When a Netflix earnings report comes out, it generates lots of news. Usually, though, they don’t claim the top spot in my most important story of the week, because not much really changes.
This week, though, Netflix did make some news. So let’s make it…
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Most Important Story of the Week – Netflix Is Forecasting They Will Break Even in 2021
Sometimes, usually even, the coverage of a Netflix earning’s report focuses around the wrong thing. For most years, that meant subscriber counts, regardless of what else happened in their financial statements. Not this week!
On Tuesday of this week as Netflix released their 2020 performance, most coverage correctly focused on this announcement from Netflix:
If Netflix can truly achieve a breakeven year for the first time since 2011, that is a big deal. I’ve long looked past subscriber counts to obsessively focus on cash flow. That’s why this is big cash flow news from Netflix.
However, even if most reporters got the most important story right, they missed a lot of the nuance and flavor around how important this story is. For example, look at CNBC’s last bullet point. Does one year of positive cash flow validate Netflix’s strategy?
This is where I need to step in. While turning cash flow positive is clearly a positive sign for the world’s biggest streamer, frankly this one announcement doesn’t validate Netflix’s entire strategy. Instead, what happens in the next 5-10 year period will be crucial.
The Two Strategic Decisions (Investments) Made by Netflix in 2007-2015
Yes, we have to go back to 2007 to explain this history of Netflix. Back then, Netflix shipped DVDs through the mail to customers. And they made a lot of money doing it! Specifically, in 2008, they generated $94 million in cash. (Technically free cash flow. We’ll be using that instead of profit since free cash flow is really the driver of modern finance.)
Reed Hastings rightly forecast that DVDs were a transitory medium. Someday, they’d be replaced by digital transmission. Instead of letting his company be disrupted as he disrupted Blockbuster, he’d run the company that would digitally transmit those shows and films. In 2007, Netflix launched streaming video in the United States. And the rest, as they say, is history.
Well, not quite. Reed Hastings made the decision to pivot correctly. But he had another decision to make. And the second decision Reed Hastings made wasn’t just to launch a streaming company, but to launch one that was financed through losing money. Lots of money. Billions of dollars. You can see this in the history of streaming. From 2007-2011, Netflix isn’t making tons of money, but they’re also not losing money. Then, from 2012 on…
What I love about this look is that it shows that Netflix really did have a choice to make in 2011. They could have continued as a streamer growing cash flow slowly year after year…or they could spend billions on content. They opted to do the latter.
Losing money in and of itself is not a bad decision. In fact, executives make this decision all the time. When a company builds a new factory, that can cost billions of dollars and years to do. The company, though, makes that investment assuming that long term the additional revenue which flows to the cash flow will pay for that investment.
(Want to know why pharma companies aren’t making more vaccine doses? Well, it’s because they don’t want to pay to build the factories that may only produce a vaccine for a year or two. That won’t pay for itself! And why the government can/should pay them to build those factories.)
This is called evaluating the “Net Present Value” of investments. This is how all business investments are (or should be) judged. Which is often called “capital budgeting”. This can be about spending dollars on infrastructure, research, new products or what not.
The core of the second decision Hastings (and Sarandos) made (and kept making from say 2015 to 2019) was how much to spend on their streaming disruption. The question was, “How much do we need to invest in this service to succeed?” And their answer was billions. Because every time they added subscribers their stock went up.
In essence, if Netflix does breakeven in 2021 (or for a full-year in 2022), it presents a turning point. This is the year that “investing” is over. They’ve stopped spending cash and now they can start to collect the future cash flows. To continue the factory analogy, the factory is built and ready to churn out widgets. In investment terms, the question is…
Was losing $9.7 Billion from 2011-2020 to launch a global streamer worth it?
Well, it depends on what “worth it” means.
How Much Does Netflix Need to Make Going Forward to Justify This Investment?
Be careful at immediately saying, “Well, 9.7 billion.”
Because of the time value of money.
(Quick reminder of the time value of money:
I’ve explained the time value of money, and it can be tricky. Basically, the idea is that a dollar today is worth more than a dollar tomorrow. Because of the certainty you have the dollar in hand. Further, you can invest that dollar and generate a return. This is the basic principle of finance.
The next most basic principle of finance is that different investments have different levels of risk. If you take a dollar and put it under your mattress, you don’t get any return on investment, but you’re certain it will be there a year. If you invest it with the government, you’re still fairly certain they’ll pay you back, so you demand less of a return on your investment. That’s usually called the “risk free rate of return”. Investing with a risky start up is much more uncertain, so investors demand high levels of return. The S&P 500 is a good benchmark for the entire stock market, which is fairly reliable but can also have big swings, as we just saw in March of 2020, when it dropped 30%.)
For entertainment, I tend to use 8% because it is a nice round number and close enough for our work. Now that we know we have to take losses into account, you can see what it really cost Netflix when they invested all those billions in content (in millions):
I’m providing you four looks at this. First, I’m giving you both the cost of capital from today’s dollars, to see how much Netflix spent of shareholder dollars the last 8 or so years. But I’m also giving the 2011 dollars to show how Reed Hastings could have been thinking about it in 2011. Also, I accounted for potential cash flow Netflix could have earned at a conservative 200 million per year. By losing money, they lost that potential cash as well.
Netflix actually needs to earn $14 billion to justify the sky high investment of the last eight years.
The trouble is that discounting continues into the future. I just said that a dollar next year isn’t worth as much as a dollar this year. That’s even more applicable in 2030, for example. A dollar in 2030 is only worth 21% of a dollar in 2021. Here’s that rough math for those who don’t want to calculate it:
Without getting too finance-y with terminal values and what not, let’s say the reasonable goal is to pay back the investment in streaming by 2030. With the discounted cash flow, what would their potential cash flow need to look like by 2030?
This is why I said breaking even is only the first step. To pay back their investment–and the longer you wait to pay it back, the higher the returns need to be–Netflix needs to add $500 million per year to the free cash flow, getting to $4.5 billion by 2030.
Is that reasonable? Sure. But it’s also reasonable that Netflix could flirt with breaking even for a few years into 2022, and find that as wealthier markets are mostly tapped, new customers cost more to acquire and churn faster. In other words, streaming could be a low margin business when it comes to cash flow. If streaming is like traditional entertainment, this is reasonable.
Or you could listen to the market, who is projecting that Netflix will achieve $11 billion in FCF in 2026, five years away. In that case, Netflix is a cash flow machine.
Here are those three scenarios over time:
In other words, using some very reasonable situations, we don’t know if Netflix has validated their strategy. What we can say is that Netflix spent a lot of money for years, and now they need to make a lot in the future to justify that investment. I mean, even our breakeven scenario demands a free cash flow growth rate of 137%! That’s a lot! And assumes they get to $500 million free cash flow in 2022.
But EntStrategyGuy, the Stock Price!
The other big caveat to my entire analysis is, “Well, if you had invested in the stock in 2011, look at the huge boom in price!”
This I cannot argue with. Though, I don’t provide investing advice. While the stock price is correlated with a company’s core fundamentals, they often move in discreet ways. And sometimes the market can have exuberance that doesn’t bear on reality.
Take Netflix’s free cash flow. I just told you the market believes in 2026 Netflix will generate $11 billion in free cash flow. How can I argue against that? Well, let’s see how well the market did in 2015 predicting 2019’s free cash flow…
Or take 2021…
That’s right: in 2014, most analysts on Wall Street expected Netflix to earn $4 billion in free cash flow in 2021, a year Netflix is predicting they will break even. Then they kept making that mistake year after year, pushing out cash flow positivity always out another year. Until a pandemic hit. Let that sink in.
Wall Street is terrible at forecasting this company.
The best analysis of this situation–and there are a few good Netflix bull analysts out there–came this week Andrew Freedman at Hedgeye, and his financial table laying out the Netflix options put this in great context:
(Sign up for his website here! He also helped me pull some of the data above.)
In other words, to justify the current Netflix stock price, their growth will need to achieve nearly 500 million subscribers at ever growing revenue per user. (Freedman uses EBITDA as a proxy for FCF, which gets to the same place.) The point is Netflix needs to hit nearly all their aggressive targets and even then the stock is only slightly higher than its current value.
The Key Question: How long does break even last?
To bring this back to the core point, in a way you could ignore all the spending of Netflix so far. Instead, just look at them as a company with $8 billion in cash, $15 billion in debt, 200 million global users, and zero cash flow in 2021.
Would you invest in that company?
The answer depends on the fundamental questions for every company: How much will they make? And how fast will that grow?
If Netflix continues breaking even through 2022 and finds that profit margins are as tight as they’ve always been in entertainment, then the growth answer is “not much”. If the growth estimates match Wall Street estimates, then the sky’s the limit. The answer is somewhere in between.
So yes, this news is big. But the game is not over. Breaking even was step one. Step two, three and four are to sustain and grow that even more. We’ll see if Netflix can do it. And the debate is very well alive to see if they can.
One Other Big Point: Did 2021 Show That Netflix Was Spending Too Much on Content?
The other fascinating question is “What drove cash flow positivity?”
The bull case is that Netflix fundamentals drove this reality. They invested in tons of content, and all the subscriber growth justified it. Indeed, that’s a headline I saw repeated in countless articles and many entertainment newsletters.
The bear case is “covid-19”.
Reality is somewhere in between. But it’s worth figuring out where exactly. Did Netflix achieve positive growth because of the huge Covid-19 acceleration in subscribers? Partially. Did their investment in tons of content drive that? Surely.
But did Netflix achieve positive growth, almost by accident, because they paused all global productions? Probably! Indeed, in Q4 Netflix said they were back to full-production on their shows, and not surprisingly they were cash flow negative again. The link seems fairly clear: when Netflix spends at their current level on content, they lose money.
How do we prove it one way or the other? We can’t, but I will point to this fun thought experiment. On the earnings call after the Q4 results were released, Netflix said that they won’t even bother forecasting subscribers in 2021. They said it’s much too difficult, and only forecast adding 6 million subscribers in Q1.
Yet, they forecast they will break even in 2021.
This begs the question, “Huh?”
All finance boils down to this: money you make and money you spend. If Netflix has said they can’t reliably forecast how much money they will make, how can they confidently know they will break even in 2021?
Because of what Netflix can control. Costs. Which means content costs. If Netflix is forecasting breakeven in 2021, but they have no idea how many subscribers they’ll grow by, they’re basically saying they’ll ensure they get there by right-sizing content costs to breakeven. Meaning they’ll cut costs if they need to breakeven.
The implications of this are, in fact, the exact opposite of every smart pundit saying Netflix has justified it’s content spend. If anything, 2021 showed Netflix–almost by accident!–that they were much too aggressive on making original content. Sans Coronavirus, likely Netflix loses $2 billion again in 2020, then tries to lower that in 2021 to break even. Covid-19 changed all that.
This ties to the strategic point above. Yes, Hastings and Sarandos built a global powerhouse. Did they need to lose $14 billion to do it? Maybe not.