of the frog put in a pot of lukewarm water that gradually becomes hotter and hotter until it boils, Blockbuster didn’t even realize that it was dying until shortly before it went bankrupt.
When big old companies are failing to adapt to change, and new innovative competitors arise, the best choice for the old company is to buy the disruptor. For example, this is what Facebook did with Instagram. Obviously this is easy to say with hindsight, because if a company fails to adapt to change, it means that management think that in the future everything will go as it did in the past. Consequently, when a company is being disrupted, management don’t even notice until it’s too late to act.
Netflix’s revenue has been going up for years now. So far, management’s priority has been growth.
In fact, the company has made little profit and has never paid out a dividend over the years. As you can see from the chart below, EBIT and net income have only recently started to rise to significant levels.
As of October 16, 2018, Netflix has a P/E ratio of 156. This is a crazy-high value even for a tech stock, but it sums up the big expectations priced into Netflix’s stock price by the market.
Even if Netflix is a growth stock, the firm’s market multiples suggest to us to think carefully before considering an investment.
The company has been investing billions in new content over time. It has been financing these investments with debt. The chart below illustrates how the company’s leverage has been over the delicate level of 2.5 for many years now.
This has translated into an increase in the interest expense, which has reduced the interest coverage ratio to below 5.
The interest coverage ratio is calculated as:
This number measures a company’s ability to pay its interest expense. A value below 5 represents a red flag. In the next few years, Netflix’s debt situation could become problematic because of the expected FED interest hikes.
Netflix’s stock performance
The number of memberships is the indicator that so far has driven Netflix’s stock price. On October 16, 2018, an increase in memberships by 2 million above the firm’s expectations led the stock price to rise by 15%. Afterwards, the price retraced, following an overall drop in the market.
Since 2015, Netflix has outperformed the Nasdaq and has risen sixfold. This is an incredible performance.
What are the best strategies to implement?
Netflix has been a growth stock since its foundation. Now, the company must be able to keep growing its subscription base to prove that its business model is sustainable. In fact, many question its ability to keep financing new content acquisition with debt in the long run. Moreover, shareholders will sooner or later ask management for dividends. Even if management have bet everything on growth, one day they will have to face the problem of profitability. In fact, for a stock with huge expectations like Netflix, shareholders expect it to make a lot of profit. The problem is that competitors like Amazon and Hulu are investing heavily in new content: this will make it challenging for Netflix to keep growing fast and reach high profit margins in the future.
The wide ups and downs of its stock price make it a good target for swing and day traders.
Hastings, Netflix’s founder and CEO, has said that he got the idea for the company when he forgot to return an Apollo 13 VHS to Blockbuster, and was forced to pay a $40 late fee. After this episode, he said: “it made me think: I can’t be the only one who is struggling with this late fee thing. And just started me thinking about the internet and DVDs and how something could work without late fees”. (4)
What do you think about Netflix’s future? Let me know in the comment section below.
Check out my book: A Beginners’ Guide to Stock Investing.
1. https://en.wikipedia.org/wiki/Netflix. [Online]
2. https://www.youtube.com/watch?v=BrpEHssa_gQ. [Online]
3. https://en.wikipedia.org/wiki/Netflix. [Online]
4. https://www.youtube.com/watch?v=pjsUsN1iLR0. [Online]