Netflix: An Industry Changing Quarter?

FTX and Sequoia

January 27, 2023

Good Morning!

Jason Gay of The Wall Street Journal had a great piece last week on Bengals DL Sam Hubbard and his wild 98 yard fumble recovery touchdown against the Ravens in the Wild Card round of the playoffs. 

My favorite part? This quote: 

"It makes Hubbard thankful for hot summer workouts with local trainer Pat Coyne, running 110-yard sprints, 15 of them a week, when nobody’s watching."

The likelihood that Hubbard at any point of his career would have needed to run 100 yards   was almost as likely as my chances of being in the NFL (low). The amount of times he must have thought "Why the heck am I doing this? What is the point?" has to be off the charts. 

However, it all paid off, became a career defining play, and now the Bengals are in the AFC Championship Game. It is the work that you put in when no one else sees that is the difference. Keep going! 

Showtime!

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DEEP DIVE

Netflix: An Industry Changing Quarter?

Introduction

Over the past several years, legacy media companies like WarnerBros Discovery, Disney, Paramount, and Comcast (NBCU) have invested/burned billions and billions of dollars to try and grow their streaming services. 

Analysts in the media space have long criticized many of these players' moves into streaming, specifically smaller players like $CMCSA & $PARA, arguing that they will never be able to replicate the profitability of the cable bundle with streaming. Rather, these companies should focus on squeezing profitability from the cable bundle while they still can and be an arms dealer to Netflix, Disney, and WarnerBros. Discovery. 

Even as Wall St. has shared their dismay with these companies (excluding Netflix) executives have stayed strong and confident in their positions that streaming can and will be a net positive to their business models. 

There is the narrative then there is the reality. 

The narrative? That streaming is a fundamentally flawed business model and will never reap profits for legacy media companies like the cable bundle has done for decades. 

The reality? Streaming has the potential to be an extraordinarily profitable business. How do we know this? 

Netflix. 

Below we will start off by taking a look into Netflix’s Q4 earnings and key happenings before going a little deeper into what this means for the media industry as a whole. 

Netflix

Last week, Netflix announced their Q4 earnings and overall, the results were viewed positively by Wall Street. Here were some of the key figures reported: 

  • Revenue: $7.85B (actual) vs. $7.85B (expected)

  • EPS: $0.12 (actual) vs. $0.50 (expected) 

  • Subscriber Growth: 7.66M (actual) vs. 4.57M (expected)

As you can see, revenue was in line with expectations, there was a miss on EPS (mostly due to non-cash write down of Euro Debt due to $462M of FX changes ), and the subscriber growth was a big beat. 

In my eyes, and I think the Street’s too, the biggest bullish statement from the call was that the company projects $3B in FCF for 2023 – a serious serious number. 

This number will be made possible by keeping content costs consistent at ~$17B, managing corporate expenses, as well as increasing revenue through various sources including the launch of the advertising tier, crack down on password sharing, and modest sub growth.  

In the week since Netflix’s earnings, the stock is up ~15% to a market cap of $162B or EV of ~$150B net debt. In other words, the company is trading at around 50x 2023 FCF or 37.5x 2024 FCF assuming that Netflix does around $4B in FCF, which are in line with current expectations lie.

Investors are showing great confidence in Netflix’s ability to continue to grow profits deep into the future. 

Arguably, the biggest news from the earnings report is that the Reed Hastings Era has come to a close. 

Hastings, the long time founder and CEO of Netflix has officially announced that he is stepping back from the CEO position and will move to Executive Chair. This marks the end of one of the greatest runs of a media executive where he created the concept of streaming and also led Netflix to 30,000% stock appreciation, since its 2002 IPO. 

Not too bad. 

Hastings has now handed the reins over to Ted Sarandos, who has been his Co-CEO for the past couple of years, as well as promoting Greg Peters, long time COO and CPO, to Co-CEO. Sarandos will likely be responsible for the Hollywood/creative side of the business while Peters will take care of everything else. 

It is interesting to note just how smooth this transition has gone down over the past couple of years at Netflix, in comparison to Disney’s mess, both currently and over the past decade.

Advertising & Password Sharing

  1. Advertising 

For years, Hastings swore against the idea of implementing an ad-tier into Netflix, however, of late, he has recognized this was a mistake. Simply put, an ad tier gives consumers greater flexibility from a pricing perspective and considerably opens up Netflix’s TAM. 

Many of the notable streaming services have their ad tiers generating greater ARPU from the ad supported model due to the power of ad revenue. This is why you will see streaming services bump their ad free costs before their ad supported costs– just like we recently with HBO Max and will see over the coming months with Paramount+ 

One of the greatest fears regarding Netflix’s ad supported model was the fact that many premium subscribers would drop down from a $19.99 a month tier to the $6.99 ad supported version. However, this does not seem to be the case as Greg Peters shared: “We aren’t seeing as expected much switching from high arm subscription plans like premium into our ads plans. So the unit economy remains very good as we modeled.”

This is really really good for Netflix bulls. 

Two other key notes from Netflix management regarding the recently launched ad supported model: 

  • “We see that engagement from ad plan users is comparable to sort of similar users on our non-ad plans.”

  • “So we are not going to be larger than Hulu in year one, but hopefully, over the next several years, we can be at least as large

Consumers are eating up the service just as much as the ad-free version and Netflix has their eyes on the ad supported business being a beast – just like Hulu. Specifically, Steven Cahall of Wells Fargo projects the company to do $1.3B in ad revenue in 2023, $4.2B in 2024, and $8.1B in 2025. 

2. Account Sharing  

Netflix is quickly cracking down on account sharing. It sounds like there will be a limit to the number of profiles that Netflix users can have on an account, and then additional users will either be forced to create their own account or add a profile for around $3-$4.

Netflix is currently working hard to try to make the adding of an additional profile as seamless and sticky as possible, including being able to have the “borrower” take their viewing history and recommended choices to their new profile – something that I think sounds cool, but many consumers won’t care too much about. 

Interestingly, the company does feel that this decision will “not be a universally popular move” and there will be a bit of a “cancel reaction” to it. However, the incremental revenue they earn from these moves will outweigh the lost revenue for churn. Netflix also has great confidence in their ability to win customers back through their content, in the long run. 

I personally have more confidence in the launch of the ad-supported tier than successful roll out of password sharing. 

Also, Netflix refers to people that use others accounts without paying as “borrowers.” I would love to be a fly on the wall in the PR/comms room that helped them come up with that term.

Pay To Play

One thing that analysts have been spot on about is the fact that streaming is an awful business right now. Why? Creating additional content, building up tech stacks, keeping subscription costs low and advertising the service costs some good money. 

Believe it or not, streaming was once an awful business for Netflix too. Yet  for some reason, had a long term perspective with the company while not cutting the same slack for legacy players. 

Check out this great chart below from TSOH breaking down Netflix’s annual cash flows since 2014:

As you can see from the chart above, Netflix lost more than $10B from 2015-2019 to ultimately help them achieve scale in streaming and establish themselves on a trajectory to become a cash cow. 

If anything, legacy media companies like $WBD, $DIS, and $PARA should be able to achieve scale in streaming at a significantly cheaper cost due to vast linear distribution capabilities, strong brand affiliation, existing deep libraries, and learning from the path that Netflix put out for them – both the good and the bad.

Specifically, legacy media executives point out the vast levers they can pull to reach profitability faster including: increase in prices, decline in spending wars on content, increase in ad CPMs due to digital capabilities, ability to create distribution agreements with companies like Walmart and Delta, and possibly adjusting subscriptions from monthly commitments to annual commitments.

Iger, Zaslav, and Bakish are paid to make money, and I am confident through streaming they will. 

Wrapping It Up

Netflix is a phenomenal company generating significant profit. The only question now is not whether or not they can generate profits, but rather, what multiple to put on these profits. 

In my eyes, a 50x multiple is too expensive and just not for me. I much prefer the company trading at ½ sales and with serious momentum – even if Wall St. is not giving it the respect it deserves ($PARA). 

Since the start of the new year, $WBD and $PARA are up 55% and 32% respectively. Since January 19th, Netflix’s earnings date, the companies are also up 21% and 15% respectively. 

Has Netflix’s success of late started to change the narrative of streaming and profitability or is this just another example of the market showing some volatility in uncertain times?

Only time will tell. 

-Alan

THE CROSSOVER ARCHIVE

Rippling, Paylocity, 2023 Predictions

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CHARTS OF THE WEEK

Savings vs. Debt and Private Equity

PORTFOLIO

The Crossover Portfolio

Note: The Crossover Portfolio is a mock portfolio of how I would be investing and not with real money. All trades are shared publicly @ The Crossover Twitter as they are recognized. 

  • Moves: Zero moves this week just as we like it! Going to wait until after earnings to deploy the cash into T-Bills as I want to be able to pounce if some of the portfolio picks have rough earnings. What a week for the portfolio. Let's do it again next week!

  • Note: The weighting in the portfolio is a little off so I am going to take a look at it over the weekend. I was just spending way too much time on it and wanted to get the newsletter out.

VENTURE CAPITAL

FTX and Sequioa 

The Rundown: Alfred Lin, Partner at Sequoia Capital, sat down with Connie Loizos of Strictly VC in a 25 minute chat. This represented Lin's first interview after the FTX debacle, where he led Sequoia's investments in SBF's company. 

Key Points: 

  • When reflecting on the investment, he pointed out that they operate in an industry where you strike out 30% and he shares that the company was "misled" in several instances

  • Sequoia owned less than 1% of FTX, represented by $150M invested from Global Growth Fund 3 (3% of fund) and $60M from their hedge fund (less than 1% of that fund)

Alan's Angle: 

While the comments from the interview around FTX are likely what is widely discussed from the interview, what really stood out to me were some of the golden nuggets around venture investing that Lin touched on. Check out these couple of quotes - the first on investing in tough times and the second on crossover investing: 

  • "Not so fun years are the best times to invest because all of the tourists are gone – both the tourist entrepreneurs as well as the tourist investors, because it gets hard"

  • "The only question we ask is whether you think these companies are going to be worth more 10 years from now than they are today. Not any short term any 3 month period, one month period, one year period."

I love the first quote from a general investing perspective and just thought it was articulated well.

Regarding the second quote, I think that funds like Sequoia will move away from simply asking "will a company like AirBnB or Snowflake be worth more 10 years from now than they are today." There is too much money to be made in the ups and downs of the market, and I expect a fund like Sequoia to become more hedge fund like around core positions that they let ride in the public markets. 

MEME OF THE DAY 

GOLDEN NUGGETS

  • Love this commercial with Kobe and Jalen Rose

  • Vin Scully was a bridge through generations. Incredible.

  • Hinge profile if it had your portfolio performance on it hahaha

  • Terry Francona getting his scooter back is everything

  • The ESPN I watched growing up...

Thanks for the read! Let me know what you thought by replying back to this email.

— Alan 

Disclaimer: The Crossover is not a professional financial service. All materials released from The Crossover are for educational and entertainment purposes. The Crossover is not a replacement for a professional's opinion. Contributors to the Crossover might have positions in the equities in the The Crossover Portfolio or mentioned in the newsletter.