On Tuesday, Netflix (NFLX, Financial) reported financial results for the third quarter of fiscal 2020. In the period, the world's leading streaming entertainment service added 2.2 million net subscribers.
Inclusive of the roughly 6 million (net) subscribers management expects to be added in the fourth quarter, the company is likely to end 2020 with more than 200 million global subs. As shown below, this would mean that Netflix has nearly tripled its global subscriber base over the past five years.
Revenues in the quarter increased 23% year-over-year to $6.4 billion, with the 25% increase in average paid members offset by a slight decline in average revenue per user (ARPU). As noted in the release, the ARPU decline reflected foreign exchange headwinds, with constant currency ARPU up 1%due to favorable plan mix in the UCAN, LATAM and APAC regions. As shown below, the company announced price increases throughout much of the world in 2019, but those increases had been fully lapped by this quarter (price increases, when announced, were immediately applicable to new customers, with existing subscribers moved to the higher pricing over a few months).
Unsurprisingly, the results in 2020 have been materially impacted by the pandemic. In the first half of the year, particularly when work from home and shelter in place started, Netflix saw a huge ramp in sub growth. Now that we've started to move beyond those restrictions and sports have returned, Netflix has seen headwinds to growth. That said, the long-term picture is still intact: the company in on pace to add more than 30 million net subs for the year, which would be a new annual record.
The combination of continued subscriber growth and higher ARPU's has enabled Netflix to report higher operating margins, even as they ramp content investments. The company now expects 2020 operating margins of 18%, with early guidance for 2021 calling for operating margins of 21%. To put those numbers in context, the company's operating margins over the past five years averaged 8%. Clearly the business is seeing benefits to its financial model as it continues to scale.
In addition to its dominant subscriber growth, Netflix is a clear leader in many markets for subscription video on demand (SVOD) user engagement. As I think about Netflix's competitive position, this comment on the call from Chief Product Officer Greg Peters stood out to me: "A very significant majority [of viewership] is driven by the recommendations that we present."
Netflix has largely replaced linear television (for entertainment programming) for tens of millions of people in the U.S. and around the world. It's become the default, the starting point, the place where people begin their search for tonight's entertainment. That has the potential to be a very valuable position to be in. What I think differentiates Netflix specifically and scaled SVOD players generally from the legacy pay-TV distributors is that they offer a more attractive product for entertainment programming (no advertising, watch content anywhere / anytime, recommendation engine offers personalization to each user, etc.), but also that they will have different economics given their ownership / influence on the content that is watched on their platform. Said differently, I view Netflix today as some combination of Xfinity TV and 21st Century Fox in a prior era (10-20 years ago). For that reasons, I think Netflix, as a global, scaled SVOD provider, is in a much better position – from a competitive and financial perspective – than the legacy content distributors were.
Conclusion
The issue for me, as has been the case with many of these high-flyers, is acquiring a minority interest in the business at a reasonable price. On Netflix, I think the equation comes down to three key variables: global subs, ARPU and operating margins. Given the results that the company is reporting today, I am confident in anticipating that, at scale, they will be able to achieve 25% operating margins (or higher). If you accept that assumption, here's what normalized per share operating income could look like for Netflix at different levels of ARPU and total subs.
Given the research I've done, I'm comfortable assuming that Netflix will ultimately reach 400 million to 600 million subscribers (which could potentially cover 2 billion individuals around the world), with an ARPU of $10 to $12 a month (with continued price increases offset by mix shift to lower ARPU regions and mobile plans). At those levels and with 25% operating margins, Netflix would generate normalized operating income of $25 per share to $50 per share.
Given that this is an estimate of where the business will be in 2025 or 2030 on a normalized basis, we need to discount it appropriately. Personally, as I think about the amount of time and risk associated with this outcome, I think it's reasonable to require a current multiple less than 10 times or so on those estimates. Simply put, while I recognize the fact that this is a growing business that may create significant value for shareholders over the long run, I also believe that one should use some caution when paying for results a decade into the future.
For those reasons, while I would consider owning Netflix, $500 per share is at the high end of what I'd consider reasonable. That said, if the stock declines by 25%, or if my thoughts on those key assumptions became more optimistic, that conclusion would change. Until then, I'll be patient.
Disclosure: None
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