Netflix: Initiating Coverage

Netflix’s (NFLX) stock has enjoyed an enviable run as a first mover and leader in the OTT streaming industry. However, of late it is facing increased competition from traditional media companies which are paying more attention to their streaming offerings. This has also started showing in Netflix’s subscriber numbers and pricing in some markets. In this report, we have analyzed Netflix’s business, past performance and various scenarios for the stock going forward in wake of the increasing competition.

We have started with a discussion on business basics, key drivers, and past performance, and then have moved to recent developments, outlook and scenarios, and the bull, bear and base case forecasts for the company. In case you are already familiar with the company, please feel free to jump to the recent developments section to get a better sense of the current events and forward-looking commentary on the company.

Business Basics

Netflix is the global leader in the OTT streaming industry. Despite the company being much younger in the entertainment business, it is in an enviable position with the ability to have industry-leading content spending on streaming. This in turn helps attract more users and give the company the ability to charge a higher price for its subscription offering resulting in even more revenues and content spending capabilities. Thus, a positive loop is created giving the company a competitive advantage.

Table: Cash content spending of major streaming companies

Source: Company Data, Marjan Invest Estimates

Table: Subscribers and Average Revenue Per User (ARPU) for Netflix and its competitors

Source: Company Data, Marjan Invest Research. (Note: Amazon Prime numbers may not be directly comparable as many consumers primarily subscribe to it for delivery cost and time savings.)

Now, that doesn’t mean the company is infallible. Media is a tough business and a company needs to make sure its content keeps resonating with the viewers. The competition is also toughening with peers resorting to mergers and acquisitions to ensure that they have content as well as spending capabilities to match Netflix. Some of the recent examples of M&A in the industry include Disney acquiring 20th Century Fox Assets, Discovery’s proposed merger with Warner Media, Amazon acquiring MGM studios to complement Prime video.

Table: Recent Merger and Acquisitions in Media Industry

Source: Company Data, Marjan Invest Research

The impact of these M&As is a matter of debate among investors and analysts, and we have discussed various scenarios in our Forecast and Scenarios section. However, there is one thing that makes Netflix more attractive for many investors compared to other peers. With other companies, most of them have a traditional linear or show business. Accelerated adoption of their OTT app sometimes also accelerate the decline in their linear or other businesses offsetting some of the streaming benefits. Netflix doesn’t have that baggage and can be much more aggressive in terms of growth. For example, if HBO or Disney release their movies simultaneously on app and theatre, or app alone, they are leaving some of the revenues on the table and angering their cinema partners. For Netflix, the priority is clearly streaming and its management does not have to contemplate the trade-offs resulting in it being much more aggressive in spending on content focused on Streaming viewers.

Understanding the Key Drivers

Netflix’s business model is simple. It generates revenues through its subscription service. So, for modelling revenues, we need to forecast the number of users and Average Revenue Per User (ARPU).

While the company operates as one operating segment, it does give a regional breakdown of revenues, users, and ARPU data for four major geographies – the U.S. and Canada (UCAN); Europe, Middle East and Africa (EMEA), Latin America (LATAM), and Asia Pacific (APAC).

Table: Geographic subscribers distribution and ARPU

Source: Company Data, Marjan Invest Research

On the cost front, content amortization forms the largest chunk of expenses and is included in the cost of revenues along with expenses associated with the acquisition, licensing and production of content (such as payroll and related personnel expenses, costs associated with obtaining rights to music included in the content, overall deals with talent, miscellaneous production-related costs, etc.), streaming delivery costs and other operations costs. The company’s content cost comprises self-produced content (where Netflix owns the Intellectual Property) as well as licensed content. It amortizes content on an accelerated basis based on historical and estimated viewing patterns and the amortization schedule is reviewed quarterly. On average, Netflix amortizes over 90% of its licensed or produced streaming content assets within four years of its launch.

Other operating expenses include marketing, technology and development, and general and administrative expenses. The company is showing good operating leverage and these numbers as a percentage of revenues are coming down as the business is scaling.

Table: Major cost items as a % of revenue

Source: Company Data, Marjan Invest Research (Note: 2021 numbers are for the first 9 months)

The Story So Far

Netflix has given more than 500x returns over the past two decades. When we have returns this high, it is always good to understand what has made the company so successful in the past.

Netflix started as a DVD rental company in 1997 disrupting the brick and mortar DVD sales/rental companies like Blockbuster and driving them into bankruptcy. The company entered online streaming in 2007. This very successful strategic pivot is the hallmark of great leadership who can think years ahead while taking decisions on the company’s growth trajectory. Imagine what would have happened if it wouldn’t have transitioned its business from DVD to Streaming!

The initial years for the streaming weren’t easy though. Unlike a DVD rental business where, once you buy a DVD, you can rent it to multiple customers without incurring any recurring content cost, in a streaming business you have to pay revised license fees for third-party content every time the contract comes for renewal. So, there were always questions surrounding costs and whether the company’s investment in licensing third-party content and other initiatives like the international expansion will give appropriate payback in the long term. In fact, the stock lost three-quarters of its value from July 2011 to September 2012 as the company’s margins declined with increasing content costs, the company’s international expansion, and a decline in the traditional DVD rental business which had much higher margins versus streaming business at that time.

There were also talks about the significant risks to the business if the content providers themselves enter the streaming business. This eventually turned out to be the case but before these competing services posed any major risks, Netflix had already started producing some of its own original content from 2013. So, again another example where management’s long term thinking helped the company retain its competitive advantage.

Source: Marjan Invest Research

Recent Developments: The company was already doing well in early 2020, and when the pandemic hit, it saw a surge in subscriber numbers in the initial quarters. However, the growth slowed post-Q3 2020 as the new content pipeline dried due to lockdown impacting the production schedule. Some investors were also concerned about the competition from new players – HBO Max, Paramount Plus etc. – having a role in this decline but management denied it based on the internal region-wise data points they were seeing.

This slowdown in user growth is also reflected in the company’s stock price which remained rangebound from July 2020 till July 2021.

Source: Marjan Invest Research
Source: Marjan Invest Research

However, the stock saw a good run up from mid-August onwards as the expectation around user growth built up thanks to the impressive content slate with new seasons of popular shows like “Money Heist”, “Stranger Things”, “The Witcher” releasing. Netflix didn’t disappoint and the company posted net subscriber addition 4.4 mn in Q3 2021 and guided for 8.5 mn in net subscriber adds for Q4 2021. Its new show “Squid Game” saw a mind-boggling 142 million members viewership within the first four weeks of the release and became one of the most-watched shows on its platform.

The stock has given up some gains since mid-November after Disney’s announcement of ~$8 bn in incremental investment in content next year taking total spending on produced and licensed content to $33 billion. While all of this spending is not related to the company’s DTC business, and sports, movies and traditional linear business account for the majority of the company’s total content costs, management’s comment that the incremental spending is primarily driven by higher spending to support its DTC business has ignited the fears of Streaming Wars intensifying in the coming years. Disney hasn’t provided specific guidance for content spending on Disney+ yet but it has indicated that there will be an upward revision in its FY2024 Disney + content spending guidance of between $8 bn to $9 bn.

Outlook and Scenarios

Looking forward, the one question on the top of the mind of many investors is what kind of subscriber growth Netflix can post in the coming years as the competition increases and some of the covid related impact wanes. Before covid, the company added ~28.6 mn net subscribers in FY2018 and ~27.8 mn net subscribers in FY2019. In FY2020, the company added 36.6 mn subscribers and if we go by management guidance for Q4, the company is expected to add 18.4 mn subscribers. One can argue that there was a pull forward in subscriber addition due to Covid and if we take the average of FY2020 and FY2021e, it again comes to around ~27.5 mn subscribers.

So, can the company continue to post subscriber growth in high 20 million over the coming years?

There are a couple of ways to think about it. While on the face of it, increasing competition entering the streaming industry does sound like a threat to Netflix and many analysts believe it will slow the company’s growth rate, there is a counterargument as well. Most of the players entering streaming are also present in the linear TV business. When these companies begin placing emphasis on their streaming services, there is a very high incentive for consumers to discontinue their cable connection (cut cord) and shift completely to streaming services. So, we are likely to see an acceleration in streaming adoption and Netflix being a market leader in the industry may be a default beneficiary.

Also, when we think about competition, not every player is well capitalised as Disney. For example, HBO Max’s parent company Warner Media is set to merge with Discovery sometime next year (subject to FTC clearance and shareholder approval.) Post-merger, the company will have a net debt of 5x EBITDA, which is quite high for a media company. As the company will focus on reducing debt, its content investments for streaming may not be as aggressive as Disney or Netflix.

So, a bull case where the company maintain its subscriber growth in high 20 million may still be possible. On the bearish side, I believe the current year’s ~18 mn expected subscriber additions probably represents the downside case for subscriber additions in the near term. If despite tough year-over-year comparisons and production-related headwinds at the beginning of the year, the company is able to add 18 mn customers, it can do equal or better in a normalized environment. The base case scenario will be somewhere in between probably in the low 20 million.

Increased competition will also impact the company on the ARPU front as the company may decrease its prices or delay price increases to more effectively counter the competition. We are already seeing some of its impact and Netflix has already started taking steps in some geographies to make sure its pricing remains competitive versus its peers. Recently, the company has reduced its prices in India between 18% to 60%. Disney+Hotstar, with over 40 mn plus subscribers and a much lower-priced offering in India, is giving Netflix tough competition there.

Table: Netflix’s old and new plans in India

Source: Company Data, Marjan Invest Research

Even after this decrease, Netflix’s offering remained premium-priced versus Amazon Prime, Disney Plus and other major players like Sony LIV in India.

Since the scale is an important factor in the online streaming business, I won’t be surprised if Netflix takes similar steps to ensure that it is price competitive in different geographies.

In Q3 2021, the company posted high single-digit growth in ARPU in UCAN, EMEA and Latin America, and mid-single-digit growth in APAC. I believe a more reasonable assumption for longer-term growth in ARPU will be mid-single digits for UCAN, EMEA and Latin America based on increasing competition. APAC remain significantly underpenetrated for Netflix with ~30 mn subscribers at the end of Q3 (compare this with Disney which has over 40 mn subscribers in India alone). So, I believe flattish or even declining ARPU is an appropriate assumption there.

Further, since subscriber growth is much higher in APAC which has a lower ARPU, there will be downward pressure on the total companywide ARPU thanks to the changing mix. However, this is automatically getting accounted for in our forecast as we are doing a region-wise forecast for both subscriber growth and ARPU (in the next section).

I believe an appropriate base case scenario for ARPU will be mid-single-digit growth in UCAN, EMEA, and Latin America for the next few years, while a high single-digit decline in APAC ARPU for FY2022 and then a flattish trend in the subsequent year. For the bullish scenario, I am assuming high single-digit growth in UCAN where Netflix has a leadership position and the rest of the geographies seeing the same growth as the base case scenario. For the bear case, I am assuming a low single-digit ARPU growth for UCAN, EMEA and Latin America for the next few years, and a high single-digit percentage decline in FY22 for APAC and a mid-single-digit percentage decline every year till FY2025.

Netflix margins are largely controlled by management as they can adjust their content and other spending to arrive at the requisite level of margins. For example, they may decrease their content spending which will result in increased margins. This would ultimately show up in less subscriber growth in the long term if their service ends up being less appealing to consumers. However, in the short term management is more or less expected to be in line with the kind of margins guidance they have given. They have given a target to reach an operating margin in high 20 percentages over the next few years. For FY2021, their margins are expected to be slightly more than 20%. If we assume a couple of hundred bps of improvement each year for the next four years, the company will reach its target by FY2025. I have considered that as a bull case scenario. My bear case scenario is the operating margins remaining at FY2021 levels with the company forced to change its content spending and operating margin guidance to keep up with the rising competition while my base case scenario is somewhere in between at mid-20s operating margin.

The industry structure may also change over the next few years. So far, Netflix has been a clear leader in the space and has enjoyed a premium P/E multiple given the growth opportunity in this industry. Even now it is trading at ~45x next year P/E. If Netflix can continue to maintain its leadership position despite rising competition and only a couple of players are able to survive owing to the scale advantage of larger companies, it can keep enjoying high P/E multiple for the next several years until the growth opportunity gets saturated. P/E multiple in the mid-40s is my bull case scenario.

In the base case, I am assuming multiple players will be there but Netflix will still be among the top few leaders and continue to enjoy better content monetization than most of the other players. A P/E multiple of ~30x will be more appropriate in that case.

In bear case, I believe growth opportunities in streaming will continue but Netflix will no longer dominate and other players will reach subscriber levels where their content economics is comparable to Netflix. In that case, I believe ~20x P/E multiple will be appropriate.


Based on scenarios mentioned in the previous section, we get the following bull, bear and base case.

Bull Case

Assumptions: 8% CAGR in the U.S. and Canada ARPU, and 5% CAGR in EMEA and Latin America ARPU from FY2022 to FY2025. An 8% decline in Asia Pacific ARPU in FY2022 and no change post that till FY2025. 27,000 subscriber additions every year from FY2022 to FY2025 and a 28% operating margin by FY2025.

Table: Region-wise Subscriber addition, ARPU estimates, and P&L forecast for Netflix – Bull case

Source: Company Data, Marjan Invest Estimates

Using FY2025 EPS of $26.45 and 45x P/E multiple we get a bull case target price of $1,190.25.

Base case

Assumptions: 5% CAGR growth in UCAN, EMEA and Latin America ARPU from FY2022 to FY2025. An 8% decline in Asia Pacific ARPU in FY2022 and no change post that till FY2025. 22,000 subscriber additions every year from FY2022 to FY2025 and a 25% operating margin by FY2025.

Table: Region-wise Subscriber addition, ARPU estimates, and P&L forecast for Netflix – Base case

Source: Company Data, Marjan Invest Estimates

Using FY2025 EPS of $20.35 and 30x P/E multiple we get a base case target price of $601.05.

Bear Case

Assumptions: 3% CAGR growth in UCAN, EMEA and Latin America ARPU from FY2022 to FY2025. An 8% decline in Asia Pacific ARPU in FY2022 and 5% decline each year post that till FY2025. 18,300 subscriber additions every year from FY2022 to FY2025 and a 21% operating margin by FY2025.

Table: Region-wise Subscriber addition, ARPU estimates, and P&L forecast for Netflix – Bear case

Source: Company Data, Marjan Invest Estimates

Using FY2025 EPS of $13.53 and 20x P/E multiple we get a bear case target price of $270.60.

We understand you might think of other possible scenarios as well. In case you would like us to run any particular scenario and arrive at a price target based on your assumptions, please let us know in the comment section below and we will be happy to run your assumptions through our model.

[Analyst: Vyomesh Pandit, Rakshit Chauhan Email: Info [at] Disclaimer: This is not financial advice customized for your needs. Please consult your financial advisor before making any investment decision. While a reasonable effort has been made to ensure accuracy of the content, no guarantee is given nor responsibility taken by us for errors or omissions and we do not accept responsibility in respect of any information or advice given in relation to or as a consequent of anything contained herein. Please do your own due diligence before investing.]

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