Bireme Capital – Netflix: Transitioning From A Growth To A Value Stock

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The following segment was excerpted from this fund letter.


Netflix (NFLX)

At the beginning of April we made an investment in Netflix. We posted the thesis on our blog here.

We wrote that “we would not be surprised if NFLX traded down from here” and that “we would be eager buyers on further weakness (assuming the NFLX business case isn’t materially impaired in the meantime.

“When we wrote that we would not be surprised if Netflix declined, we were envisioning potential valuation compression from a further wash-out in the growth stock bubble. We were not envisioning the dramatic negative turn in subscriber growth and company guidance revealed in Netflix’s Q1 results that sent the stock down more than 30% overnight.

Shares now trade at around $215 per share, a steep fall in a very short time from our average price around $350. We should note here that our Netflix position was conservatively sized; our losses to date on the Netflix position amount to less than 2% of our portfolio NAV. Furthermore, our significant short book of correlated stocks has also mitigated the hit to the portfolio. As of April 21st, FV remains up 3.6% for the year compared to a loss of -7.5% for the S&P 500.Nonetheless, our NFLX bull thesis has been severely tested by the disappointing results.

Results

The primary cause of the share price drop was a miss in subscribers, both in the Q1 results and in the company’s guidance for Q2. For Q1, Netflix lost 200k subscribers. Although they gained 700k subs if you exclude the impact of exiting Russia, this was still a miss of over 2m subs relative to their January guidance. On top of that, the company guided for a loss of 2m subscribers in Q2, which would be their largest ever subscriber loss in a single quarter.

The company blamed the disappointing numbers on high penetration, increased competition, macroeconomic factors, and lower sales of smart TVs. Management does not believe the subscriber declines are solely due to a hangover from the pull-forward of COVID-era demand, which was their original explanation for the late-2021 sub growth slowdown.

That being said, the company made clear that they will not stand still and watch the subscriber base wither, and are moving forward on several new initiatives to re-ignite growth.

First, they plan to start charging password sharers. Management claims that 100m households globally share passwords without paying, including 30m in the US and Canada. We are very confident that Netflix can accomplish this technologically. However, the difficulty is in doing this in a way that doesn’t cause a large number of cancellations. In South America, Netflix has begun testing various methods to unlock this value.

While this will only be a one-time boost to subscriber growth, the numbers are nonetheless compelling: if Netflix could extract an average of $5 per month from all 100m households who currently pay nothing to enjoy the service, Netflix’s profits would double. $5/mo is a small fraction of their ARPU and we think is doable.

Second, they plan to eventually sell an ad-supported tier of the service. This will come as a shock to many, considering how consistent co-CEO Reed Hastings has been on the benefits of an ad-free experience. But with subscriber growth waning and many competitors – including historically ad-free HBO – going this route, he changed his mind. On the conference call he argued that the benefits of consumer choice trump the simplicity of the current model.

While it may dilute the purity of the Netflix brand, the financial promise of an ad-supported tier is large. Hulu paved the way on this many years ago as the first streaming service to offer an ad-supported tier. Hulu’s results show that this lower-priced tier is not necessarily dilutive to revenue. In fact, Hulu appears to generate roughly the same amount of revenue from both their $6.99 (ad-supported) and $12.99 (ad-free) tiers, collecting $12.75 per month across all subscribers despite having previously disclosed that most of their subscribers are on the ad-supported plan. This is extremely significant, since it means that subscribers who cannot afford or justify $12.99 have another option to watch the service – and at a price point where Hulu is largely indifferent between the two options. This surely results in more subscribers, more revenue, and a larger content budget than Hulu would have if it only offered an ad-free product.

Advertising is a large portion of Hulu’s business, with eMarketer estimating that Hulu generated $3.1b in advertising revenue in 2021. The advertising business at Netflix has the potential to be multiples of this size as Netflix averages more than twice Hulu’s share of total US TV time. We suspect that given their technical chops, ability to recruit talent, and the TAM of the opportunity, Netflix will be able to build out a world-class programmatic advertising business in short order that will bring in substantial additional subscribers and revenue.

Reunderwriting

We now expect the next few years to be difficult at Netflix, and the growth outlook is cloudier than it has been for a long time. The business model may need to be adjusted and budgets may need to be cut.

But at the end of the day, most of what we wrote in our original thesis remains true. The company sells a fantastic product at a great price point in a secular growth industry. Though an earnings miss of this magnitude will always lead investors to question management’s judgment, we still believe management is best-in-class, and are encouraged by management’s willingness to change their minds about the fundamental structure of the business when faced with new evidence.

When a stock makes the transition from being perceived as a growth stock to being perceived as a value stock, it can often engender precipitous declines. Essentially the entire investor base needs to turn over, and the price necessary to elicit interest from value investors is usually dramatically below the price which growth investors were willing to pay for it. Netflix’s transition from a perception of growth to that of value seems to have happened abruptly over just the last two earnings calls. Part of that is due to legitimate business trouble; part is just that Netflix had so far to fall given the high expectations baked into its pandemic-darling status.

Sentiment has never been more negative than it is today. Even some value investors are giving up on Netflix due to the dramatic change in business prospects and industry uncertainty.

But this creates opportunity. At 20x trailing GAAP earnings, investors are essentially paying a market multiple for Netflix.

We have re-underwritten our investment with what we think are extremely conservative assumptions: annual subscriber additions of only 5m, a meager 3% ARPU growth, long-term margins plateauing at 25%, and a terminal PE of 20. This pessimistic scenario would still generate a double digit IRR from today’s prices. Any upside from reaccelerating subscriber growth, above-inflation ARPU growth, or significant margin expansion due to Netflix’s immense operating leverage, is pure optionality.

On this basis, we increased our stake in the company to make it a 5% position.


Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.