Netflix: Redefining Entertainment
A deep dive into the world's leading entertainment company, from movies to series to games and live events
Hi, fellow investors!
Welcome back to another deep dive on a wonderful company. This time, we’re analyzing Netflix, the biggest streaming service company in the world.
Netflix, the streaming service giant we all know and love. With more than 277 million subscribers and a vast library of entertainment, including movies, TV series, and games, the company is a clear market leader in its industry. Netflix generated more than $5 billion in earnings on over $33 billion of revenue in 2023. But how did Netflix reach its current position, and is Netflix a good investment today?
Table of Contents
1. History
1.1 Marc, Reed, and DVDs
1.2 David and Goliath
1.3 From DVD to Streaming
2. Contemporary Business
2.1 Netflix’s Business Model
2.2 The Essential Numbers
2.3 A Streaming Service’s Moat
2.4 Leap into the Future
3. Management
3.1 Greg Peters and Ted Sarandos
3.2 Ownership and Compensation
3.2 Capital Allocation
4. Conclusion
1. History and Culture
1.1 Marc, Reed, and DVDs
Netflix was founded in 1997 by Silicon Valley entrepreneurs Marc Randolph and Reed Hastings. At the time, Hastings was leading Pure Atria, a software development tools company, which had recently acquired Integrity QA, a start-up co-founded by Randolph. After the acquisition, Hastings appointed Randolph as vice president of corporate marketing, and they began carpooling to work, taking turns driving.
With Pure Atria preparing for a merger that would leave both Hastings and Randolph without jobs, Randolph began thinking about ideas for a new business. As the two drove to work each day, Randolph pitched various concepts to Hastings to gain feedback and to convince Hastings to join as advisor or investor. Randolph’s initial ideas varied from customized baseball bats to personalized shampoo by mail and dog food tailored to individual dogs. Hastings tactfully denied each idea, citing their flaws.
Finally, Randolph proposed selling videotapes online, an idea inspired by Amazon. Hastings saw potential in the scalability and repeat purchase appeal of videotapes compared to personalized goods. However, the idea faced practical challenges: videotapes were bulky, prone to damage during shipping, and expensive, making it hard to build a substantial inventory.
But the idea gained traction when the then-nascent technology of DVDs emerged. Although DVDs were still in their early stages and primarily popular in Japan in 1997, they were lighter, smaller, and cheaper than videotapes, making them ideal for shipping. To test the idea, Randolph and Hastings mailed a CD (DVDs were still difficult to find) in a simple envelop from the local post office to Hastings’ home. The CD arrived undamaged, validating their idea.
Hastings became Netflix’s angel investor, and Randolph its first CEO. Netflix, at its launch in April 1998 as NetFlix.com, boasted an inventory of only 925 films. There weren’t any more DVDs available. The advantage was that Netflix could claim their library held every DVD title, but the obvious disadvantage was that it was still a small library. Netflix’s launch was a success, or rather a disaster, depending on your point of view. The company’s servers crashed due to high traffic. Despite early challenges, the startup quickly resolved issues and began to grow.
Two important events occurred in 1999. First, Netflix introduced a monthly subscription model, allowing customers to rent four DVDs at a time for $15.99 a month. The model proved successful and by February 2000, Netflix had completely transitioned from à la carte rentals to a subscription-only service. Second, Hastings took over as CEO from Randolph, believing Randolph lacked the skills to advance the company. Randolph stepped back but remained in a leadership role until he left the company in 2003 on friendly terms. Hastings went on to lead Netflix as CEO until 2023.
1.2 David and Goliath
In 2000, during the collapse of the dot-com bubble, Netflix was suffering significant losses. Due to the collapse of the stock market and overall pessimism, especially for companies that ended with ‘.com’, it was impossible to find new investors to raise further capital. To save the company, Hastings and Randolph offered their company to former DVD rental chain Blockbuster for $50 million. With over 9,000 stores at its peak, Blockbuster overshadowed Netflix in size and revenue. Instead of taking the golden opportunity, Blockbuster dismissed the offer as a joke and rudely declined.
This rejection fueled Hastings and Randolph’s determination to defeat Blockbuster. But the company still faced financial difficulties, prompting them to lay off one-third of their 120 employees. Surprisingly, this resulted in a more efficient, better-operating Netflix, as the layoffs removed the least talented employees, leaving behind only the best. Hastings would later refer to this as ‘talent density’.
After the chaos of the dot-com bubble and the 9/11 attacks subsided, Netflix went public in 2002 under the ticker symbol NFLX, with an offering of 5.5 million shares at $15 each. From 2003 onwards, Netflix became increasingly profitable.
In response to Netflix’s success, Blockbuster introduced its own online DVD rental service. While trailing Netflix’s subscriber count, Blockbuster still hurt Netflix by taking away customers. The popular story of Netflix bankrupting Blockbuster, however great it sounds, is false. Netflix was fortunate that Blockbuster carried significant debt and faced internal issues. By 2005, activist investor Carl Icahn had acquired nearly a 10% stake in Blockbuster, securing three seats on the board. Icahn opposed the unprofitable online segment of Blockbuster that competed with Netflix, favoring short-term profits. A dispute between Icahn and CEO John Antioco in 2006 led to Antioco’s departure in 2007. Blockbuster’s internal problems and debt forced the company to file for bankruptcy in 2010.
While the story of David and Goliath is compelling, it doesn’t fully capture what happened between Netflix and Blockbuster. Yes, Netflix was becoming a prominent competitor, but Blockbuster could have maintained its market-leading position with better execution.
1.3 From DVD to Streaming
Netflix introduced its online streaming service in 2007, initially allowing customers to stream movies for a limited amount of time each month. The most popular subscription at the time offered 18 hours of online viewing a month, with just 1,000 titles available for streaming compared to over 70,000 in the DVD inventory. Another limitation was that streaming was only available on computers. Nevertheless, this marked the first step towards Netflix becoming the company it is today.
In the following years, Netflix’s streaming service steadily improved. The viewing limit was removed due to increased competition, more titles were added, and faster internet speeds made streaming more accessible. Netflix gradually expanded to more devices, allowing users to stream directly on their televisions. As Netflix thrived, Blockbuster edged closer to bankruptcy.
By 2009, streaming had overtaken DVD rentals in popularity, a development that would continue indefinitely. Surprisingly, Netflix continued its DVD mailing segment until 2023, sending out its final red envelope on September 29 of that year.
In 2013, Netflix launched House of Cards, its first original show. This was a risky and costly bet, but its success demonstrated that creating original content was an effective way to stand out from competition. Netflix would never stop making original content, with hits like Stranger Things, Orange is the New Black, Squid Game, and Narcos.
Streaming became the dominant entertainment medium, and Netflix secured the largest share of the market.
2. Contemporary Business
2.1 Netflix’s Business Model
Netflix provides its customers with a vast library of on-demand entertainment, including movies, TV shows, and games. For a monthly fee, users gain unlimited access to Netflix’s entire library. This subscription model generates recurring and predictable revenue. Additionally, Netflix has recently introduced an ad-supported tier, offering a cheaper subscription plan that includes advertisements, diversifying its revenue streams.
Netflix’s business model is highly scalable, as adding a new subscriber incurs minimal costs. This means that revenue from each additional customer largely translates to profit. The company’s scalability is reflected in its rising operating margin.
The majority of Netflix’s expenses stem from additions to content assets, which includes licensing, purchasing, or producing new content.
Another key element of Netflix’s business model is its data-driven approach to personalizing user experiences. By leveraging algorithms to recommend content, Netflix enhances user engagement and satisfaction.
2.2 The Essential Numbers
To qualify as a high-quality stock, a company should have:
Consistent and sustainable revenue growth.
High free cash flow generation.
High and consistent returns on invested capital (ROIC).
A strong balance sheet.
Revenue growth is the main driver of higher profits, making it a key aspect of any investment case. Without revenue growth, any company’s profitability is limited. Besides, failing to grow revenue while competitors do grow results in a lower market share.
Netflix’s 5-year compound annual revenue growth rate is 16%.
Although Netflix has experienced high growth, it has been slowing. 3-year compound annual revenue growth rate is 10%, but revenue increased by less than 7% in both 2022 and 2023. The positive news is that revenue is reaccelerating in 2024, with revenue reaching nearly $19 billion in the first half of the year—a 16% increase over the same period in 2023.
The question remains whether Netflix’s growth is sustainable, especially considering its already large scale. This will be discussed further shortly.
High free cash flow generation is crucial to any investment, as free cash flow provides the actual cash that management can use to reinvest in the business, pay dividends, repurchase shares, and more. High and consistent (future) cash flow is key for a stock to become an attractive option for the high-quality investor.
Netflix has struggled with consistent free cash flow, which has been notably more volatile compared to net income. However, free cash flow surged to nearly $7 billion in 2023, and the run-rate for 2024 amounts to around $6.7 billion free cash flow.
The inconsistency in free cash flow can be largely attributed to Netflix’s content spending (additions to content assets) and the amortization of its existing content assets. Unlike typical intangible assets such as software or intellectual property, Netflix’s content is amortized over just a few years on an accelerated basis. This method is logical: when a new movie or TV show is released, most subscribers watch it within the first weeks or months. After that, the content’s value diminishes as viewers seek new content.
That’s why, in 2023, Netflix amortized $14.2 billion in content assets while spending $12.5 billion on additions to content assets. (Netflix had planned to spend more, but the writer’s strike significantly hindered content production.)
In the coming years, Netflix plans to keep its content spending at around $17 billion annually. As net income rises and content amortization remains steady or increases—reflecting higher spending on new content—free cash flow should grow more consistently.
Next, a company must achieve a high and consistent ROIC before the high-quality investor even considers investing in it. ROIC is a critical aspect of a company’s fundamentals, as it indicates the efficiency with which a company generates profits from its capital. Generally, the cost of capital ranges from 6-12%, so I focus on companies with an ROIC above 15% to ensure value creation.
Netflix’s ROIC is currently high enough to be value creative, but I see room for further growth. A large portion of Netflix’s invested capital is tied up in content assets, and with content spending expected to remain relatively flat in the coming years, invested capital shouldn’t increase too rapidly. For Netflix to improve its ROIC, it would need to continue growing revenue and exercise operating leverage to further improve its operating margin. I believe this is achievable.
Some napkin math:
For 2024, Netflix is guiding for a 26% operating margin and revenue of around $38.8 billion. Assuming an effective tax rate of 15%, similar to historic rates, this would result in a net operating profit after taxes of around $8.6 billion. With invested capital remaining stable, this translates to an estimated ROIC of roughly 25% for 2024. That’s very solid and a good improvement on historic ROIC.
Such calculations shouldn’t be taken too seriously, but it is food for thought.
Finally, a company must have a strong balance sheet before the high-quality investor considers investing in it. As of the most recent quarter, Netflix carries more than $6.6 billion in cash and equivalents, against nearly $14 billion in total debt, of which $1.8 billion is short-term. This leaves them with a net debt position of $7.4 billion. Given that Netflix generated $6.9 billion free cash flow in 2023, I view the debt as healthy and manageable. Moreover, Netflix’s interest cover ratio (operating income divided by interest expense) for 2023 was 10, which is decent. This indicates that Netflix’s operating income was ten times its interest expense, highlighting that interest costs are a minor part of its overall expenses. Therefore, Netflix’s debt level is not burdensome.
2.3 A Streaming Service’s Moat
The moat, or sustainable competitive advantage, is crucial in determining whether a company will be able to continue to generate above-average returns on capital. Without enduring advantages, reversion to the mean is inevitable.
Netflix’s moat is largely built on its vast scale, particularly its huge content library. Netflix has the most movies, TV shows, and games in the entire industry, and they’re not stopping: Netflix is expanding into new areas like live entertainment, including sports events. Having the biggest offering can be a decisive factor for potential subscribers.
Netflix’s scale also allows them to keep its leadership position. The company’s significant capital resources, unmatched by any other streaming service, allows it to maintain a $17 billion annual content budget. This financial strength enables Netflix to widen the gap between itself and its competitors.
Additionally, Netflix’s global reach is a key component of its competitive advantage. While other streaming services typically also operate globally, Netflix tailors its offerings to local markets, producing content in various regions and languages to appeal to local audiences. Productions such as La Casa de Papel, Dark, and Lupin are great examples.
Finally, Netflix is able to more effectively enhance user satisfaction and engagement thanks to its scale. This is because Netflix collects the most amount of data which is used to continuously improve its recommendation algorithms. A better recommendation algorithms keeps viewers happy and reduces churn.
Netflix’s scale allows it to offer more and better content due to its larger budget and to appeal to a global audience more effectively than its competitors.
While scale is clearly Netflix’s biggest advantage, the company also enjoys a strong brand. The brand is synonymous with video entertainment, and the name has become a household name. The first streaming service that comes to people’s minds is most likely Netflix. A strong brand creates a perception of superior value compared to lesser brands.
2.4 Leap Into the Future
As discussed earlier, one of Netflix’s risks is the matter of sustainable revenue growth. The question is whether the company can continue to grow its revenue at above-average rates.
To help answer that question, we should analyze Netflix’s subscriber count, market share, and relevant secular trends.
As of the most recent quarter, Netflix has almost 278 million subscribers. However, this figure does not directly reflect the number of individual users, as different subscription plans allow for varying numbers of users per account. Estimating that at least two people per subscription use Netflix, it's clear that the platform easily serves over half a billion people. With a global population of over 6 billion in the countries where Netflix operates, the company's total addressable market equates a significant portion of this population, given the universal appeal of entertainment. Based on this estimate, there is still a lot of room for growth.
Netflix’s market share also suggests potential for more upside. Within the streaming industry, Netflix holds a share of 8.4%, trailing only YouTube, which is free. More importantly, the streaming segment is expanding, while traditional broadcast and cable TV are declining. This long-term secular trend suggests that even though streaming already has the largest share, there is still considerable room for growth.
This is one of the most important long-term growth drivers for all streaming services, including Netflix.
“If we execute well — better stories, easier discovery and more fandom — while also establishing ourselves in newer areas like live, games and advertising, we believe that we have a lot more room to grow. Across streaming, pay TV, film, games and branded advertising, it’s a $600B+ market, and today Netflix accounts for just ~6% of that revenue.” — Netflix Q2’24 Shareholder Letter.
Netflix is well-positioned as a market leader in an industry poised for long-term growth.
3. Management
3.1 Greg Peters and Ted Sarandos
Atypical for many companies, Netflix operates with two co-CEOs: Ted Sarandos and Greg Peters. This leadership structure emerged following the departure of co-founder Reed Hastings. Sarandos was initially appointed co-CEO in 2020 and worked alongside Hastings for three years before the latter stepped down. In 2023, Peters was named co-CEO alongside Sarandos.
Sarandos is especially important for Netflix. He joined Netflix in its early years and had been responsible for Netflix’s original programming and entertainment efforts as Chief Content Officer. Netflix’s original content has become a crucial part of the company’s offerings. Sarandos is a Netflix veteran, who knows the company inside out.
Peters, who joined Netflix in 2008, previously held roles as Chief Operating Officer and Chief Product Officer. His extensive experience with the company complements Sarandos's content expertise.
It’s difficult to estimate how skilled both of them are as CEOs, but considering their experience and previous accomplishments within the company, it is safe to say Netflix is in capable hands.
It’s also important to mention that Reed Hastings is still involved with Netflix, now serving as Executive Chairman.
3.2 Ownership and Compensation
It is important for management to have interests aligned with those of shareholders. Management often has similar interests when they are shareholders, preferably large ones.
Co-founder Reed Hastings holds 1.25% of all outstanding Netflix shares, as of the latest proxy statement. This indicates that he is still deeply involved with the company, overseeing its general direction and culture.
Greg Peters holds 364,912 Netflix shares, valued at approximately $230 million, while Ted Sarandos holds 673,889 shares, worth about $425 million. Peters’ total compensation for 2023 was $40 million, meaning his stake in the company is nearly six times his annual compensation. Sarandos’ total compensation was $50 million, with his stake being 7.5 times his compensation. While their stakes are substantial, I would feel more secure owning Netflix shares (I don’t own any shares at the time of writing) if their ownership was even larger relative to their compensation.
A positive aspect is Hastings' continued active involvement and significant stake in Netflix. However, I’d feel more comfortable owning Netflix if the new CEOs were to increase their stakes.
3.3 Capital Allocation
Effective capital allocation is a crucial task for management. As mentioned earlier, Netflix invests heavily in new content—whether through purchasing, licensing, or producing—to maintain its market leadership. This is necessary to keep its position as market leader, and because content amortizes extremely quickly. Naturally, this is good capital allocation. The company also allocates capital to share repurchases (which began in 2021), debt repayments, and capital expenditures.
Overall, Netflix’s capital allocation strategy is straightforward and effective. However, I am cautious about share repurchases at the stock’s current valuation, doubting whether that’s value enhancing.
4. Conclusion
Netflix is a terrific company. The DVD rental service turned streaming service was the first to see the potential of streaming and capitalize on it. They’ve created the streaming service industry, while others followed. As a result, Netflix is the market leader, benefiting from immense scale, but also from a strong brand. The company has a solid track record, and ROIC and free cash flow still have a lot of potential for growth. With the ongoing rise of streaming, Netflix remains well-positioned to capitalize on industry growth.
While Netflix meets my investment criteria, the stock is currently valued at a premium. It remains on my watchlist, and I would be interested in adding this exceptional company to the Summit Stocks Portfolio when the price is more favorable.
Thank you for reading this far. I hope you’ll have learned a ton about this company. If you want to read further and learn more, I’d suggest the following sources as a starting point:
Stay tuned for more deep dives into other wonderful companies!
Disclaimer: the information provided is for informational purposes only and should not be considered as financial advice. I am not a financial advisor, and nothing on this platform should be construed as personalized financial advice. All investment decisions should be made based on your own research.