Netflix: A Valuation Discussion

What do we have to believe to think NFLX is fairly priced at $435? What future would make it cheap? Or really, really cheap?

In this valuation oriented Netflix post, I’ll discuss a few things:

1. Netflix’s long-term subscriber and average revenue per member

2. Why it is hard for management to keep operating margins down

3. Why Netflix’s long-term margins are higher than most are willing to assume

4. The recent acceleration of share repurchases and how much of the company management might be able to retire if the stock remains flat

5. A long-term scenario analysis in with five different outcomes plus a Priced In scenario—a reverse DCF—and corresponding valuations of the business based on those scenarios (a PDF with screenshots for IE subs; the downloadable Excel model for IE with Models subs)

6. A discussion of why this opportunity exists

Revenue

When I think about Netflix’s revenue potential, I think about the long-term opportunity to penetrate into more global broadband households. There are an estimated 1.6-1.7 billion households ex-China and ex-Russia (“ex-C&R”) and 600-650 million are thought to be broadband households today. That’s a broadband penetration rate close to 40%.

I assume the number of households grows at the long-term population growth rate of about 0.9%. So that gets the ex-C&R figure to almost 2.0 billion by 2042. I assume the global broadband penetration rate gets to the mid-80%s by then (99% in UCAN and 85% elsewhere; if you have a meaningfully different view on this, please let me know). So that would suggest almost 1.7 billion broadband households. Again, that compares to 600-650 million today, of which Netflix is being watched in something like 300-350 million homes, of which 247 million are currently paying. I also assume there is no meaningful difference between broadband homes and connected TV homes by then.

So big picture, Netflix’s household TAM is going to grow a lot over time. And what are these broadband households going to be watching on their TVs or iPads or headsets or 3D hologram projection glasses or whatever else? It’s not going to be linear TV, which won’t exist. It’s going to be streaming. And which company has the overwhelming scale advantage that positions it strongly to be the #1 streaming service in every market around the world ex-C&R? I don’t need to answer that. Netflix is already #1 around the world and its competitive position is only getting stronger, which I discussed in my last Netflix post.

So what percentage of broadband households is Netflix going to be in in 20 years? All we can do is estimate but one data point is pay-TV penetrated 80% of U.S. households at its peak. In my Base case, I assume UCAN goes from about 62% broadband household penetration today to 70% over that period. EMEA goes from 39% to 45%, LATAM goes from 41% to 50%, and APAC goes from 25% to 42%. That means that globally Netflix goes from 40% to 47% of global broadband households. With those assumptions, Netflix would have 790 million paid subscribers in 20 years, up from 247 million today.

The world is a big place. Tripling the subscriber base over time seems like a ton of growth, but I still don’t have a great answer for what the other 53% of broadband households ex-C&R will be streaming. For one thing, price is unlikely to remain an inhibiting factor. The lower cost advertising tier broadens Netflix to appeal to all demographics (yet still monetizes as well or better than Netflix’s Standard tier in the U.S.) and increasingly contributes to that. Further, there is potential for a free-ad supported offering. Management did not deny that is being considered when asked recently. And we all know services like Facebook and YouTube—popular, free ad-supported services— have close to 3 billion global monthly active users each. I can’t say Netflix could not approach similar levels over time after a free ad-supported option is available and flourishing. So while I stop at 47% broadband household penetration in my Base case looking out 20 years, I’m not quite sure why.

As for average revenue per member, Netflix is at $11.70 per month globally today. In my Base case, I have that getting up to $21.31 by 2042, which is a 3.1% CAGR. That is arguably no higher than inflation will be over this period. It’s also a downshift from the 3.9% annual pace since 2017. Certainly, this assumption is not aggressive.

Together, these subscriber and ARM assumptions would suggest Netflix will have just about $200 billion of streaming revenue in 20 years, up from about $34 billion this year.

Margins

Given Netflix’s largely fixed cost operating model, I think it is hard for management to keep operating margins down. Consider this exhibit from the letter:

Despite massive increases in content spending, operating margins still marched higher year-after-year (until last year when the growth temporarily ran into a wall). This long-term margin expansion trend resumed this year and should end the year up 220 bps to 20%. That’s largely due to the fixed cost nature of its content deals, the temporary plateau in content amortization due to the writer’s strike, and the accelerating revenue growth thanks largely to paid sharing and the ad tier. And the margin expansion train should continue next year. Management guided to another 200-300 bps of expansion to 22%-23% next year, barring any wild swings in foreign exchange rates. Consider that this is happening despite meaningful investments in gaming—operating four acquired studios and at least two internally created ones—a live experiences offering, and building out advanced advertising capabilities. Operating margins would be…

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