TIVP059: Netflix (NFLX): The King of Streaming w/ Shawn O’Malley & Daniel Mahncke

26:52And I say that as a joke, but seriously, whenever people refer to your industry as being locked in a war, that doesn't historically bode well for shareholders since competition usually erodes access returns. And I looked at Disney, I think two or three years ago by now. And that was at a time when they doubled down on Disney Plus and everybody talked about the streaming wars. And if there's one thing that I can probably say now, looking back at it, is that Netflix seems to just not take part in those wars. Disney, Peacock, HBO Max, they all fight over both subscribers and retention. And Netflix seems to be just sitting on the side and keep coming out on top of all of that.

27:30And we like to talk about consumer insights, as you mentioned before, when we talk about companies, because, you know, sometimes there are these things that you can't really explain, but you feel them. And if you would live in a country that, I don't know, doesn't use Netflix, doesn't have Disney or HBO or whatever service, I think I couldn't logically explain to anyone why you wouldn't cancel Netflix. Yes, I could try and argue with the algorithm and you know that some individual shows are great and you can't see them anywhere else. But I think most of it is probably not rationalizable. I mean, Netflix is the one streaming subscription that most people just never cancel, at least that way for us and for most people in our social circles, while others just feel a bit more fungible and dependent on content release schedules.

28:14Maybe you want Disney Plus around the holidays to watch some Christmas movies, which are fantastic on Disney Plus. or you have Per One Plus so you can watch certain NFL games or in my case, the Champions League next year. Or maybe just to watch, you know, the new season of Landman. But none of these platforms have, at least I think that, the same year-round pull in retaining subscribers as Netflix does. And that just counts for a lot. Most people define Netflix's competitive set as other streaming apps. And that is true in a narrow sense. Disney Plus and Hulu do compete for subscription dollars.

28:47HBO Max competes for premium scripted series and Prime Video competes because, well, Amazon can subsidize content economics in a way that no pure play streamer can. But I think fixating on them too much breeds a sense of paranoia. I mean, yes, those businesses are all vying for a slice of Netflix's pie. But really, the streaming pie has grown to accommodate more players. While no one has really eaten into Netflix's slice yet by most measures. Netflix's competitive framework is meaningfully broader than, in my opinion. And they don't just benchmark themselves against streaming services. They benchmark themselves against everything that can steer a person's leisure time away from Netflix consumption.

29:29So that includes linear TV, user-generated content on YouTube, video games, and social media as well. So their strategy is less about beating Disney and more about winning the specific moments when someone decides what to do with the next hour of their life. And management refers to those as moments of truth, which is a useful phrase because it forces the company into the most honest version of thinking about their competition. Not who has the best catalog in the abstract, but who wins when the consumer's thumb is hovering over a remote or a phone or a controller in that split-second decision.

30:10And on that point, despite Netflix's cultural footprint, its share of total TV viewing, and this was a surprise to me, remains under 10 % in every country they operate in. And I think it's fair to say cable has persisted longer than some would have thought. But as the number of hours devoted to cable TV viewing continues to decline, a chunk of that consumption will inevitably flow to Netflix as it already has, increasing the company's share of total TV viewing hours. And so even in markets where Netflix feels ubiquitous, the majority of leisure time is still dominated by the everything else category, especially linear TV and non-Netflix entertainment.

30:50And so while competitors often obsess over each other, which is sort of natural to do, I like that Netflix's own lens is aimed at a much bigger prize in a way, which I'm inclined to crown them at this point the winner of the streaming wars and just say that, you know, hey, for the most part, everybody else is fighting for second place. I mean, that's just what it looks like in the numbers. It's so interesting. I sometimes try to nudge my parents to watch more Netflix and less linear TV. and although I'm pretty convinced it's a better product, it's just impossible. I feel like it's a generational thing and linear TV will still take some time before it actually dies.

31:27And on that point, subscription counts really became the defining metric for Netflix and also other streaming platforms to just compare how they stack up against each other. But I do feel that metric is just less and less relevant for Netflix as they move into focusing a bit less on increasing the audience size at all costs and instead basically increasing their average revenue per user or up you instead, which is something that we talk about a lot of times. And the questions then would be more about, you know, how can you get passport shares to actually get their own plan, like it happened with you?

31:56Or how can they get ad supported users to go premium? And maybe premium users are willing to pay even more than they currently do. And perhaps even you can fit more ads into the ad tier without offsetting churn, which I obviously hope doesn't happen, but likely it will at some point. So those are, I would say, all the incremental ways to drive more monetization. that's right wall street spent years treating netflix like a pure subscriber story net subscriber editions became this like quarterly obsession for folks on the street and the stock would behave accordingly and so the reason that pivot toward monetization is so important is that again it signals that netflix is in really another phase of its progression ahead of the streaming competition but also a business that worships subscriber counts will do a lot of reckless things to keep the growth chart pointing up and to the right and that leads to underpricing over marketing ignoring quality issues and then all that kind of stuff degrading the business's flywheel and then ultimately value creation for shareholders and at some point monetization does have to become the focus you can't just always be thinking about growing at all costs and so you know don't get me wrong.

33:06I'm not saying Netflix is done growing, but clearly they have shifted toward prioritizing monetization much more than they used to. And so far that has reaped tremendous benefits for shareholders, which is where we talk about this concept of earnings power, where for years they could have monetized more, but they chose not to. So when you're evaluating a business, you have to actually think about what is the underlying ability to generate more profit if they really wanted to versus what they're doing in the moment to prioritize growth over monetization. That was the story of Netflix for a long time.

33:41And Netflix actually considers engagement to be the real engine of the business here. If members or subscribers are deeply engaged, two things become true at once. Retention improves because the service feels valuable. And then customer acquisition improves because satisfied members market the product organically through behavior and word of mouth in conversation. And so for them, engagement is not like a feel-good metric. But really, it's a thing that allows the company to spend less to retain and acquire customers and still grow revenue over time. And this might be just my personal experience, but I feel like this is where I get a bit worried about Netflix, honestly.

34:20Because I pay for the ad support tier, which, like I said, is only five euros a month. Because it is so ridiculously cheap compared to everything else. And if I just compare how much I actually engage with the platform, and also most of the people I know, it doesn't happen that often. If there's not a show that I can actually binge, most of the time I do not log in. And we often just talk about Amazon Prime, for example, which is just, you know, price compared to the value that you get makes so much sense that you have to subscribe at that point. But if I compare how much I actually use Netflix, I'm not so sure.

34:52I mean, when I compare Netflix to YouTube Premium, for example, YouTube could literally double pricing on me and I would still not give canceling a second thought. When the idea is that Netflix doesn't compete with Disney or HBO, but basically everything else that costs your time. for my personal view as a consumer, I might not make Netflix a top five app most of the times. And switching gears a bit here and go back to the maybe more bullish argument of the company, and there are many of them, another potential opportunity that I think Netflix could double down on might be licensing. I mean, in the beginning, Netflix was basically an intermediary distributing other creators' content.

35:29But after going to on-demand video streaming, the next big shift was in creating their own content, these Netflix originals like Squid Games or even Stranger Things. And much of which has been just like very, very popular. We're even talking about the early ones from House of Cards, which is one of my favorite shows, to Squid Games, like I said, which is yet another one of my favorite shows. So, you know, add to the list of competitors, maybe not just other streaming apps bidding for content, but also Hollywood Studios creating content too. And for the sake of just intellectual consistency, I feel it's fair to say that back in 2013, if we were doing this podcast, we would argue, at least I would argue, that producing shows and movies for global audiences is just way beyond their circle of competency, as a software business at least.

36:13And therefore, they would be unlikely to do it well. And, you know, that has turned out to be the most untrue thing that I could have ever said. And once again, they justified the arts here. And I feel like they've done it so often, again and again. And today, they're as big of a play in Hollywood and also Bollywood and other global hubs in cinema as anyone. So a long introduction, basically, to my question for you, which is how do you think about balancing between the content they produce and the content they license and whether they will begin licensing Netflix content, let's say, to other apps as a way to increase revenue.

36:47So I'm imagining, let's say, Stranger Things, after spending years solely on Netflix, getting a second live on Apple TV or something like that. So that's one of the defining things about Netflix. Netflix originals are only available on Netflix. And given how much they've succeeded in producing hit shows, as you were alluding to, that is a serious value add in platform differentiator compared to other apps. Licensing their content to others, even if at a lag, is seen internally as weakening their moat more than anything else. And so the economic rewards of doing so simply don't justify the cost to their brand perception and the value add of specifically being a Netflix subscriber.

37:26But But yeah, I mean, a common assumption during the rise of the streaming era was that licensed content would wither away as everyone walled off their own catalogs. And we've seen that to an extent. But, you know, really the logic was, why would a studio keep licensing hit shows to Netflix if they could keep that content for themselves for their own service? And I remember, for example, being devastated when The Office was taken off Netflix and put exclusively on Peacock. And at that time, I probably would have said that, oh, this is a huge blow to Netflix and maybe the final nail in the coffin if it's going to be indicative of what would happen with the rest of their content.

38:03But again, my instincts just have not been all that accurate about Netflix in the past, which is maybe why I'm willing to finally get bullish on their ability to continue proving me and the rest of the world wrong. And so ultimately, the exit of any single show, even something as beloved as The Office, I regret to say, has proven inconsequential for the overall business. And just anecdotally, I am still a Netflix subscriber today, but I'm pretty sure I've never paid a cent to Peacock, even though they exclusively house one of my favorite shows ever. And I mean, it's been a depressing reality, but I can't get myself to justify paying for a subscription that I only watch one show on when for a similar cost, I could have Netflix's entire catalog.

38:48So to some extent, having original content is a hedge for them against others pulling popular content from their platform. They also see an opportunity, though, in taking popular shows from other platforms and giving them new life on Netflix. So an example of that is the show Suits. And this is a second run show, but it suddenly became a monster hit on Netflix long after its original airing. And the lesson is not that Netflix got lucky, but that Netflix has shown it can take an already proven content asset, license it at a fraction of the cost of producing a new original, and then still generate enormous engagement amongst their subscriber base.

39:29And that matters because the whole Netflix model is built around delivering enough value per dollar of content spend. So if you can buy engagement more efficiently through licensing than through originals, that's what you do. It strengthens the member proposition and it improves the return on capital tied up in content spending. And so to me, the more interesting question is whether others are cannibalizing themselves over time by licensing their shows to Netflix in exchange for a few dollars today. And if you truly think long term like Netflix's management team has, then these are the kinds of imbalances with competitors you can take advantage of.

40:08If your competitors aren't nearly as profitable and scaled as you, and so therefore they're very desperate to prove their monetization capabilities to their own shareholders, they may license you content that you can better monetize and use to reaffirm your own moat against them. It's kind of this catch-22 situation that they're in. And so Netflix realized that as rivals have built their own streaming platforms, many of them bled cash doing so. And at some point, the whole incentives just flip and their back catalog of content at these other streaming companies eventually just becomes a funding source where competitors say, look, we can tap into some of this content, license it to Netflix so we can stop some of the bleeding financially that we're incurring to compete with them.

40:54And so, in other words, the really strange outcome of the streaming wars is that in many cases, the market leader, aka Netflix, is also the best customer for everybody else's content libraries, which further entrenches them as the market leader. And that is the kind of setup we love to invest in as shareholders. Netflix surely came out of all the streaming wars debates so much better than anyone would have thought. But I guess even more interesting to me about all this licensing would be them basically licensing, not just the streaming apps, but just the IP in other ways. So I imagine building, let's say, a strong IP and then monetizing it in the physical world.

41:34I don't know, you know, theme parks or similar things. It doesn't have to be capital intensive as Disney does it, for example. They could follow a model similar to Nintendo, which basically takes their IP and then just licenses it to other theme park providers and makes money basically off of that. And that's likely to be far out if it will ever happen. But I think it's one of the things that I see when I think about Netflix in, let's say, 20 years. But I would say now it's timely to dig into this content strategy a bit more. Because Netflix is sometimes framed as being an American platform, which it obviously is, expanding outward.

42:08And so it wasn't as clear whether they would have success internationally. But the fact they have been able to make hit content produced locally across a number of global markets is just really impressive. Perhaps even more impressive is that international shows with completely different cultures and languages, obviously, have also been huge hits globally. I mean, the most prominent example out of all of them is likely to be Squid Games, which has been, I think, a hit show in almost any country that watches Netflix. The global playbook is not to push Hollywood everywhere by any means. As you said, they have aimed to make great local content everywhere with the hope that the best stories will travel really well on their own.

42:47And so they have to build authentic programming for local markets at scale because that's the only way to truly compete for free time in over 190 countries. And I actually think Squid Games is a really good example of this. It's not like they made the show expecting it to be a global hit. It was created first and foremost for Korean viewers. But then that story was so compelling that it reached the rest of the world because in my opinion, at least, authenticity travels much, much better than some kind of intentionally globalized storytelling that tries to cater to the largest audience possible.

43:23Perhaps this is also, you know, I think at least it could be when Netflix started to lose its positioning among investors as a tech giant like any other, because it's a lot more capital intensive when you try to achieve further scale in all of these other countries, producing all that localized content, head shows in India made for Indian audiences, as well as for Japan, Colombia, France, the UK, and so on, all of these countries, it's just very expensive. And we always use the example of selling Microsoft Excel subscriptions because that ends up being much more scalable. The underlying functionality is basically the same across all cultures.

43:58And the only thing that needs to be adjusted is language translation, which doesn't end up to be very expensive. So each incremental subscription sold comes at a very high margin. Whereas For Netflix, if they can only attract new customers by basically creating content for new markets globally, they just have to invest significantly in content to support that growth. It's funny you say that because for years, one of the most common critiques of Netflix was the balance sheet. Too much debt, too much cash burn, too much negative free cash flow. And you are right. Netflix doesn't quite enjoy the same unit economics as businesses like Alphabet and Meta.

44:36Though I will say those companies are quickly looking less and less capital light as they dump hundreds of billions of dollars into AI related capex. But that's another tangent to go on. And so anyways, original content requires upfront cash long before the payoff arrives. I think that makes sense. And that comes with a substantial drag on free cash flow. But you're spending for something that generates value across years of member engagement. And it reminds me a lot of what Universal Music Group does. Their core business is based around betting on musical talent, funding their production and touring, and then profiting off of a share of those royalties from hit songs that could be popular for decades in some cases.

45:16And so TV shows and movies are a bit different in that they get played on repeat to a lesser extent. But also the consumption time is much longer. You know, the length of one movie could be the equivalent to someone streaming a song 40 times. And so, of course, some content proves to be timeless, creating assets with effectively indefinite lifetimes. Any piece of hit content can sometimes be revitalized by interest from the next generation. So the point I'm trying to make here is that Netflix was making very front-loaded investments to produce assets that could create value for them for, I don't know, maybe the next 30 years.

45:55I think you could say that Netflix has had basically the luxury of overcoming its cash burn and also achieving excess economic returns during a time where just few competitors kept it from expanding its subscriber base and achieving the scale that is critical for success. And more recent and also especially future competitors, they must attempt to reach scale while offering a compelling alternative to numerous other streaming choices and services out there, which is just a lot harder to do. I do believe that's an advantage and getting past the cash burn phase with minimal competition it is actually a competitive advantage we've talked about with one of our other favorite companies Uber it's a portfolio holding in our intrinsic value portfolio but for Netflix there's still a mismatch between when the cash costs of content spending occur versus when the actual consumption happens with the monetization happening more gradually over time and that also gets a bit messy to measure because it's not like you can directly measure how much revenue a single Netflix original generated itself since revenue primarily comes from subscriptions that provide access to the entire platform's content and we do know that shows with more engagement drive viewing hours which supports the value offering of a Netflix subscription which keeps people subscribed for months or years so kind of abstractly we know how to think about it but the thing is though, now that Netflix has made many of these content investments, they can lean on their content archive while continuing to invest tens of billions into new productions.

47:28But as the business grows, there is some degree of operating leverage to be had that we've seen bear out in the financials as those content spending costs become a smaller and smaller percentage of overall revenues. And so that's where the business is at now. But a decade ago, they did not have that same scale, nor did they have their own content to lean on, meaning it would have been very demanding to try and fund these investments with the business's own cash flows. So they opted to tap the capital markets for debt funding. And that's not always a good thing. But in this case, Netflix had a lot of confidence in their ability to invest in content because, you know, for goodness sake, they have more data than anyone else in the world on hundreds of millions of people's viewing habits.

48:09So they do have an idea of what works and what doesn't in streaming. And instead of draining all their free cash flow in a given year to invest in content production that would have a very long, useful life, they found they could use debt funding to kind of spread out the financial burden of those investments over time, better matching the monetization profile associated with them. And only after becoming sustainably free cash flow positive did they decide that they no longer needed external financing for day-to-day operations. And that corresponded with them effectively hitting the scale they needed to really just become this impenetrable juggernaut that I think really nobody can touch today.

48:47And so now, after building the moat of a massive global content library, the company is pivoting toward free cash flow generation. The burn phase, in other words, was the construction phase of their moat. And now we see them increasingly reaping the benefits of having done that as free cash flow explodes. And then yet, they're still pouring massive sums into making some of the best content in streaming, which just further adds to their moat and ability to generate excess returns on capital for a long, long time, hopefully. And just to go back to your points about the streaming wars and whether Netflix has won them, I do think this business model bears similarities with other winner-takes-all models, such as Costco or Amazon.

49:29And Nick Sleep, who is probably an investor who I'm sure many in our audience are familiar with, refers to this model as having shared economies of scale. And that basically means instead of retaining the benefits of scale through, let's say, higher margins, these efficiencies are shared with the customer, thereby strengthening the company's mode. And just think about how much is continually reinvested into making Amazon Prime the most valuable and useful service possible to customers, rather than just trying to squeeze out every last cent out of what people might be willing to pay for that service.

50:01And the idea is really to have a service so useful that you just can't justify not paying for it. In 2006, Nick Sleep wrote that, quote, Quote, Costco is the best example we can find of scale efficiencies shared with customers. We often ask companies what they would do with windfall profits, and almost no one replies, give it back to customers. How would that go down with Wall Street? That's why competing with Costco is so hard to do, though. The firm is not interested in today's static assessment of performance. It is managing the business to raise the probability of long-term success. And as you were saying, Jeff Bezos has articulated similar aims that we can see pretty clearly now with Amazon Prime.

50:47In an Amazon investor letter in 2005, he wrote, as our shareholders know, we have made a decision to continuously and significantly lower prices for customers year after year as our efficiency and scale make it possible to do so. This is an example of a very important decision that cannot be made in a mathematical based way. In fact, when we lower prices, we go against the math that we can do, which always says that the smart move is to raise prices. And so he continues, we have significant data related to price elasticity. With fair accuracy, we can predict that a price reduction of a certain percentage will result in an increase in units sold of a certain percentage.

51:27With rare exceptions, the volume increase in the short term is never enough to pay for the price decrease. However, our quantitative understanding of elasticity is short term. We can estimate what a price reduction will do this week and this quarter, but we cannot numerically estimate the effect that consistently lowering prices will have on our business over five or ten years. Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow and thereby to a much more valuable Amazon.com.

52:09So if I were to get really bullish on Netflix, it would effectively be that. Scaled economy shared. And I love the idea of owning businesses that are so good. Literally no one can compete with them. That's the type of earned monopoly Peter Thiel praises in another one of our favorite books, Zero to One, as actually being beneficial to society. despite the kind of derogatory associations with the word monopoly, which are usually referring to monopolies that are formed by regulatory decree and that come with greater cost to society. You could say that alphabet is monopoly that society is better off for having.

52:48That's kind of the point. What I liked so much about reading Jeff Bezos' letters is that by now you see all these learnings over X and in so many places, but he wrote this in 2005. So he really was the visionary seeing this and then knowing it will play out like that in 10 or 15 years from now. Well, it hasn't been common knowledge with investors nowadays, but maybe this is also the right time to basically get off my rant on Amazon Prime. Because I just can't understand why Amazon Prime has still by far the worst user interface of every streaming service on the internet. I can't imagine that it would take Amazon, let's say more than a handful of interns and two weeks to improve that website.

53:25It makes me angry every time I visit it. And I just recently did because I have my HBO subscription basically running over Amazon Prime. And I don't know, considering the size of the streaming industry, I think even the argument that Amazon has more important things to focus on doesn't really count here. And with all of this, it's no wonder that despite all of Amazon's resources, this service just doesn't come close to competing with Netflix. But getting back to Netflix, because this is the company we're talking about today, as we have alluded to, a lot has been written about its culture. The company's culture deck became quite famous for a reason, which led to the book No Rules Rules.

54:01And the reason I think people are so fascinated by Netflix's culture is that products, features, interfaces and processes, all of that can be copied, but you can't copy culture. And to me, it seemed that this has probably been the most differentiating factor for Netflix, especially in those early days. We just don't have the same mode as you have today compared to all the other players. we have our own biases because this is something that our company the investors podcast network has learned as a framework from netflix which is to treat a company like a professional sports team and not necessarily a family and so if you think about it on the chicago bulls in a way all the team members probably feel like family but to be on the team you have to meet the highest performance standards so everyone is competing for their spot in the family which sounds a little weird You know, acting like businesses, though, are families creates a sense that you can't get kicked out, which feels and sounds really nice.

54:58But it's just not reality. And so thinking about companies as sports teams where each year you have to earn your spot again, even if you're Michael Jordan, is really pragmatic. It creates a performance oriented culture built around attracting, keeping the best people, not the most people. And as such, they're willing to pay top of market to do that. And that's not just an HR philosophy. Another part of their culture that stands out to me too is their willingness to be bold when the opportunity is big. Netflix did not tiptoe into international growth, original content. They committed in a really, really big way.

55:33And that willingness to go all in at the right moment is probably a bigger part of the story than most people give them credit for. There's an old cliche that luck and also success come when hard work meets opportunity. But, you know, you can do all the hard work in the world and prepare. But if when the moment comes, you don't act, well, then you will miss the opportunity. And I don't think anyone could accuse Netflix of not being willing to act boldly at some major transition points that have allowed them to basically keep compounding intrinsic value at excess rates well longer than they would have been able to if they just stuck to DVDs or stayed domestically or never went into the original content or now starting an advertising business.

56:15The opportunities keep coming too. One of the things it's easy to forget is that even now we're still in the early parts of the transition of consumer viewing time streaming. In the US, streaming was about 38 % of total television viewing time in 2023, just starting to overtake broadcasts and cable. But broadcasts and cable combined were still a bigger share than streaming. That's how early we are. Assuming streaming provides a better experience for most customers, which I think it does, then over time, the share of viewing delivered over the internet should keep moving higher. And that provides a tailwind for the category.

56:55And there's no more of a pure play bet on streaming than Netflix, of course. And in terms of competition, vying for a share of that continued migration from cable to streaming, their entertainment industry is unique because tastes are really so wildly diverse. If Netflix is a slate you love, Disney is not a direct substitute. If Disney has something you love, Netflix is not a direct substitute. You might rotate services, but you're not necessarily replacing one with another in a pure commodity way. And I think that's the biggest thing people miss in the early days of the streaming wars when they just immediately expected Netflix to be supplanted by these other streaming platforms.

57:32That means Netflix's job is not to eliminate competitors, but to remain essential, And correspondingly, the presence of competition on its own does not inherently limit Netflix's ability to generate excess returns, which is a really, really unique phenomenon that we don't see in many businesses that we've ever studied. And we talked about a mess last week, and you could probably argue that there are no differences between an MS bag, a Chanel bag, and an LVMH bag. But if you do that, you would certainly miss the point here as well. And all of those bags are completely different things to their respective customer basis.

58:07And I think that's kind of the point. It's similar with streaming services, just because their portfolio of shows and their IP, they're just so different. You don't want to watch any sitcom, Sean. You want to watch The Office. But, you know, having said all of that, and I think it's pretty clear by now, how about we zoom in more on probably the most important part, which would be the unit economics here, because I'm really curious how much Netflix generates on a per-user basis. That's probably one of the most important metrics for Netflix now, especially since the slowdown in user growth. and what I would be interested in also is whether it's just about the premium tier or if they actually make money on the ad tier as well.

58:44So in 2024, Netflix would generate about$39 billion in revenue. An average revenue per subscriber or ARPU, it was about$11.64 per month. But as you can guess, there is a lot of variation in that number by region. In the US and Canada, it was about$17.20 per month. In the Asia-Pacific region, the ARPU is only$7.30 per month. On the cost side, content amortization is the big item. That's their primary cost of revenue. It was about$22 billion last year, around 50 % of revenues, which is actually down from 60 % of revenue just three years ago. So that's 10 percentage points of operating leverage just right there.

59:28And then you have marketing expenses at about$3 billion, which is roughly 8 % of revenue, while technology and development costs another$3 billion within overhead. So, you know, kind of like admin and HR and those kinds of jobs being around four and a half percent of revenue. And so if you stack all of those together, you get an operating profit margin of nearly 30%, which is very, very healthy and actually not that far off from Alphabet. But operating profit is not free cashflow. And that distinction has been at the heart of Netflix's stock psychology for years. In 2024, Netflix generated about$7 billion in free cash flow, while operating profit was$11 billion.

1:00:08But the delta between those was more extreme due to the cash spending on content back then, since Netflix invests upfront in original content, as we've talked about, which depresses cash in the present, even as accounting amortization smooths out those costs over time and over the last few years Netflix has hit an inflection point where that gap narrows because content spend can stabilize while revenue continues to grow producing operating leverage and the question really that people are debating is now that Netflix has proven its operating leverage by increasing operating profit margins from 20 % to 30 % in just the last few years how much further can that go and the more they move into gaming and podcasts and new forms of entertainment to support subscribers and memberships, the greater the strain on operating margins for sure.

1:00:58But obviously they would not go into those areas if they did not think it was necessary for them to compete long term and maintain the moat around their business. And how do you see churn factor into the union economics? Because we, you know, kind of painted a picture here that nobody cancels on Netflix, but probably I guess there is some churn. And how does that factor into the economics here? the churn is hard to estimate cleanly given how many different markets that netflix operates in and the different stages of maturity that netflix has reached in penetrating those markets but churn is probably about 2.5 percent from the estimates i've seen which is lower than their competitors and if basically people stay engaged they don't churn they don't churn your customer lifetime value increases and if lifetime customer value rises you can invest more aggressively in content while earning attractive returns.

1:01:50And so a good bit of that churn is also offset by the reality that no one is ever really permanently unsubscribed from Netflix, right? Maybe you'll cancel for a year, but the rates of account reactivations are pretty solid, as you can see with me as a case study. We've talked about this a bit now, but Netflix's unit economics have shifted by moving into original content production because it's so cash intensive up front, whereas licensing is less cash intensive since you're not funding development years ahead, but licensing means you don't own the IP and don't control the rights to it. And the key for Netflix then is not the absolute cost of a title, but what viewing that title generates relative to the spending on it.

1:02:32And so Netflix then thinks in terms of an efficiency ratio, but they also think about the halo effect or the cultural impact, you might say, of a piece of content, which drives customer acquisition too, if everybody's buzzing and talking about, you know, the finale of Stranger Things. So through that lens, content creation is part of the marketing budget in a way. What is everybody's favorite icebreaker at work? It's usually to talk about what they're watching on Netflix, right? And think about how valuable that viral word of mouth marketing is. And so historically, marketing costs and entertainment have been a variable expense.

1:03:05But Netflix has turned much of that into a fixed expense by using their product itself, their content as the marketing channel, surfacing titles based on your behavior and preferences once you open the app. So they've turned the algorithm into the most effective marketing tool you could possibly have. Much more effective than Super Bowl ads and banners on the side of the road. None of that competes with just Netflix's own algorithm. And so Netflix has found a model where content becomes a marketing asset. And I think that's really special. If you own the content and the distribution, you can reduce customer acquisition costs in ways that are very, very hard for competitors to replicate.

1:03:48I personally never watched Stranger Things, but then a couple of weeks ago before the new season came out, I actually watched the entire show. And since then, even on Instagram, I've seen so many memes about it, so many discussions that I just can see how all of this basically is marketing that they don't even spend anything on. And it worked on me with starting that show. And one other thing that is quite unique about Netflix, beyond the great content and recommendation engine and all of that stuff is that I've always noticed and even more so in recent weeks when I also tried HBO Max and Disney Plus is that Netflix just works so well.

1:04:21Minus a handful of live events maybe that they've tried to stream where tens of millions are viewing at once, basically, almost no matter where you interact with it. I found Netflix tends to just work better than other streaming apps. It loads faster, it crashes less often, it has more accurate closed captioning and it has an intuitive interface to navigate. all that sort of stuff. And like I said, Amazon Prime and also some other services, they definitely don't have that. That's a good point. And there is a real reason for that. Netflix moved to the public cloud early, migrating infrastructure and compute to AWS over what was actually a painful seven-year process for them to do all that.

1:04:59But that matters because personalization and recommendation engines become more compute intensive over time as they're learning more and more about you. And a cloud native architecture positions Netflix to scale those capabilities, essentially. And then on top of that, Netflix built and operates its own content delivery network, also known as a CDN called Open Connect. And it's essentially a proprietary CDN that helps internet service providers localize and manage Netflix traffic, improving streaming quality and consistency. So there are about 17 ,000 servers for Netflix that are deployed across nearly every country in the world.

1:05:38And that infrastructure helps explain why Netflix just works more reliably than other apps. And so Netflix has also invested heavily in subtitling and dubbing as you suggested. And they subtitle and dub in dozens of languages. Something like 97 % of subscribers have watched a non-English title in a single year, which is pretty astonishing compared to how people used to consume content. right? It used to be very uncommon to consume content that's not in your native language. And you can also see how this adds to Netflix's intrinsic value with really high quality translation that increases the reach and shelf life of each piece of content.

1:06:15And so once you spend 20 or$30 million on a movie, you want to maximize global viewing and language accessibility is a force multiplier for that. And so I've heard this comparison with Netflix made before, and I really like it. So I'm going to steal it, which is to say what makes Netflix so inescapable, you know, what makes it so special. And the comparison I'd make is that a restaurant is not just the food. And to the same extent, Netflix is not only the content. People go to restaurants for the hospitality, for the service, for the atmosphere, maybe for server to tell them the chef's favorite dish that day, right?

1:06:54That's the Netflix suggestion algorithm. And by making deliberate investments, Netflix has made its app so easy, so intuitive, so vivid, and so consistent that those user experience factors have actually become drivers of customer loyalty in their own right. I only found out recently that apparently after Netflix came out, so many more people use subtitles. I personally use them and I not only use them when I watch shows in English, we use them when I watch shows in German or any other language. So that's also a pretty interesting fact. And, you know, all of these to some listeners might sound just like soft factors, but, you know, you heard my rant on Amazon Prime just 10 minutes ago.

1:07:30So this really matters. And I might be the perfect example of that. And, you know, I want to go to the valuation in a moment. But before we do, we have to talk about the Warner Brothers deal, of course, which I kind of hesitate to mention because by the time we get this episode published, you know, the news may have already changed, but we cannot, you know, have this episode and not talk about the deal. So we should at least talk about where the deal is at at the moment. And you know, there's so many questions to ask. Most importantly, maybe, do you like the deal for Netflix? Is it likely to create value for shareholders?

1:08:04So why don't we recap the competing offers to begin with here. Netflix offered to pay$27.75 for each share of Warner Brothers with$23.25 being paid in cash, while the other is paid with about$4.50 in Netflix stock. And so that implies an$82 billion enterprise value for the deal. So that includes the value of all of Warner Brothers debt, which then implicitly values Warner Brothers equity at$72 billion. And so as part of the deal, though, Netflix would not be buying all of Warner Brothers. They would actually be leaving Warner Brothers global TV networks like CNN and TNT and assets like Discovery Plus and Bleacher Report out of the deal, which would be spun out into a new company called Discovery Global, that all current WBD shareholders would get a proportional share in on top of the payout from Netflix.

1:08:59And so the controversy here, beyond the debate about whether this is a good deal for Netflix, is that Paramount Skydance also wants to buy Warner, and they're offering to buy the whole thing for$30 per share in cash, including the TV networks, which implicitly, if you contrast that with Netflix's offer, then values these remaining TV networks and Discovery Plus that Netflix wouldn't be buying at about$2.25 a share. And so while Paramount is making a competitive offer, Paramount is only a$13.5 billion company. So they would be trying to purchase a company about five times their size, which is, I don't know, Daniel, you tell me, a little ambitious to say the least.

1:09:42And that would require, obviously, a significant equity infusion from an outside investor or a lot of debt to make the deal happen. And while fortunately for Paramount, their CEO is David Ellison, son of Larry Ellison, the founder of Oracle, and one of the richest men on the planet worth several hundred billion dollars. And he has personally offered to backstop the financing of the deal. But if you ask me, it's a little weird. You've got daddy backstopping a deal worth tens of billions of dollars, which doesn't exactly inspire confidence in the market that the Paramount deal is being offered on sound terms.

1:10:20The Ellisons are good for the money, I'm sure. But given that the credibility of their financing is dependent in many ways on a single outside investor who is a family connection, as opposed to Paramount actually having the cash or equity value to make the deal itself, that whole thing just makes the deal feel somewhat precarious. And so there's a risk here that the deal falls through entirely where Warner Bros is left several billion dollars poorer as a result. So that's part of what they're trying to balance between the two offers, right? Determining which offer has the firmest financing and which combination is most likely to clear antitrust hurdles.

1:10:57And carving out some of the linear TV assets in Netflix's offer is actually meant to help with some of that regulatory scrutiny. But of course, there is always politics involved. One angle here is that the Ellisons are apparently very close with the current presidential administration. And since the president has said he'd have antitrust concerns about the Netflix deal specifically going through, that has some folks thinking that what will swing the steel to completion may ultimately be politics. And the most politically connected player, which is paramount, would be the beneficiary of that. And still Warner Brothers board has continued to endorse the Netflix offer to their shareholders, but it'll ultimately be up to shareholders to vote and decide.

1:11:41And so the whole thing is getting very messy very quickly. And clearly Paramount feels like they wouldn't be able to compete with a version of Netflix that includes all of Warner Brothers assets like HBO. So there is some desperation maybe on their end, in my opinion, to prevent that from happening, even if it means making a massive, massive deal and relying on the CEO's dad to help backstop the financing from it for other banks. And so if the deal does close, it's probably going to be about 12 to 18 months out once it clears regulatory reviews. You know, my other question is also just whether the deal is actually just a good thing for Netflix in the first place.

1:12:21This would be by far their biggest acquisition and it would also mark a real pivot in their strategy. Even just a few months ago, before the deal was announced, I saw an interview with co-CEO Greg Peters on Bloomberg, where he was basically saying that Netflix continues to prefer building its own brands and business units rather than just acquiring others. especially because the media industry has been consumed by so many bad mega merger deals over the years. So if we were to buy shares on Netflix today, should we be hoping for the deal to go through or fall through? It's a difficult question, honestly.

1:12:58Mergers like this are notoriously complex and messy. It could be a nightmare or could mark the next bold, big pivot for Netflix and creating shareholder value. And that's a little bit of a vague range of options, but to some extent, it is about trusting management. And this is a team with an exceptional track record that is very well schooled on the issues historically with big media mergers. And so for them to even consider this, they must see a huge opportunity. And I think Paramount's desperation validates that. The concern for me is probably less that Netflix's management team is pushing a structurally bad deal and more so that a good deal could turn bad if the bidding war with Paramount escalates and makes things even more expensive for Netflix.

1:13:40In the past, disastrous media mega mergers have revolved around buying a bundle of great IP that comes with a bunch of baggage via legacy distribution channels, tying up the companies and culture clashes while debt servicing costs from the deal limit further reinvestment into the stronger parts of the business. And that's why I like what Netflix is trying to do because they're basically doing the opposite of that in a way. They want to buy their streaming and studio crown jewels and not the legacy TV networks. And so as the streaming industry matures, it becomes increasingly about mitigating churn and maintaining share of watch time, which makes it very important to have a broad, deep content catalog to ensure there's always something to watch, plus iconic franchises that can drive periodic spikes in viral popularity.

1:14:27And so correspondingly, the deal with Warner Brothers gives Netflix a premium brand, an HBO, with incredibly valuable franchise IP like DC Comics and the Harry Potter universe, providing a library of rich, evergreen content that should further increase pricing power or at least make it even harder for people to justify canceling their Netflix subscription, especially if Netflix were to directly include HBO content or if HBO Max was bundled into Netflix subscriptions at a discounted price relative to paying for HBO Max alone. since approximately 75 % of HBO Max subscribers are also Netflix subscribers, I learned.

1:15:07And so Warner Bros. IP catalog would also really enhance Netflix's move into gaming. And even if gaming isn't the main reason for the deal, it supports this idea of having a Disney-like flywheel for Netflix, where IP ownership leads to series and films and games and themed live experiences and merch that all increase the clout of the IP in the first place and drive further incremental monetization. So through that lens, the approach could be to mirror the best part of Disney's business model while leaving behind the more capital intensive aspects of it, like theme parks and cruises. And I should mention though, that there is still a real business shift here.

1:15:48Netflix has been telling the market it will maintain Warner Brothers current operations, including theatrical releases and traditional windows for those releases, which shows that Netflix is sort of leaning into a different monetization stack than just entirely forcing Warner Brothers into a straight-to-streaming model to fit Netflix's current culture. And so the risk isn't that HBO is bad, but that the integration proves more costly than expected while increasing capital intensity and opening the potential for creative dilution. Netflix is shifting from this asset-light-ish platform toward running a massive studio ecosystem.

1:16:29And if the combined company starts optimizing too hard for scale and efficiency, the prestige of HBO that makes it such a special asset could get watered down along the way. And that would be a very, very costly blunder for them to make. Gosh, I think I'm so torn about the deal. So on the one hand, if we assume Netflix is a place that people don't cancel anyway, then I'm asking myself, why spend 70 or even$80 billion on this acquisition, especially when the vast majority of HBO customers seemingly already to be subscribed to Netflix anyway. And then on the other hand, the IP is worth a lot of money.

1:17:05And, you know, having classics like DC or Harry Potter or Netflix certainly wouldn't hurt retention. And again, if you think about licensing and, you know, possibly monetizing on IPs outside of just, you know, being on Netflix, but having some physical assets as well. I think it could also be a huge winner for them in the long term. But I don't know if you read anything about it. I heard Netflix was considering buying Champions League rides this year. Unfortunately, they didn't. And Paramount actually was the one company that bought them instead. And from what I know, sports rides are an incredibly valuable tool for acquiring basically a whole new and very valuable customer base.

1:17:41So yeah, obviously, Netflix is already doing that to some extent with these big events, especially in boxing. But I think I would hope to see more of that in the future. But okay, well, we need to get to the variation before we run too long here. And I've definitely got some opinions on Netflix already, but please tell me how attractively valued you think the stock is today. So it's a cop-out for me, but I wanted to focus on valuing Netflix, excluding the Warner Brothers deal, because it's not guaranteed to be accepted by Warner Brothers shareholders or to close after regulatory review. And without being an M &A expert personally, I'm inclined to say that management has earned the right to be trusted here.

1:18:20And if the deal goes through, I do think they'll make it work. Maybe that's wishful thinking, but this is not a management team that I want to be betting against, even if this is a big change in strategy for them. And so if anything, rather than trying to explicitly model the effects of a Warner Brothers acquisition, I would be inclined to just increase the margin of safety we use on our intrinsic value target from a 20 % discount to fair value to maybe 30%. which just lowers the threshold, the price at which we would find the stock attractive to purchase just to give us some margin of safety.

1:18:52But yeah, I mean, Netflix has shown that it has more operating leverage than many would have thought years ago. And as such, I think the business can continue to scale and benefit from content costs becoming a smaller and smaller percentage of sales, increasing profit margins faster than revenue growth, right? That's what operating leverage is. And so that's not to say they'll be spending less on content, But if revenue rises 10 % and you're spending on content rises 7%, then you gained three percentage points of margin there. And so operating margin just refers to revenue growing at faster percentages than costs after a certain scale of the business, allowing for profit margins, as I said, to rise faster than revenues.

1:19:30And so anyways, in my base case, I've got operating profit margins rising from 29.5 % today to 35 % by 2030. And so for context, since 2021, Netflix's operating profit margin has risen from 21 % to over 29%. So this would reflect some deceleration in the rate of margin expansion while the top line still grows near a double digit annual clip. Thanks to international subscriber growth, price increases and developed markets and then just from advertising. And at the same time, in my bull bear and base cases, I reflect them continuing to do substantial share repurchases between 10 to 15 percent of revenues on buybacks annually as has been the precedent for the last few years and then depending on what valuation they make those buybacks at that could shrink share count by maybe one to two percent a year and so actually in a bear case assuming the valuation gets hammered to well below 40 times earnings which is around where it's currently trading and you can imagine they might even be more aggressive in making repurchases which is another way to grow earnings per share or at least every dollar of repurchases they spend would go further in reducing the share count so i'm modeling some different assumptions around buybacks revenue growth and margin expansion in the three scenarios and assuming moderation generally in the valuation as the business matures meaning a decline in the pe by 2030 to maybe 30 times earnings in my base case plus a 30 margin of safety discount for the uncertainties surrounding the Warner Brothers deal, I get a blended fair value estimate of$100 per share.

1:21:05But an intrinsic value purchase target for us of where we would consider adding it to the portfolio at around$70 per share. So at current prices, it's safe to say we would probably need another 20 % discount for me to be really excited about and interested in adding Netflix to the portfolio. But that's just how I'm thinking about it. I gotta say, coming into this episode, I didn't realize Netflix was still trading at a multiple close to 40. So I was surprised to see that it would still need such a big decline for it to be attractive to us. But part of the truth is that a 30 % margin of safety is a lot.

1:21:40And I think it's granted given the uncertainty around the possible acquisition. And generally, I would just say when we value businesses, we want to be conservative, sure. But we also want to make assumptions that we think are realistic. And if I need to choose, I want to limit my downside first. But I also don't like missing opportunities because I model so conservatively that I miss out on a great deal. And we actually just had a call in our intrinsic value community a couple of weeks ago with Andrew Branton. He's the co-founder and CEO of Turtle Creek, which is an investment firm with just a stellar track record.

1:22:12We are talking 20 % a year for almost three decades. And he mentioned how he doesn't try to model conservatively, but just right. And again, this takes a lot of fundamental research and trust in the management team as well. And I I think that's kind of where you then get the margin of safety from. And all that said, this is just some background on why you may come up with a different intrinsic value than Sean in this case. And I agree with you, Sean. I think at these current prices, it's not yet attractive enough to also displace one of our existing positions. Because in 2026, it's not only about clearing our hurdle rate, which we always communicated being about 12%.

1:22:49It also needs to be more attractive than all the companies we currently have in our portfolio. and I would agree it's probably not yet there. Okay. Well, talking streaming has been a ton of fun today, but it would not be the Intrinsic Value Podcast if we didn't look ahead to the next stone we'll be turning over. So how about you give us some hints for your pitch next week, Daniel? Yeah. I mean, next week's company has certainly seen a downturn too in the last few months, and it has actually been the largest drawdown in an otherwise incredible compounder and compounding track record for decades.

1:23:24It will once again be a company threatened by AI. You know, surprise, surprise. And many listeners have repeatedly asked us to cover it also here in the comment section on YouTube and Spotify. And its stock has already been covered on our sister podcast We Study Billionaires before, I think even multiple times. But I do think considering the historic drawdown, it's worth valuing the stock now too for us here on the show. Sounds like it'll be a good one, as always. On that note, I'll close us out today with a quote from Reed Hastings himself, who says, most entrepreneurial ideas will sound crazy, stupid, and uneconomic, and then they'll turn out to be right.

1:24:02Netflix certainly sounded crazy when it first started, especially since the name literally includes a reference to the internet at a time when the DVD was just first going mainstream. So nobody can say it was not a visionary company when it was founded. We'll see you again next week.

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1:25:19Thank you.