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As I write this, Netflix (NASDAQ:NFLX) has a market cap of precisely $100.01 billion. At just under $225 per share, it has seen quite a decline from the lofty heights of $700, though it has rebounded nicely off the lows now. The immediate cause of the decline, beyond the Fed rate hikes that are affecting everyone, is the two straight quarters of subscriber losses.
Can Netflix rebound from this? I believe it can, because it is a tech company, and it has the data to do it.
Tech Vs. Media
It’s long been one of the most passionate (good-natured, for the most part) debates among both investors and Seeking Alpha analysts whether Netflix can properly be considered a tech company or not. And with the dramatic plunge in the stock, those who have argued “no” and taken the hit for years may justifiably be feeling some vindication. In 2017, Disney’s (DIS) announcement that it would be pulling its movies off Netflix for the new Disney+ led Contributor David Trainer to renew the argument, made several times already, that Netflix should be thought of like a media company, not a tech company, and have its stock right-sized accordingly. He urged Netflix investors to cash out of the stock before the decline accelerates.
David is one of my favorite authors, so that is the old article I chose. Look more recently, and you will find many, many more such articles,
I’ve never quite agreed, and respectfully, I don’t know. Netflix is a tech company.
Setting The Criteria
Why is Netflix a tech company? I suppose a predicate question would be, what’s a tech company?
Certainly it’s no longer a company that uses computers in its business – that would describe almost every business on the planet at this point. Definitions vary, but most of us feel like we know a tech company when we see one.
From an investing perspective, I would argue that a company is “tech” if it meets two key criteria: it has a relatively low marginal cost of service or goods, and it engages in some substantial degree of data analysis. Some might argue a better word for this is “software company,” rather than tech.
Meeting The Criteria
Netflix meets both of these criteria. The standard argument against Netflix’s tech status is that content is very expensive to produce, which means that its gross margins are not nearly as cost-free as their marginal costs. Yes, Netflix spends a lot on content, but it doesn’t spend any more when 50 million people watch a movie instead of 5 million.
That’s true of all studios, of course. Does that make every content creator a tech company? Well, if they all keep converting to streaming, maybe one day, but I think not.
What sets Netflix apart from other content creators is what it pairs its content with: a world-class, unmatched – in the premium content world, at least – recommendation engine.
A World-Class Engine
This engine is content data mining at its finest. It analyzes all of Netflix’s viewership data – which it has a lot more of than its competitors, since it’s been streaming since 2008 and renting DVDs since 1998 – to generate sophisticated models of what in Netflix’s catalog each viewer is likely to find enjoyable next, after they finish what they’re currently watching.
This data mining is key to the bullish case for Netflix, because it illustrates one of the fallacies of modern media analysis I think: that the only way to get new content in front of consumers is to create more of it, sometimes at prohibitive cost. Netflix certainly does create content, as does AMC Networks (AMCX) and Paramount (PARA) and everyone else. But this is not the only way it satisfies viewers.
With now some 100 years of filmed entertainment in archives and data banks, there are undoubtedly a lot of things out there we want to watch that we don’t know we want to watch. Recommendation engines are a way to put them in front of us to be discovered, and they keep us in Netflix’s ecosystem instead of us going to Tubi (FOX) or Peacock (CMCSA) to find our next flick. But consumers as a rule aren’t going to sit around scrolling for recommendations for very long before they go find that show they saw advertised during the football game, or rewatch that movie they saw in theaters over the summer. Streamers have a very limited amount of time to convince the viewer to stick around.
Recommendations Vs. Productions
The significance of this is more profound than some realize. When people come to Netflix for a recommendation about what to watch, instead of to find a piece of content they’ve already decided on, they are far, far more valuable to Netflix. In fact, there’s an argument to be made that if Netflix had to choose between one recommendation inclined customers than five specific content ones, it would be more profitable to take the former.
The reason for this is that when consumers want a specific piece of content, Netflix has no leverage in negotiating for that content with the creator – it either pays what they’re asking or it loses the consumer revenue it would have brought. This means that over time, for content-seeking customers, Netflix becomes precisely what its bears always feared – a simple pass-through entity between creators and consumers, with little profit for itself.
Making the content itself doesn’t help much, either. The consumers are probably seeking a specific actor, writer, director, or intellectual property, so substitute them for “creator” and you’ve got the same dynamic as above. If a movie with Chris Evans is going to be worth $20 million more than a movie without him, Evans would be a fool to charge less than $20 million; and Netflix would be a fool to think in the long-term that sort of movie would ever generate substantial profit.
Setting The Tables… And Turning Them
But recommendation-seeking customers are very, very different. If a customer will allow Netflix a few minutes of their time to find a movie or TV show to watch, Netflix can take what they know about the customers tastes and essentially have a bidding war amongst all content providers who fit the criteria they’re looking for. Whether the customer wants a thriller, a romcom, a mystery drama, sci-fi, crime procedural … there’s probably 20 different content providers who can offer it.
And Netflix controls the consumer relationship. This means that it can set those content providers bidding against each other for who will offer the content needed for the lowest cost. In this scenario, even Netflix’s own Originals are just one more “bidder” with a cost figure attached – provided they haven’t been made already. Existing Originals will probably always be first in line. The same applies to content Netflix has already struck third-party deals with.
These content pieces have a marginal cost of $0, just like software at a tech company. And the better Netflix gets at selling its recommendation software – or more accurately the results it outputs – the more money it saves on content and the more profit it makes.
Massive Data Requirements
But this can only be done with data so good that you consistently generate winning recommendations before the customer gives up and leaves. And that’s not as easy as it sounds. In fact, when HBO Max (WBD) launched, it openly admitted it was going to try human-generated curation. It just didn’t have the data to compete on a pure machine learning level. Aside from Netflix, there’s few others who can manage it.
While this was dressed up as an artistic choice of returning the human element, all major streamers understand just how recommendations can shift the balance of power in content negotiations. If anyone thought they could match Netflix in this regard, I’d bet my bottom dollar they’d be moving heaven and Earth to try. But more and more of them are admitting that with how large Netflix’s head start is and how determined it is to preserve its lead, there’s just no point.
Netflix itself knows this, and for all its content spending, it also spends not inconsiderable sums trying to tweak its recommendation algorithms. There are a few companies it does need to stay ahead of, including Amazon (AMZN) and YouTube (GOOGL) (GOOG) because they’ve been doing this nearly as long as Netflix, and so have nearly as much data to work with as they do. Amazon has been selling DVDs in the mail almost as long as Netflix has been renting them, and YouTube actually started streaming a year earlier than Netflix did.
Running The Calculations
Without detailed viewership data, which Netflix isn’t sharing for obvious reasons, we can’t really extrapolate how many customers like this currently exist. Instead, I am simply going to calculate, at Netflix’s current ARPU minus operating expenses, how many subscribers would have to be pure platform subscribers – i.e., no marginal content costs – to justify a substantial rise from Netflix’s current price. Let’s set the target at $350, close to where it was before the disastrous (for investors) Q1 earnings print. That would put its market cap at about $145 billion.
I will define operating expenses at $2 per month, the same figure I’ve used for streaming services pretty much ever since Disney+ was announced back in 2017. That leaves $10 per month for Netflix at its current ARPU, or $120 per year, per subscriber. Assuming for now that the market is going to hold at a 20 P/E, $45 billion of market cap requires a run rate of $2.25 billion of profit. Thus, roughly 19 million subscribers seeking recommendations instead of specific content world-wide is enough to get Netflix back to $350. It has over 220 million subscribers and is projecting a return to growth in the third-quarter. While we can’t say how many recommendation-seeking customers it has, I believe a 9% share is not a stretch.
Even Netflix’s $700 heights are not completely out of the question if it continues to grow well and its recommendation algorithm keeps getting better. A $700 share price would be a roughly $310 billion market cap, and getting $210 billion over current levels would require roughly 87.5 million recommendation-seeking subscribers. At 220 million subscribers that’s probably not quite doable, but if the subscriber base doubles…
Risk Factors For NFLX
Ironically, the biggest risk to this thesis may be Netflix’s own advertising plans. Advertising offers cheaper prices, which consumers love, but it also degrades the user experience, which they hate. If advertising becomes widespread on the Netflix platform, it may hurt its ability to attract recommendation-seeking customers because such customers are, after all, flexible in terms of their content desires. Which means they don’t have to put up with ads to watch the content they want. If they’re weighing where to go watch and not looking for something specific, odds are they’ll go somewhere they can watch ad-free. Ad-based content just won’t make the cut.
My qualms about this have been eased slightly by the firm stance management has taken that it sees advertising as complimentary to its current plans. I assume management has learned the danger of raising prices too high after its subscriber losses immediately following this latest price hike, so I foresee ad-free plans remaining more or less where they are now while ad-based plans slot in below them at a lower cost.
Also of note is that most Netflix subscribers say they’re not interested in downgrading their plans to ad-interrupted, even with the savings Netflix is offering. Netflix management should be very grateful for that. It might be saving them from themselves.
A Few Real Recommendation Competitors
The other risk factor might simply be that YouTube and Amazon will catch up and destroy Netflix’s advantage. Both companies are well-regarded for their recommendation engines, just like Netflix is. TikTok has also proven that once you crack the recommendation problem, even new kids on the block can surge quite quickly. But TikTok and YouTube don’t pursue premium content, believing margins are better in amateur level. And Amazon seems more inclined to maximize its own system-wide revenues, meaning its recommending rental/purchase titles or titles on another service in its Prime Channels store as often as its trying to drive purely subscription driven selections on its own Prime Video.
Other Investment Implications
I consider Netflix and Amazon to be the world class leaders in premium content recommendations, a crown shared by YouTube and TikTok in amateur video. But this doesn’t mean that every other streaming service is doomed. Just that they won’t generate substantial recommendation-driven profits. The other path to profit is to simply be so good at analyzing content itself for profitability that you fund more winners than losers. Paramount, which I am also long on, has proven it can do precisely that. Comcast’s NBCUniversal also seems to be ahead on scripted content profitability, but its attached to a dying cable broadband monopoly and its sports book may be far less profitable than its scripted. So as an investment that’s considerably riskier. Fox and Warner, respectfully, seem less stable in terms of the profitability of their content; Fox is basically just News and NFL, two things unlikely to survive the collapse of the pay-TV bundle, while Warner’s profitable Discovery nets are being dragged down by its ever-less profitable TNets.
Investment Summary
$700 was far too rich for me, even if Netflix can get there eventually, and at $350 it already seemed clear Fed hikes were going to decimate the market. The Fed’s not done hiking yet, but given the profound sentiment shift around Netflix since it started losing subscribers, I’m not sure it will fall any lower, and I think it’s undervalued here. I am buying into Netflix for the first time in years.
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