Vertical Integration in Media: Netflix

The Queen’s Gambit

A month ago, Netflix’s new limited series “The Queen’s Gambit” took the world by storm. For chess enthusiasts like myself, the allure was the central role chess played in the film [Beth Harmon’s games were allusions to famous World Chess Championship matches, openings like the Sicilian were featured prominently, etc.] Although, I wasn’t quite clear what differentiated this show from the run-of-the-mill drama series for the non-enthusiast. After all, the Chess World Blitz Championships in 2019 brought in only a few thousand live viewers and Magnes Carlson – probably the greatest chess player to have ever lived – only has some ~360k followers on his Instagram [compared to 1m+ for celebrities in other fields]. All in all, it wasn’t an exceptional show from an objective standpoint, yet its release in October was the best thing to happen to chess in the last five years.

[If you are unfamiliar with Google Trends data, the “interest over time” is an indexed graph that tracks interest relative to historical interest. 50 represents an “average” interest, while 100 would represent the peak interest in a given time period. Breakout implies search growth of more than 5,000%.]

The Queen’s Gambit didn’t rise to prominence by its own merit; rather, it’s the most recent beneficiary of the “Virtuous Cycle” while virtually guarantees success of a film that Netflix chooses to promote. When a show is released, Netflix can feature it prominently on our screens and simultaneously send a push notification/email to 200m subscribers at no cost. When people start watching it, they tell their friends. They post it on Twitter. Then their friends buy a subscription just to watch the show and rarely unsubscribe. These shows become ice breakers and personality expressions. They enter the cultural zeitgeist, and Netflix suddenly transforms previously obscure topics [like chess] into pop culture.

Netflix the Consolidator

In the U.S., this role used to be relegated to a handful of media executives who ran the three biggest networks – CBS, NBC and ABC. These networks controlled what people watched every night. The invention of cable television in the 1950s upended the industry. Now, it was the cable operators – Charter, Dish, AT&T – who controlled flow into people’s homes. These operators paid affiliate fees to the networks to stream content to millions of customers’ homes. Today, the baton is being passed yet again to OTT [Over-the-Top] streaming providers like Netflix, who stream content through the Internet. At first look, there is nothing incredibly special about Netflix – it’s just another distribution platform. However, while in the past the two nodes of content delivery – programming and customer acquisition – were disjoint, Netflix seeks to disintermediate the cable operators. In essence, Netflix wants to produce AND distribute the content, something we haven’t seen in over 50 years. Previously, what made the cable operators so profitable was their access into customers’ homes [you can draw parallels to health insurers like UNH who control access of providers/drug manufacturers to millions of Americans]. Their monopoly-like position allowed them to levy exorbitant fees that benefitted both themselves and the networks who shared in these profits through affiliate agreements with cable companies. It follows that if Netflix can inherit some of these advantages plus some due to vertical integration, it stands to become a very profitable company.

Of course, the analogy between Netflix and cable operators isn’t exactly apt. What gave cable operators local monopolies was the debilitating cost of substitution. If Charter already services a local area, building a network on top of theirs required digging up roads and spending millions in capex for an uncertain ability to get customers to switch when all was said and done.

“It is extremely costly to build a cable network. It’s so expensive that it isn’t viable to build a network over someone else’s network, because you aren’t guaranteed those customers. For instance, back when I worked for Charter as a field auditor, there was a small cable company that was overbuilding us in certain locations. This was completely legal and while it was frowned upon by most cable companies, it wasn’t unheard of. This small company spent millions and millions overbuilding us, and was honestly offering a very competitive product, but they didn’t have the marketing skills or the trust from a brand name, so they couldn’t get enough customers to make that build viable. Last I heard Charter was positioning to buy them for pennies on the dollar.”

– Rob Hebert, Quora

In contrast, for an OTT service like Netflix, all you need is an internet connection. Netflix doesn’t own your distribution any more than Hulu or Amazon Video or Disney does, but it is much larger than any of these other companies, and this virtual network is difficult to replicate. Over time, this larger scale = ability to pay more to content providers = better service/platform/choice/etc. for customers = increases willingness to pay/grows subscriber base = ability to pay more to content providers. Netflix makes it very clear that this is what they’re going for.

Netflix the Distributor

Underlying this cycle is an efficient distribution model. As the Queen’s Gambit case demonstrates, Netflix can ensure success of many programs that aren’t necessarily “fit” for primetime television. First, compare the biggest hit shows on Netflix to the biggest box office movies:

Box office (Source):

  1. Avengers: Endgame
  2. Avatar
  3. Titanic
  4. Star Wars: The Force Awakens
  5. Avengers: Infinity War
  6. Jurassic World
  7. The Lion King
  8. The Avengers
  9. Furious 7
  10. Frozen II

Netflix (Source):

  1. Extraction – 99 million views
  2. Bird Box – 89 million views
  3. Spenser Confidential – 85 million views
  4. 6 Underground – 83 million views
  5. Murder Mystery – 83 million views
  6. The Witcher – 76 million views
  7. The Old Guard – 72 million views
  8. Money Heist (Season 4) – 65 million views
  9. Tiger King (Limited Series) – 64 million views
  10. The Irishman – 64 million views

Do you see the difference? Over the last five years or so, the only “successful” box office movies were superhero films, remastered classics or epics. Other genres like comedy and drama haven’t done so hot, but they’ve found a home in Netflix. Most would agree that “Murder Mystery” starring Adam Sandler and Jennifer Aniston wasn’t “Top 10” material, yet Netflix’s distribution ability allowed it to catapult its own production into the top 10 list. But this isn’t limited to Netflix original films. Recently you may have noticed the movie “The Impossible” starring Tom Holland showing up in your feed – this is a 2013 film that suddenly became the most watched movie on the platform after Netflix featured it.

This compares favorably with the “traditional” route. Once a studio produces a movie, it must embark on a strenuous marketing campaign involving trailers, interviews, etc. to get people to go to theatres and pay $10.99 a ticket, not to mention the huge box-office risk. In the Netflix scenario, the incremental marketing needed after production is minimal [mostly direct email], freeing up more capital to create better content. And of course, you have the traditional advantages in terms of content creation that Netflix regularly espouses [i.e. not confined to primetime slots, more varied content, binge-watching, etc.]

Take “Extraction” starring Chris Hemsworth as an example. The movie was watched by 99m households in its first month of release. It is unfair to compare this to box office records because a significant portion of this viewership wouldn’t pay, say, $10 to watch this in theatres, but if we assume 20% will have purchased a ticket, that comes out to $10 * ~20m people = $200m. Typically, anything above $100m would be considered a blockbuster showing. The budget? Only $65m, but Joe Russo, the director, mentioned that even this was higher than he would have gotten anywhere else.

“Extraction cost $65 million to make, and producer/screenwriter Joe Russo argues that’s around double the budget they’d have landed if it had released in theaters, and been funded elsewhere. ‘This is not a $100 million movie, or above. That’s the market that is getting squeezed right now, the one under that level.’”

Source

As someone on VIC put it, a studio that can churn out blockbuster films at little to no marketing would be pretty damn valuable.

Of course, this is Netflix’s most popular original film, but the point still stands: Netflix has a more robust distribution model than anything we’ve ever seen in the media industry. Most people levy arguments against this calculation, arguing [correctly] that Netflix viewership numbers on something perceived as a “free” edition to the platform cannot be compared to paying to see something in the theatre. This is a valid critique, but as this example shows, the Netflix model de-risks the content creation process, a sore point for marketers having to budget for uncertain successes… clearly this is worth something. As another example, take Breaking Bad, one of the most popular TV series. According to Vince Gilligan (the director), the show would have never made it on traditional television.

“I think Netflix kept us on the air. Not only are we standing up here (with the Emmy), I don’t think our show would have even lasted beyond season two. … It’s a new era in television, and we’ve been very fortunate to reap the benefits.”

– Vince Gilligan (Source)

Or Cobra Kai:

“Our content successes highlight our ability to tap into our global audience of nearly 200m members and underscore the notion that content is discovered on Netflix. This applies not only to Netflix originals, but also to second run programming, like Schitt’s Creek and earlier seasons of Lucifer, both of which are very popular with our members. The latest example is Cobra Kai (based on The Karate Kid films), which originally debuted on YouTube’s subscription service in May 2018 and recently launched on Netflix on August 28. In its first four weeks of release on Netflix, 50m member households chose to watch season one, dramatically expanding its audience.”

– NFLX Website

Indeed, this is a testament to an effective distribution model that allows Netflix to (1) commit to non-traditional types of content, (2) spend more on the best content by virtue of low incremental marketing spend, (3) economically produce its own content and (4) insert itself into the cultural zeitgeist. Combine this distribution platform with the other qualitative points NFLX bulls proliferate – better data on customers allows for more specialized content/recommendations [i.e. the Netflix algo as an advantage], content discovery more appealing on NFLX vs. other competitors [avg. time it takes to find something on NFLX < peers]; the ability to leverage content from one country to consumption in another [the quintessential example is La Casa De Papel [Money Heist]]; a more appealing user interface with no advertisements [vs. Hulu/Apple] – and you have yourself a very compelling qualitative thesis. These ancillary points – all true – obscure the true advantage of Netflix, though. The main point is that in a world where the TYPE and MODE of content is changing, Netflix is in a structurally advantaged position relative to incumbents when it comes to PRODUCING and DISTRIBUTING said content. The distribution prowess begets more production, and more production increases the distribution footprint – thus far, no company has come close to replicating this ecosystem. All of this can be done at a lower cost to competitors [or rather, a higher incremental margin as the same costs are spread across more subscribers].

“Since 2013, we’ve been at a scale where we can economically create original content for Netflix and our offering has improved as we grow further and gain greater confidence. With each original, we learn more about what our members want, about how to produce and promote effectively, and about the positive impact of originals on our brand.”

– NFLX 2019 10-K

Other companies [Amazon, Disney, etc.] are desperately trying to achieve a similar scale. Amazon gives Prime Video to Prime Members at no incremental cost. Disney prices its service at half of Netflix’s pricing. Additionally, companies are pouring billions into original content [most notably, Amazon]. Disney is ahead of the original content game by about a century, but it is a laggard on the DTC front. Most services, however, are fraught with issues and muddled value propositions. Amazon Prime Video, while a great service, has subscription offerings mixed with paid rentals/purchases that all but hampers a consumer’s confidence when they find out that they must pay an additional $4 to stream a title. Disney charged an extra $30 to watch Mulan on its platform. Moreover, Prime Video has a whopping 65,500+ titles, 66% of which are user generated which makes discovery incredibly difficult [Netflix has less shows than Amazon, but more high quality shows if we go by IMDB ratings].

“While the video service [Amazon Prime] is known for original movies and shows that have won Oscars and Emmys—such as ‘Manchester By the Sea’ and ‘Transparent’—the site also carries thousands of conspiracy-theory videos, amateur productions and short instructional clips. Similar to Alphabet Inc.’s YouTube, some videos are uploaded by individuals who made them or by others owning the rights to the content. Others Amazon bought in bulk as part of vast libraries of amateur content.”

WSJ

The Hulu + ESPN + + Disney + also spans a swath of different audiences, and it is unclear exactly how successful this bundling was. All this being said, Netflix must match [read: exceed] the content budgets of these well-capitalized companies. From a purely cost standpoint, though, it is hard to see how Netflix gets outcompeted on the content front. It can spread these content costs over 200m paid subscribers vs. ~70-80m [AMZN Prime Video/Disney], 30-40m [Apple/Hulu/HBO Max] and 20m [Peacock], although instead of spreading costs, it simply chooses to outspend its competitors by a wide margin.

[Note: based on these numbers and the total number of Netflix original titles [Source], we can tease out the 2018 and 2019 numbers on this graph. Netflix released 371 series/movies in 2019. This is up from 240 released in 2018. If we add to graph above, we have 540 in 2018 and 911 in 2019. As of November 9th, 2020 [time of this writing], Netflix has over 1,500 original titles, which implies 589 released in 2020. Once you consider a 1-2 year lag from content spending to when the content is added onto the platform, 2018/2019 clearly represent a period of exponential spending on content that will be released over the next several years.]

So yes, since 2017 Netflix has spent ~$45bn on new content and ~$8bn on marketing. Moreover, it has ~$16bn of contractual content obligations for the next 1-3 years alone. These are obviously huge numbers but insofar as they allow Netflix to continue exploiting its distribution advantage, this could be a huge positive for Netflix. Additionally, the riskiness of these productions is a lot lower relative to a traditional media company that doesn’t control the distribution of its productions [remember Cloud Kitchens]. I would argue this is the classic case of building one’s competitive advantage. <100m subscribers wasn’t enough distribution capabilities to economically produce content. At 200m subscribers, Netflix can produce content economically without eroding its competitive position. At 300m subscribers, Netflix can probably produce more content than anyone else at a significant margin. Already, Netflix produces more content that then entire entertainment industry produced in 2006 and 30% of new content this year will come from Netflix. And absent long-term irrational competition [a clear risk when you’re competing against Amazon], marketplaces businesses are typically winner-take-most systems. The big question mark, then, is whether this spending will translate into pricing power. Historically, Netflix has risen prices in its N.A. region by mid-to-high single digits every year. In Europe, the number is ~4-5%, LATAM is low-teens on a constant currency basis and APAC has remained stagnant. Pricing power is important because this is the primary driver of margin improvement. The incremental costs of raising subscriptions by $1 are virtually zero, so 80-100% of price hikes flow down to operating income. Indeed, as we will see in the valuation section, the key ingredient for the NFLX bull thesis to materialize is sustained price hikes on the order of 3-4% across all regions. The only way Netflix can sustain premium pricing vs. competitors like Disney who are offering streaming services at a fraction of the cost is if customers perceive Netflix as a differentiated service.

Perfect Substitutes? The Case of Competition

The creation of original content is and will continue to be a necessity for Netflix from a competitive standpoint. If we compare 2012 Netflix to the developed streaming players of today, the only point of differentiation is type of licensed content. In a world where content isn’t owned by the distributor and customer switching costs are low, the content creators can levy huge rents absent a competitive advantage in the distributors. In the case of OTT streaming services, this was obviously the case; unlike cable operators, the switching costs between Hulu and Amazon or Netflix and Apple aren’t that high. In fact, customers typically subscribe to a number of these services. This is probably not the best vertical to play in. Prior to Disney +, Netflix was paying Disney ~$150m/year on licensing. Netflix was also spending $90m to stream “Friends”. And prices for licensed content are only going up: after beating Netflix’s bid of $90m to keep “The Office”, NBC will be paying $500m over 5 years for exclusive rights to the show [albeit to a fully-owned subsidiary but the point still stands].

More importantly, exclusive licenses have short lives, often only a few years. As a result, content libraries of these platforms would continuously change, changing the value proposition calculus every year. In other words, a licensed world is essentially a commoditized world where subscribers will flock to whichever platform offers the best content in any given year. A business like this doesn’t have a sustainable path to raise ASP [Average Selling Price].

In this world, the owners of content win, not the OTT services. In this world the Netflix bull case is all but eviscerated: the best content will always get bid up = Netflix cannot buy differentiated content on a cost effective basis = sub growth will decline, pricing power erodes and ARPU remains stagnant = content purchasing ability trends to average. With low switching costs, subs will rise and fall in tandem with content spending every year. Content spending becomes a fixed percent of revenue expense rather than something that can be leveraged to generate substantial margins over time.

The only way out of this “reverse flywheel” is the production of original content. Why? If you can create a differentiated platform that isn’t easily substitutable with competitors, the subscriber base becomes stickier. If content never leaves the platform, the value proposition always follows an upward trajectory [i.e. owning the IP creates an “unamortizable asset” – see Disney]. Most importantly, content has a fixed cost, leading to huge margins on incremental subscribers. So, incumbent players with original content like Disney/HBO Max and the legacy media companies who are entering streaming [i.e. ESPN+] have a clear advantage over majority-licensed models like Hulu. Combine this with a first-mover advantage and Netflix is the only company that fits the bill.

The other view, of course, is that these are substitutes. Once the dust settles, customers will use one, maybe two, services, but will see them as interchangeable. That is, the culmination of the streaming battles will be an all-out price war between the 3-4 largest players, and they will forever be destined to operate at razor-thin margins.

I don’t think this is true.

It would be ludicrous to say that the same person watching “Frozen II” is watching “The Queens Gambit” or that these are even similar offerings. It would also be ludicrous to say cord-cutting households, after saving over $100 on cable, will confine themselves to one mid-teens purchase.

“An April 2019 survey conducted by Streaming Observer found that while around 60% of Netflix subscribers were unmoved by the prospect of Disney’s service, 12% were considering cancelling Netflix in favour of the new service and 2% were sure they would. A further 20% were planning on combining the services.”

Source

Inevitably, though, some must compromise for the sake of finances – if they use 5-6 services, one might need to go. Fortunately, Netflix is low on the list for the first one to go… 44% of people say its indispensable, which is very powerful. For people under 35, this number is 59%. In the U.K. Prime Video is apparently growing faster than Netflix. However, people aren’t switching from Netflix to Prime – they are buying Prime on top of Netflix. If you include the people who subscribe to Netflix as one of the services, this number has actually increased and the percent that sub only to Prime has halved over the last three years.

So, both logically and analytically, all of this points to a Netflix that isn’t necessarily a substitute [I prefer the logical approach: different content companies are not substitutes if they have different proprietary content, almost by definition]. It competes with some services [Amazon Prime Video, Hulu] more than others [Disney +], but it competes on more favorable terms [each $1 of costs spread out amongst more subs]. Moreover, Netflix has risen prices from ~$7.99 to ~$13.99 for its streaming service in the U.S. over the last 7 years – this doesn’t happen to commodity-like businesses.

Valuation

The bull argument justifying Netflix’s optically high valuation goes something like this. Today, we live in a market where every large tech company is fighting tooth and nail to create a differentiated product. Netflix is no different but is leagues ahead of all these competitors by virtue of it entering the streaming market before anyone else. TODAY, Netflix can spread the costs of creating a differentiated service [which will probably be on the order of a few hundred billion dollars] over a subscriber base 3x larger than its nearest competitor. And while the U.S. has well-capitalized competitors, Netflix is virtually unchallenged in the international sphere. Disney+ has almost no international presence and Amazon Prime only recently began expanding in Western Europe. If and when these companies break the international barrier, Netflix will enjoy similar advantages it exploits in the U.S. due to it being a first-mover. Add this to a better UI + more data on customers [i.e. a “de-risked” production model] + a brand name + a culture of innovation/disruption and NFLX will probably come out on top in most markets. As the platform becomes more differentiated, existing customers will be willing to pay more – this increasing ARPU flows straight down to operating income. In a “steady-state” scenario, NFLX enjoys margins in line with leading marketplace businesses [i.e. about ~50%] while still outcompeting new entrants on content. Today, Netflix generates an operating income of ~$4.5bn on revenues of ~$25bn [mgmts. 2020 forecast]. If pricing increases by 3% and we assume an incremental margin of 80% [which is probably low], operating income increases by ~$750m [$25bn*3%], or 16.7%. If there is a long runway for pricing increases [say 30-40% above today’s prices?] and a potential subscriber TAM of ~500m households internationally [895m households worldwide ex China * 75m penetrated in U.S./140m total U.S. households assuming saturation], then this is a company that can grow earnings by ~20% for over a decade. If this “steady-state” occurs in 10 years, we have an annual return of ~11.4% assuming an exit multiple of 15x.

To support this very bullish argument, look no further than the fact that Netflix still has ways to go in penetrating international markets.

High population countries like India have even lower penetration rates. A very credible argument can be made that as the worldwide shift from pay-TV to streaming services continues, countries become wealthier/disposable incomes rise and people have more downtime, Netflix subscriber growth will continue to be buoyed.

Is all this possible? Absolutely. Likely? Uncertain.

That’s the bull argument, but what about the bear? Few can argue against the structural tailwinds for subscriber growth, but pricing and margin could go either way. While Netflix will continue to grow, it won’t have the power to increase its price as much as bulls are expecting. The streaming wars are a race to the bottom. All these companies are on a content treadmill, and the price of licensing content is unlikely to subside anytime soon. Any attempt by Netflix to raise prices will be met by an exodus of subscribers who will flock to another platform with similar content. As a result, Netflix will never enjoy these high incremental margins and steady-state margins won’t be anywhere near 50%. We can point to Netflix subscriber numbers in the U.S. growing more slowly than competitors [albeit from a larger base] and entrants like Amazon growing exponentially in select international markets [i.e. the U.K.]. New entrants like Disney with a swath of original content provide better niche/differentiated services at a lower cost. There is already evidence of loss-making companies willing to compete on price, evidenced again by Disney’s monthly ARPU/mo which is ~50% that of Netflix’s and Amazon giving away Video for free to existing Prime members. Giants like Apple and Amazon will continue to dedicate larger budgets towards perfecting their algorithms and offering more content. Subscriber growth will eventually hit a peak, and the industry will devolve into a fixed-pie, commodity-like business. This peak is likely to occur at less than 500m subs. Given that some international markets still primarily rely on cable television [i.e. Latin America] and other countries have low purchasing power [i.e. India], it is hard to make the argument that the worldwide OTT SVOD penetration rate will be similar to that of the U.S. Sure, Netflix might continue to be the leader but in an industry that wasn’t nearly as attractive as everyone thought. Doing the same calculation above with 500m households, but assuming pricing does not change [and therefore margin remains at ~20%], our steady-state operating income drops to $12.5bn, hardly enough to justify today’s valuation.

As this point, I usually say “the truth is somewhere in the middle”, but I don’t think that’s the case here. This is a binary outcome: either Netflix becomes this high ROI distribution machine or to competes forever in a low margin commodity business. So far, it looks like the former is more likely, although it is too early to say for certain. For one, Netflix has been consistent in communicating that it expects some ~300bps of margin improvement every year. While the company started originals in 2013, it didn’t affect revenue numbers until 2017. In 2017, margins were 7%; today, they are 18%. Management expects to hit a 19% margin in 2021. Of course, this could be chalked up to changes in content accounting, but I will note that content amortization/content spending is surprisingly resilient and original content results in greater discrepancies between cash/amortization relative to licensed content. Anyways, we see a similar showing in FCF: -17% margin in 2017 and a ~-15.5% in 2019. Of course, 250bps less negative is nothing to get excited for, but this occurred in the largest years of Netflix’s original programming push. In 2020, NFLX will generate $2bn of FCF [~$1.2bn in Q2 alone], although this is tricky to evaluate. Management is quick to say this gives us a “glimpse” into what the steady-state will look like, but it is easy to show high FCF margins in one year – whether NFLX can maintain this WHILE maintaining is competitive positioning is an entirely different matter. Nonetheless, management says 2019 was the year of “peak negative free cash flow” and its uphill from here: 2021 forecast of -$1bn to breakeven. On the operating side, ARPU/month in the U.S. has grown from $9.97 in 2017 to $13.40 today [annual CAGR of 7.7%], in EMEA from $9.17 to $10.88 [4.3% CAGR], in APAC from $8.09 to $7.27 [>10% CAGR in constant currency] and $9.11 to $9.20 [~2% constant currency]. The most surprising thing about the Netflix story was its ability to generate ARPUs in other countries that rival those of the U.S. In other words, people in other countries are willing to pay the same amount as Americans to watch Netflix, indicating that that either the value proposition of Netflix is really high or the U.S. service is priced far below people’s willingness-to-pay… or both. Notwithstanding the Asian market [which is depressed due to a low disposable income and initiative’s like the $4 subscription in India], there is also pricing growth in each region which is driving margin improvement. As a whole, the international business has been profitable from a contribution margin perspective since 2017.

What does this all mean? We WILL see leverage in the business model, no question about that. Whether this will lead to 50% steady-state margins is up in the air, but Netflix has shown that it can both thwart competition and earn attractive returns on content spend. The latter should increase as subscribers grow. Speaking of which, how does sub growth look like over the next five years? Of course, this is dependent on marketing and content spend, but we can say that the U.S. is saturated. Management’s goal is 60-90m subs in the U.S. compared to 73m today [including Canada]. We can reasonably assume this levels off at 80m. Internationally, EMEA is growing at ~30%, LATAM at ~20% and APAC at ~35%. If we assume these growth rates halve for the next five years, international subs hit ~235m. Other estimates have Netflix hitting high 200s/300m total subs within the next five years, so I feel this to be reasonable. At today’s ARPU/month of $10.40, this generates ~$39bn in revenue [(235m intl. + 80m U.S.)*$10.40/mo*12mo = $39bn]. At today’s margin of ~20%, this is $7.9bn in operating income. On top of this, we can overlay a 3% annual price hike. Over five years, this increases the price from $10.40 to $12.06/month [$10.40*(1.03)^5 = $12.06]. If we assume this $1.66 increase in revenue/month/sub is 80% incremental, then our incremental operating income on 315m subs is ~$5bn. Overall operating income comes out to ~$13bn, which is  28.5% of total revenue of $45.6bn in 2025. This is less than a 300bps annual operating margin improvement starting from 19% in 2021. Moreover, an 80% incremental margin on price hikes seems too low – there is no reason to believe why there should be any incremental cost on price hikes as long as they don’t lead to significant churn. However, my revenue assumptions might be a little aggressive [some estimates are as low as 264m subs by 2025]. Overall, I feel directionally correct.

Of course, if Netflix could achieve this + become FCF positive, then there is no reason to believe it can’t go from a 30% margin to a 40% margin. At that point, the ceiling is the WTP of customers – people have thrown out $40/month as a reasonable steady-state number. It is impossible to say for certain, but directionally we can agree that pricing power will exist in this scenario. Suffice to say this should garner an above-average multiple, say 25x or 30x earnings which is what larger, slower growing, high margin tech companies like Google/Facebook trade at [I understand NFLX is a media company, not a tech company, but an internet-enabled monopolist with high steady-state margins and runway for growth will trade like a tech company]. Applying a 25x multiple on 2025 earnings of $13bn gives us $325bn in enterprise value, or ~$318bn on a equity basis [~$7bn in net debt], or an ~8.4% annual return. This is a best-case scenario, of course. In the worst-case scenario, the company still grows subs substantially [say ~5m/quarter] and reaches ~280m subs. Margin improves to 25% due to spreading out content costs over a larger bases, but this represents the steady-state margin. Pricing growth is only 1% instead of 3%. In other words, the bear case essentially plays out: no pricing power, structurally low margins and smaller subscriber cap. In this scenario, operating income is $9.2bn [280m subs*$10.93/mo*12 months*25% margin = $9.2bn]. Multiple in this scenario is average. If we assume a 20x multiple, this becomes a $177bn business on an equity basis, representing a NEGATIVE 3.6% annual return.

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