In the series of posts covering FANG stocks, Aswath Damodaran, a Professor of Finance at the Stern School of Business at NYU, shared his musings on Netflix on his blog, discussing whether it is a future of entertainment or house of cards. He starts with an elaboration of Netflix’ history, its success story, the challenges it faced since its beginnings and its current position on the market thus setting a foundation for his valuation of the company with the subscriber-base approach.
This year in March, exactly twenty years after launching of its website, Netflix’s market capitalization reached $139 billion, thus reaffirming its place among the largest entertainment companies in the world, although being the smallest among the FANG stocks when it comes to market value and operating metrics.
During a 15-year period (2002-2017), the company dealt with various challenges on its path to success. The story starts off with Netflix mailing out videos and DVDs to its subscribers, thus outgrowing video rental businesses. Next, the company meets technology and customer preferences by introducing the streaming of movies. By 2012 a few un(expected) issues appeared, such as a drop in revenue and more importantly rising of content costs since movie studios (content providers) started to charge higher prices for content. In the following years, Netflix struck back by shifting to original content – television series and direct-to-streaming movies, besides streaming licensed content. In 2017 the company spent $90 million on Bright (a movie). Moreover, this company is a role model to other entertainment businesses, as evidenced by Disney’s acquisition of BAM Media and Fox Entertainment in a desire to adapt to the Netflix’s streaming model.
These days Netflix spends a lot on content delivered to its subscribers, almost $9.8 billion in 2017 (in cash expenses) although income statement showed different figures – $7.7 billion (in accrual expenses). This difference can be viewed as the “equivalent of capital expenditures,” or the money spent on attracting and keeping the audience (subscribers). Although using two different accounting standards (for licensed and produced content) when it comes to accounting content expenditures, the company capitalizes and amortizes both. Moreover, it spent $6.3 billion on original content thus becoming one of the biggest spenders in the entertainment industry. This trend continued in 2018. The reasons are a production of new content according to subscribers’ preferences and creation of ‘sticky’ customers. All that in order to attract more subscribers from all over the world. Last year, the number of Netflix subscribers was higher outside the US than in the US. So, when it comes to its subscriber base, the size (apparently) does matter, since the larger the base, the larger the revenue. Between 2003 and 2009 the company increased its market capitalization by $3 billion, while it “became a superstar investment” in the following period. By 2017, the company added about $120 billion in value. Moreover, in January 2018, its stock rose over 40% due to an increase of 8.3 million in subscribers. So, the bottom line is that subscribers are the fuel that drives Netflix’s engine.
That’s why the professor Damodaran used subscriber based approach when valuing Netflix. So, he used the above-mentioned numbers when breaking its overall costs down. When valuing existing subscribers he assumed that 20% of the expended content costs ($7,600 million) are in fact costs of servicing existing subscribers. Also, he added to that G&A cost, deriving a value of $508.89 subscriber. Speaking in terms of Netflix’s 117.6 million subscribers, a total value is $59.8 billion.
The value of new subscribers is estimated using the total marketing costs and capitalized part of the content costs as well as the gross increase in the number of subscribers. A total value of $137.3 billion subscribers is yielded.
And finally, there is a corporate cost that doesn’t have anything with existing or new subscribers. The valuation of this final piece of the puzzle is based on technology & development costs and remaining 80% of the expensed content. With an assumption that T&D costs will grow 5% a year and the content cost will drop of 3% a year, professor Damodaran calculated corporate cost drag of $111.3 billion.
In the end, he estimated the value per share of $172.82 (compared to the stock price of $275 as of April 14, 2018), by subtracting the corporate drag and the $6.5 billion in debt that the company has outstanding, from the above-mentioned equation. In best case scenario, the company will “grow at “double-digit rates for the next decade,” since its value will grow with new users. Comparing to Spotify that’s another subscription-based model also listed and traded, Netflix is a few steps ahead having more versatile and original content and higher renewal rates. However, the company has to bring under control its key value driver – the content costs, otherwise the company ‘s equity value will become negative, or in other words, it will go bankrupt. That’s why the smartest thing would be to put your wallets ‘on hold’ for now, at least until Netflix shows discipline in controlling content costs.