Dixon's Take: A Holiday Lesson About Netflix and Its Future
A simple question reminded me why securities analysis is still one of the greatest parlor games of all time.
"Well, I look at stocks and try to see if the market is fairly valuing the company. If I think the market is overpricing the stock, I recommend selling and if I think the market is undervaluing the company I recommend buying."
"How do you do that?"
"Well, I start with the SEC filings that companies are required to file, look at the reported accounting numbers and then make some projections and assumptions about what will happen and how those numbers might change. The SEC filings don't always give you a clear picture but at least it is a place to start. I also like to look at companies that I know something about, either I use their products or understand their business, and where I have actually met and talked with the management."
"What kind of products? "
"Stuff we buy, stuff we eat, stuff we rent."
"Like this movie we just downloaded?"
"What about Netflix? How would you analyze Netflix?"
And so it began, a weekend tutorial that took me back and reminded me why securities analysis is still one of the greatest parlor games of all time.
We started by going online with EDGAR and took a quick look at Netflix's (NFLX) recent filings. Besides a couple of 8ks that showed the company had raised $200 million through a zero coupon bond and then raised another $200 million in equity, we were able to take a look at the September 2011 10-Q and find out some numbers. We started with revenue to see if there was any growth and where it was coming from. There had been lots of reports through the summer of people abandoning their subscriptions, and the company had acknowledged a huge problem trying to separate their business into streaming versus DVDs, and shareholders had run for the hills driving the stock into the low $70s from its peak level approaching $300.
But behind all the noise, what was really going on? With trusty HP-12C in hand we took reported revenues, divided it by the number of subscribers and calculated ARPU, or average revenues per user, for the nine months and three months ending in September. For the first nine months of 2011 monthly ARPU was $11.42 versus $11.92 per month versus the same period a year earlier as subscribers grew by 49% to over 25 million or approximately one in every four US television households. So on a nine-month basis, things looked pretty good. Growth had come primarily from unit growth as opposed to dollars spent per user, and the decline in ARPU could be easily explained as the result of an expanding base where early adopters gave way to a broader user base. Total subscriptions had now achieved a critical mass of over 20% of the market, while ARPU was basically flat. This looked very similar to traditional adoption patterns for new 20th Century technology like VCRs, DVDs and even radio in the 1920s. Recent trends were a tad disappointing. In the third quarter, subscribers declined and ARPU dropped slightly to $10.50, but this certainly wasn't surprising in light of the snafu in pricing and the debacle surrounding the attempt to split the business during the summer. What was interesting was that the growth of the growth rate (second derivative) had clearly declined, perhaps explaining the migration away by growth investors and tumultuous 77% decline in the stock over the year.
We were also able to see that gross margins net of amortized film inventories were about 35%, while incremental expenses for technology, marketing and general and administration costs had reached $550 million for the nine-month period, and were on track for about $740 million for the year.
The next step was to begin to make some assumptions about the business. If the company could maintain 25 million subscribers and capture $11 in ARPU a month from each, it would generate $3.3 billion in annual revenues and, applying the 35% margin, an estimated $1.16 billion in gross profit, or almost $400 million in EBITDA based on the current run rate of the other expenses. Not a bad business. In fact, if the ARPU dropped to $10 per month the company would still generate $300 million in EBITDA; and if it could grow its subscriber base to 30 million at $10 per month, it would be positioned to generate about $500 million in EBITDA.
We also saw from the Management Discussion and Analysis (MD&A) that management intended to grow the business internationally in 2012 and expected to post losses on the new operations, presumably reflecting increased spending on marketing and technology and administration for the expanding operations.
Armed with this information we dug deeper. Cash at the end of September was $365 million with debt of $200 million. Adjusting for the $400 million raised from the convertible and secondary in late November and early December 2011, the company had estimated net cash of $165 million at year-end. Total shares out in September were 54 million, or probably closer to 60 million at year-end reflecting the incremental raise plus an allowance for options.
So putting it all together, estimated year end EBITDA looked to be about $6.67 - $6.75 per share, the company had about $2.75 per share in cash and was trading with a TEV (Total Enterprise Value) of little over 10 times projected year end EBITDA.
"But what does that mean?" asked our budding Warren Buffet.
"Well it's a good question. Ten times is a benchmark trading level for most media companies and high-growing companies in the sector have traded as high as 16 times, so if things don't get worse at Netflix it's unlikely to see the multiple drop a lot more from where it is today, and if the company can improve it's cash flow or the market assigns it a higher multiple the stock should trade higher. If the company generates $500 million in EBITDA, and trades at 12x it would be valued at almost $100, which would be a pretty great return from here.
We also know that the company was able to sell stock recently at around current levels, so unless they really miss their numbers, there are probably some buyers looking to add to positions at the $70 level. The good news is that management is also a little gun shy -- they got hammered in 2011 so they are probably going to try real hard to not do something stupid."
"Can things get worse?"
"Sure, there could be more competition, the cost of programming could continue to rise, and the international expansion could take longer and be more expensive, or multiples could decline, but do you think we are going to download more or less videos in 2012 then in 2011?"
And with that we turned back to the TV and downloaded another movie.
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