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Analysis & Valuation
For MGMT E-2620, Prof. Dalko
TEAM - 10
Alegra Horne, Larry Montello, Brian Schoenherr, Anirudh Udayashankar & Junyao Zhao
May 7, 2016
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COMPANY PROFILE
Netflix is the world’s leading Internet television network with over 75 million members in over
190 countries watching 125 million hours of viewing per day, including original series, documentaries,
and feature films. Netflix is a global Internet TV network offering commercial-free unlimited viewing
on any Internet-connected screen for an affordable, no-commitment monthly fee. It offers a personalized
experience based on a sophisticated user monitoring to make individual recommendations.
STRATEGY ANALYSIS
The Internet Publishing and Broadcasting industry represented about $39.4 billion in 2015, and
paid content accounted for an estimated 35.2% of industry revenue and consists of digital media that
requires a user to pay in exchange for access – which means that Netflix represented about 48% of this
market in terms of top line revenues. While Netflix dominated the early years of the video streaming
industry, today’s business environment is hyper competitive, with powerful companies leveraging their
strengths in finance, media, and/or infrastructure with the sole aim to dislodge Netflix from the number
one position in market share.
Industry Analysis - Porter’s Five Forces
Bargaining Power of Buyers (High): A 2014 Nielsen report showed that 90% of homes in the United
States with streaming video service choose Netflix. However, almost one-third of these households
subscribe to more than one video streaming service. The bargaining power of buyers is very high
because there are companies (e.g. Amazon and Hulu) who offer streaming video with subscription
prices of less than $10 per month. Most video streaming service providers require no annual contract
and offer a free trial. Therefore, the cost to switch between providers is essentially zero. Netflix has
to make sure its content is compelling enough for subscribers to justify keeping the service.
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Bargaining Power of Suppliers (High): As more television studios and movie networks debut their own
streaming services, some are less willing to share content. Netflix suppliers are slowly evolving to
supplier-competitors who may choose to keep content exclusive to their platforms or charge Netflix
a premium. Suppliers are developing strategic alliances or partnerships and make it that much less
likely Netflix will be able to stream their content.
Degree of Rivalry among Competitors (High): Netflix (48% Market Share in 2015) competes directly
against Amazon Prime (20%) and Hulu (10%), but Netflix also competes with major networks like
HBO (4%), CBS (2%), and Fox (less than 1%) who have their own streaming video service available
on apps for streaming devices like Roku, Chromecast, and Apple TV. Hulu offers next-day viewing
of current hits, which could be important for customers who want to replace their cable with a video
streaming service (Netflix does not have the ability to stream shows so soon after airing).
Threat of New Entrants (Medium): One contender for new entrants is YouTube Red, a premium version
of YouTube which provides access to original shows and links to a YouTube Music app that creates
playlists Google Play Music. YouTube Red combines original content, music and social media with
a streaming video service. A new entrant to the streaming video industry that does not have the same
scale and support as YouTube Red has from Google could find competing against a well-established
rival such as Netflix difficult, if not impossible. New entrants would almost have to partner with an
established brand, network or studio to compete on the same scale. Another strategy for new entrants
is appeal to a niche - to pull select customers from Netflix. There are many niche offerings: Fandor
for foreign and independent movies, Disney for children’s programming, Bloomberg for business,
and ESPN for sports.
Threat of Substitutes (High): Traditional cable services are popular with most established viewers of
sports, news, and drama. Cable offers its own streaming services free to their subscribers. The video
streaming industry reports a high degree of seasonality in its subscribers: as summer arrives, they
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find their subscribers “opting outside” over watching TV inside. In addition, Netflix faces a risk of
people substituting its service by pirating content. Whether the pirates get their videos from one of
the many Internet piracy sites or from a friend’s borrowed Netflix log-in, there is an enormous cost
to- the company. Netflix also has to compete against other streaming video providers such as PBS,
Crackle or Snag Films who offer some content for free or in exchange for airing commercials.
Competitive Strategy
Netflix’s competitive strategy is to differentiate its content to keep their current customers and
draw new subscribers to the service. Their strategy is to develop and acquire compelling content of
interest to a global audience. According to one research report the Video On Demand market will grow
from $25.3 billion in 2014 to $61.4 billion in 2019. Since they are in a highly competitive industry we
expect Netflix traditional high growth in the early years to slow to the pace of the general market (20%
CAGR).
Netflix has clear first mover competitive advantage in the streaming video market. They have the
largest customer base and a significant amount of valuable content. They have the ability to monitor
their users to help direct acquisition/development of new content. However, this advantage is probably
not sustainable. As the undisputed leader in video streaming, it is clear that competitors will be focused
on copying and/or out-innovating Netflix (Ref. Exhibit 1).
Another key to Netflix competitive strategy is expansion into the International market before
their competitor can gain a foothold. Their international market is twice the size of the US market (Ref –
Exhibit 2). Their large US platform (about 10x the bandwidth and twice the number of households as
next streaming competitor) and consumer monitoring and measurement will enable them to understand
the unique needs of their international customers.
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Netflix’s strategy depends on a supportive regulatory environment, because their large
bandwidth usage (as much as 37% of all prime-time downstream internet traffic) and dependence on
other provider’s networks, makes it vulnerable to surcharges by providers if net neutrality is not strictly
regulated by the FCC (and the equivalent in other countries). This is not an issue for competitors such as
cable operators and telephone companies who provide their own access, but may be a bigger issue as
part of their international expansion.
Corporate Strategy Analysis
Netflix has three reportable segments, domestic streaming, International streaming and Domestic
DVD. A majority of Netflix’s revenues are generated in the United States, and substantially all of
Netflix’s long-lived tangible assets are held in the United States.
Netflix has successfully transformed their company from a DVD rental to a streaming media
company. Throughout this evolution, Netflix has developed the tools to understand their customer’s
preferences to provide relevant recommendations on the most attractive content. The mail-order DVD
business is very profitable for Netflix. However, we expect that the rental business will not be an
important contributor (declining 15-20% per year over the next 5 years). Netflix’s major strategic thrust
is to expand its platform to lead the industry expansion into the international market. They are
completing their Global roll-out in 2016 and plan to develop relationships to acquire in-country custom
content for the new markets (This strategy is well summarized in the quote in Exhibit 3). In a bold
strategic move, Netflix’s is increasing its subscription fee by $1.00 to US subscribers later this year.
This will be a crucial test of customer loyalty and if successful will help fund the growth of custom
content. However, if it is unsuccessful, it could impact the investment in market specific content and
thus slow growth in international markets.
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Conclusion
The Streaming Video industry is highly competitive. Netflix’s competitive strategy is to
differentiate its content and extend its global reach with a corporate strategy to invest in developing their
own content and extending their global platform to leverage their number 1 position. However, we
expect Netflix will reduce their overall US subscriber growth to industry norms (15-20% subscriber
growth on a large base) and merely a healthy expansion into international markets (20-25% subscriber
growth on a much smaller base) while managing the increased cost of content acquisition.
ACCOUNTING ANALYSIS
Key success and risk factors
One key measure of Netflix’s success is its vast library of streaming and DVD content, which
can currently be accessed globally. This is represented as current and non-current content assets on the
balance sheet. Netflix offers content on a subscription basis only, and does not derive any advertising
revenue (as does most of the industry).
Netflix does not release title-level ratings; instead they release ratings for Netflix as a whole
every quarter with their membership growth report. It is their understanding the member viewing and
satisfaction propels growth, but hides the profitability of individual investments, and may become harder
to gauge going forward. It is also a risk that contracts for service content are a fixed cost, while Netflix’s
revenues are variable to the number of user subscriptions - the impact of which is discussed in the
accounting flexibilities section below.
Therefore, for Netflix to keep adding additional content and continue to generate positive free
cash flow, they need to continue to increase their subscriber base to pay for that additional content.
While we are projecting majority growth to come from the international segment, the negative
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contribution margins of this sector is currently an inherent risk, but this ratio is improving year over
year. The company translates the assets and liabilities and re-measures non-U.S. dollar subsidiaries into
U.S. dollars using exchange rates in effect at the end of each period - and these volatility present
considerable future risks. The gains and losses from the re-measurements are recognized in interest and
other income (expense). For 2015, international revenues and cost of revenues account for 29% and
39%, respectively and resulted in losses of $331 million.
Accounting flexibilities and justification
Significant items in the financial statements subject to estimates and assumptions include the
amortization policy for the streaming content assets, and the recognition and measurement of income tax
assets and liabilities.
While the individual contracts for titles is impossible to determine, Netflix amortizes the content
assets (licensed and produced) in “Cost of Revenues” on the Consolidated Statements of Operations
over the shorter of each title's contractual window of availability or estimated period of use, beginning
with the month of first availability. The amortization period typically ranges from six months to five
years. For most of the content, Netflix amortizes on a straight-line basis. For certain content where
Netflix expects more upfront viewing, due to the additional merchandising and marketing efforts, the
amortization is on an accelerated basis. Netflix reviews factors impacting the amortization of the content
assets on a regular basis, including changes in merchandising and marketing efforts. Changes in
estimates could have a significant impact on Netflix's future results of operations. In the third quarter of
2015, Netflix changed the amortization method of certain content given changes in estimated viewing
patterns of this content. The effect of this change in estimate was a $25.5 million decrease in operating
income and a $15.8 million decrease in net income for the year ended December 31, 2015. The effect on
both basic earnings per share and diluted earnings per share was a decrease of $0.04 for the year ended
December 31, 2015.
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In 2015, the difference between the 14% effective tax rate and the Federal statutory rate of 35%
was $30.4 million due in part to $13.4 million release of tax reserves on previously unrecognized tax
benefits as a result of an IRS audit settlement leading to the reassessment of reserves for all open years,
and another $16.5 million related to the retroactive reinstatement of the 2015 Federal research and
development (“R&D”) credit and the California R&D credit. This gain was partially offset by state
income taxes, foreign taxes and nondeductible expenses.
Accounting strategy
Streaming delivery services such as Hulu, HBO Go and Amazon Instant Video are very similar
to Netflix's business model and have similar balance sheets due to content licensing and streaming
capabilities. But, unlike Amazon and Comcast, Netflix capitalizes the fee per title and records a
corresponding liability at the gross amount of the liability when the license period begins, the cost of the
title is known and the title is accepted and available for streaming. For productions (and this is
increasing year-on-year), Netflix capitalizes costs associated with the production, including development
cost and direct costs. Participations and residuals are expensed in line with the amortization of
production costs. This represents approximately $6.1 billion that is not represented on the Balance Sheet
(Ref. Exhibit 4), but we are in agreement of this policy, as recognition would lead to a corresponding
increase in non-current assets – artificially inflating the balance sheet as a whole - while leaving the net
long term assets unaffected.
Red Flags
It should be noted that while content costs are recorded an investing (and not operating) cash
outflow, only amortization costs are recorded on the Income Statement. We argue that this is correct, as
Netflix, which doesn’t earn revenue from each individual stream but instead from subscriptions, cannot
accurately project how any particular show or movie license will contribute to revenue. Netflix has been
strategic in implementing this policy to keep content still unavailable for streaming off the financial
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statements – the recognition of which would have pushed down its EPS into negative territory. The rate
of amortization is discretionary to management, and a potential red flag with future growth in content
assets.
While accounting policies are largely legal, the above discussion shows what potential changes
could influence investors, most of which seems to be largely ignored by the market to support the
current stock price owing to the expected growth (and P/E ratio in excess of 300X). Some key financial
statement disclosures that we should watch for include the high cash usage upfront due to production of
original content - this is an upward trend, and a potential red flag for net operating income, and cash
generated by operating activities.
Conclusion
In analyzing the financial statements we found that Management discussions are extremely
detailed regarding all inherent risks to the future growth of the company - both in terms of customer
acquisition and technological advancements - and has proven to be reliable in representing the business
in the correct light, allowing investors to make calculated assumptions about opportunities on hand. We
concur with Netflix’s claims to manage balance sheet to lower blended cost of capital over time, while
maintaining financial flexibility.
FINANCIAL ANALYSIS
Growth and Profitability - The Big Picture (Ref. BAV Table 1)
In the past five years, Netflix’s sales have grown more than 20% each year along with a 30%
growth in gross profit margin over the interval. The increasing profit margin is a result of increasing
revenue being generated from rapid growth of new subscribers each year, but the high profit did not
flow to the bottom line of the income statement due to the increasing and high operating and content
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expenses, which lead to the decreasing and low profitability ratios (Ref. BAV Table 2). For 2015,
Netflix’s ROE was only 5.5%, which dropped by about 900 bps from 2014.
Interpretation of ROE: ROE has experienced a decline over the past 5 years. The rate of growth of long
term content assets far outpaced rate of sales growth, which leads to declining profit margin and
declining asset turnover - both of which contribute towards a declining ROA. The Asset Turnover
ratio has been decreasing for the past 5 years due to the heavy investments associated with building
and content assets.
Netflix has negative gains from its financial activities, but the trend is decreasing. Netflix
increased its debt significantly from about $240 million to $2.4 billion over the past five and an
additional $1.5 billion of long-term debt was issued in 2015.
To increase ROE, Netflix needs to improve its operating performance as well as use debt
efficiently.
Sales Growth: Consolidated sales growth was 23.2% from 2014 to 2015 primarily due to the growth in
average paid subscriptions, especially from the international segment. The impact of sales growth
from memberships was offset slightly by a decrease in average monthly revenue per paying
streaming membership, as well as unfavorable foreign currency fluctuation impact to the
international streaming segment (Ref. Appendix - Table - Netflix’s Sale and Income Growth).
The Net Income fell by 54% from 2014 to 2015 due to increased marketing and headcount costs
to support their international expansion and increased content expenses as Netflix continues to acquire,
license and produce contents - including more Netflix originals. Net income is further impacted by the
increase in interest expense associated with debt issuance in the first quarter of 2015.
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Operating Management (Ref. BAV Table 5)
The EBIT and net income margin are both low and on a decreasing trend for the past five years,
which results from their strategy to reinvest in the business. Netflix’s exhibits increasing efficiency in
procurement of contents and its production process, but its profit is offset by high operating costs mainly
from SG&A, amortization and depreciation expenses. SG&A expenses associated with Netflix
implementing its competitive strategy - were 27.8% of sales for 2015 and remained relatively constant
for the past 5 years. These high expenses show that it is competing on a differentiation strategy. Other
expenses include building depreciation and content amortization, which represented 52.3% of sales and
is on an increasing trend due to the increase in content library as well as expanding global licenses.
Investment Management (Ref. BAV Table 6)
Netflix does not have any account receivable because of prepaid subscriptions for their streaming
service. As Netflix capitalizes its content assets, we can argue the working capital management has
improved over the past five years and can be seen in the form of longer Days Payable. The net Long-
term Asset turnover on the other hand has decreased, which is due to significant increase in long-term
assets, primarily in contents assets as well as infrastructures both domestic and international. In 2015,
Netflix entered into additional lease agreements for its Los Gatos headquarters. Netflix investment
management has resulted in negative working capital margin and decreasing net long-term assets
turnover due to the nature of the business.
Financing Management (Ref. BAV Table 7)
Netflix’s has good liquidity with their current ratio at 1.5 compared to an industry average of 0.8.
The big difference between quick ratio and current ratio comes from the current portion of content
assets. Their interest coverage ratio shows they have the resources to pay their interest obligations, twice
over.
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Dividend policy: Netflix has not declared or paid any cash dividends, and has no intention of paying
cash dividends in the foreseeable future. On July 14, 2015, Netflix exercised a 7:1 stock split in the
form of a stock dividend to all shareholders.
Recurring NOPAT Margin and Sustainable Growth Rate
Growth-stage companies such as Netflix deploy a lot of capital in their investment activities.
With massive use of cash for up-front contents expenses, Netflix has resorted to debt to finance its
various investments. For 2015 Netflix's total debt has exceeded the size of its equity with a D/E ratio of
1.08.
A majority of Netflix’s costs stem from content license fees and investment outlays for setting up
its Internet infrastructure and running online operations. Netflix's NOPAT margin is considerably thin at
3.5% for 2015 which decreased about 200bps from 2014. Recurring NOPAT margin for 2015 is 0.4%
higher than the NOPAT margin, which reflects a portion of Netflix’s NOPAT is derived from source
other than its core operations. EBITDA is 56.4% for 2015 which indicates the overall high profitability
of Netflix’s business, and the ratio is on an ascending trend for 2010 to 2015.
The dividend yield is zero therefore the Sustainable Growth Rate is the value of ROE at 5.5%.
Cash Flow Analysis (Ref. BAV Table 8)
Operating cash flow before working capital investments: Netflix’s cash position before consideration of
its working capital investments has trended negatively for each of the past five years. Based on the
company’s high growth rate, its negative cash position can be attributed to content expenses and
other working capital differences. In 2015, revenues were $6.8 billion--all driven by the company’s
growing subscriber base. Content expenses burned nearly $5.7 billion in cash, an increase of 53.9%
on the previous year. The significant net cash used in operations stemmed from the increase in
streaming content contracts requiring more upfront payments. In addition, there was also an increase
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in payments associated with higher operating expenses - increased head-count, international
marketing expenses, etc.
Operating cash flow before investment in long-term assets: By liquidating $1.3 billion of operating
capital mainly through increases in accounts payable, deferred content acquisition costs and other
liabilities (partially offset by increases in other current assets), Netflix’s operating cash flow before
working capital investments was -$635 million in 2015.
Free cash flow available to debt and equity: As Netflix capitalizes DVD content assets, an outflow
of $77 million was recognized towards long-term assets. In addition they expanded office facilities
at their Los Gatos headquarters, spending another $91 million. Net change in short term investments
accounted for approximately $8 million in outflows leaving net cash available to debt and equity of -
$813.9 million.
Free cash flow available to equity: Net proceeds from a $1.5 billion debt issue (Ref. Appendix - Table -
Standardized Statement of Cash Flows - Netflix, Inc.) and the increase in after-tax net interest
expense resulted in free cash flow available to equity of $5.7 billion. As a result of negative cash
from operations in 2015, the company had to borrow heavily, with debt (long term) accounting for
25% of cash inflows. In addition, the company issued common stock, resulting in a net increase in its
cash balance of $78 million.
Conclusion
Although Netflix generated high revenue they are utilizing their free cash flow to build their
content library. Netflix increased the use of long-term debt to finance its global expansion and ended
2015 with an additional $666 million in cash. It is currently considered as a growth business and not
under financial distress.
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PROSPECTIVE ANALYSIS
Baseline forecast (Ref. BAV Exhibit 6): The following sets of assumptions support Netflix’s current
stock price of $95.50. Revenue would have to grow 25% per annum over the forecast period and
although Netflix has been successful in generating impressive YOY revenue growth we believe this
growth rate is high. Revenue growth comes from adding additional subscribers and the only way
Netflix can support the lofty growth assumptions is to add 15 million subscribers each year over the
forecast period. Since Netflix added 5.5 million new subscribers in 2015 this seems to be an
unrealistic assumption. NOPAT margins are assumed to grow approximately 7.4% per annum over
the forecast period which is consistent with Netflix NOPAT margins in 2008 - 2011 but despite our
confidence in Netflix's current competitive position - we believe these assumptions in NOPAT
growth are unattainable. Net working capital to sales remains negative as short term liabilities
outpace current assets but this is acceptable given the front end loading of the content building
strategy. Net long term assets increase over the period and is justified as building long term content
is essential to their growth strategy. Book value of capital leverage increases over the forecast period
as the company must raise capital as they try to stay relevant and maintain its competitive advantage
but market value of capital leverage decreases due to expected increases in shareholder equity over
the forecast horizon. The abnormal ROE being greater than the cost of equity and the ROA being
greater than WACC implies that Netflix can maintain its competitive advantage. We disagree and
believe Netflix will not be able to achieve wide gaps of profitability and productivity in a very
crowded, highly competitive and fast growing industry.
Years until terminal year and defining terminal values: The prospective analysis uses a 5 year forecast
horizon with the 6th
year used as the terminal year of the forecast period. The terminal value
represents Netflix’s competitive position in 2016 to perpetuity. Netflix has been able to maintain its
competitive position in the industry through 2015 but we argue that the company will not be able to
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maintain its position in the terminal year and will fall short of the projected terminal value of $36.1
billion.
Forecasting performance until terminal year: Revenue growth over the forecast horizon starts at 30% in
2016 and decreases to 18% in 2020. This robust assumption of revenue growth is driven by high
expectations of subscriber growth, higher U.S pricing structures and a successful international ramp-
up but this growth cannot be justified by its current competitive position. NOPAT margins start at
8.0% in 2016 and decrease to 7.0% in 2020. While the gradual decline in NOPAT margin is
expected, we believe the high NOPAT margins assumptions are unrealistic and see NOPAT margins
and EVA being competed away over the forecast horizon.
Selecting the discount rate and cost of capital parameters: The terminal revenue growth rate (the
discount rate) and NOPAT margins are 9.7% and 6.0%, respectively. The market risk premium used
in this forecast is 6.71% and is based on the geometric average MRP from 1966 to 2015. The risk
free rate (based on the 10 year T-Note) is 2.0% in the first year but will gradually increase 25 bps
each year to reflect the anticipated increases in U.S interest rates. Netflix corporate tax rate is
expected to stay relatively flat at 30% over the forecast horizon. The cost of debt (currently at
5.65%) is based on existing debt obligations but we forecast higher debt costs over the next 3 years
as the company becomes more levered (Ref. Exhibit 5). Netflix has a levered beta for equity of 1.29.
Scenario Analysis
Best case scenario (Ref. BAV Exhibit 7): Our best case scenario has a price target of $95.06. This stock
price is based on the belief that Netflix has achieved a level of sustainable scale, growth, and
profitability that is currently reflected in its current stock price of $95.50. Supporting this price target
is robust revenue growth increasing from $6.7 billion in 2015 to $29.5 billion in 2020. This scenario
suggests the company can thrive among the competition and maintain its competitive position.
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Worst case scenario (Ref: BAV Exhibit 8): Our worst case scenario has a price target of $30.03 and is
based on declining U.S contributions margins and higher than expected costs in international
markets. Under this thesis, U.S subscriber growth will slow and international contribution margins
will be weaker than expected due to challenges with international payment systems, price sensitivity
among international subscribers and strong local competition. We believe these factors present a
challenging road ahead and the current stock price does not reflect these increasing challenges.
Most likely scenario (Ref. BAV Exhibit 9): The most likely scenario for Netflix has a price target of
$65.30. This stock price is based on the belief that Netflix has achieved a level of sustainable scale
and profitability but its prospects for growth will start to experience mean reversions in ROA and
ROE as the U.S streaming segment reaches maturity and competition intensifies.
Interpretation of the most likely scenario (based on the proformas and graphs)
We forecast average revenue growth of 24% over the forecast horizon which is consistent with
Netflix’ prior revenue growth rates albeit higher than the industry average of 9.6%. NOPAT margins
start at 6.8% in 2016 and decrease to 6.4% over the forecasted period due to increased interest expenses
and reduced revenue from declining U.S streaming contribution margins and a sagging DVD segment.
Net operating asset turnover is -4.74% in 2016 and has a steady decline over the forecast period that is
consistent with a decline NOPAT margin and increase in the asset base. ROA and ROE experience
mean reversion as competition reduces profitability over the forecast period and into perpetuity.
Valuation using price multiples
The P/E ratio, EPS ratio and Price to Book ratio are used to reinforce our belief that Netflix is
currently overvalued compared to its top competitors Time Warner Cable (HBO) and Comcast, and
fairly valued against Amazon Inc. We used these standard price multiples because they clarify our
assumptions of value versus competitors. Netflix’s current P/E ratio of 398 indicates that investors are
willing to pay 398 times 2015 earnings compared to TWC’ P/E of 28.7 and Comcast’s P/E of 17.4.
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Amazon has a P/E of 540 and we believe this is also overvalued compared to its competitors. Netflix’s
price to book ratio of 18.3 indicates that investors are willing to pay over 18 times more than the current
book value for each share of stock. TWC and Comcast have P/B of 5.85 and 2.64, respectively. Netflix’s
high P/B ratio indicates a significant premium compared to competitors in the Internet Publishing and
Broadcasting industry. Since TWC and CMCSA are both content companies with streaming arms and
mature businesses they're probably a good proxy for where Netflix P/E and P/B ratios will be in the
future.
Conclusion
Assumptions for growth, asset management, leverage and cost of capital parameters in the
baseline forecast will not support the current stock price as competitive forces and industry changes
erode Netflix strategic position over the 5 year forecast horizon and beyond. The most likely scenario,
which is grounded in the foregoing strategic, accounting, and financial analysis, indicates that Netflix is
trading at a 30% premium to fair value.
OVERALL RECOMMENDATION
Netflix stock has 52 week trading range of $78 - $133. Currently trading at $95.50 and we
believe the company stock price is overvalued. We assign a SELL rating to Netflix, Inc and believe the
fair value of the company is reflected in a $65 stock price. Although the current stock price reflects
investor acceptance of the high growth / low margin nature of the company, we believe these investors
are capitalizing on hope as they ignore increased competition, low margins, increasing debt, and
negative cash flows from the company. As such, we believe the stock price is overvalued.
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APPENDIX
BAV Table 1 – Netflix’s Key Profitability Ratios
BAV Table 2 – Netflix’s Traditional ROE Decomposition
20
BAV Table 3 – Evaluating ROE
BAV Table 4 – Alternate ROE Decomposition
21
BAV Table 5 – Evaluating Operations
BAV Table 6 – Evaluating Investments
22
BAV Table 7 – Evaluating Financial Management
BAV Table 8 – Standardized Statement of Cash Flows
Year Ended Dec-10, (MM USD) 2010 2011 2012 2013 2014 2015
Net Income 160.85 226.13 17.15 112.40 266.80 122.64
After-tax net interest expense (income) 11.61 12.60 11.24 19.15 38.35 114.72
Non-operating losses (gains) -10.50 0.00 0.00 0.00 0.00 0.00
Long-term operating accruals -101.32 -1,487.96 -782.48 -808.22 -980.54 -2,207.38
Depreciation and amortization 340.07 839.62 1,702.08 2,241.68 2,781.80 3,547.05
Other -441.39 -2,327.58 -2,484.56 -3,049.90 -3,762.34 -5,754.43
Operating cash flow before working capital investments $60.64 -$1,249.23 -$754.09 -$676.67 -$675.39 -$1,970.02
Net (investments in) or liquidation of operating working capital 227.37 1,579.55 788.09 793.65 730.22 1,335.30
Operating cash flow before investment in long-term assets $288.01 $330.32 $34.00 $116.98 $54.83 -$634.72
Net (investment in) or liquidation of operating long-term assets -116.09 -265.82 -245.91 -255.97 -42.87 -179.19
Free cash flow available to debt and equity $171.92 $64.50 -$211.91 -$138.99 $11.96 -$813.91
After-tax net interest expense (income) 11.61 12.60 11.24 19.15 38.35 114.72
Net debt (repayment) or issuance -1.78 195.98 -2.62 270.05 398.91 1,499.45
Free cash flow available to equity $158.53 $247.88 -$225.77 $111.91 $372.52 $570.82
Dividend (payments) 0.00 0.00 0.00 0.00 0.00 0.00
Net stock (repurchase), issuance, or other equity changes 49.78 219.56 3.66 124.56 67.62 95.61
Net increase (decrease) in cash balance $208.31 $467.44 -$222.11 $236.47 $440.14 $666.43
Standardized Statement of Cash Flows - Netflix, Inc.
23
Exhibit 1 - Growth of Netflix competitors
Source: “Premium Prospects for OTT in the USA” study from MTM, Ooyala and Vindicia
Exhibit 2 – International Market Size
24
Exhibit 3 - Quote from Netflix report from Argus Research (Jan 21, 2016)
“International expansion has been a key growth strategy for Netflix. The company has pursued a
series of country rollouts beginning with Canada in September 2010; Latin America and the
Caribbean in September 2011; the U.K. and Ireland in January 2012; Scandinavia in October 2012;
the Netherlands in September 2013; and Germany, France, Austria, Belgium, Switzerland, and
Luxembourg in September 2014. The company also launched service in Australia and New Zealand
in March 2015; Japan in September 2015; and Italy, Spain and Portugal in October 2015. In January
2016, it essentially launched service in the rest of the world, excluding China. Netflix is cautious
about moving into China, a key market by any measure, but one that is also rife with obstacles.
The company's international expansion will require significant spending for content acquisition,
technology development, and marketing. Netflix is also likely to face additional regulatory and legal
costs, and challenges related to the cultural acceptance of its service and business model in other
countries. On the fourth-quarter call, management tried to tamp down expectations about its
international expansion, noting that markets tend to ramp up slowly after initial launch before
gaining momentum. That said, local country reaction to Netflix's content has generally been quite
positive and should become even more favorable as the company increases production of both local
and internationally oriented content, including what it calls 'global originals,' e.g., the recently
launched series 'Narcos,' a bilingual English-Spanish co-production with Telemundo, with a mostly
Latin American cast and crew.”
25
Exhibit 4 – Reclassification of long term liabilities - scenario
If re-classified
Year Ended Dec-10, (MM USD) 2010 2011 2012 2013 2014 2015 2015
Assets
Cash and Marketable Securities 350.4 797.8 748.1 1,200.4 1,608.5 2,310.7 2,310.7
Accounts Receivable 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Inventory 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Other Current Assets 290.6 1,033.1 1,492.7 1,858.4 2,332.0 3,121.1 3,121.1
Total Current Assets 641.0 1,830.9 2,240.8 3,058.8 3,940.5 5,431.9 5,431.9
Long-Term Tangible Assets 309.5 1,183.3 1,637.7 2,224.7 2,923.2 4,486.2 4,486.2
Long-Term Intangible Assets 7.1 8.3 8.3 0.0 0.0 0.0 0.0
Other Long-Term Assets 24.5 46.8 81.1 129.1 193.0 284.8 6,384.8
Total Long-Term Assets 341.1 1,238.3 1,727.1 2,353.8 3,116.2 4,771.0 10,871.0
Total Assets $982.1 $3,069.2 $3,967.9 $5,412.6 $7,056.7 $10,202.9 $16,302.9
Liabilities
Accounts Payable 222.8 924.7 1,453.3 1,884.4 2,318.8 3,042.5 3,042.5
Short-Term Debt 2.1 2.3 3.1 1.1 1.2 0.0 0.0
Other Current Liabilities 163.7 298.0 219.5 268.7 343.1 487.1 487.1
Total Current Liabilities 388.6 1,225.1 1,675.9 2,154.2 2,663.2 3,529.6 3,529.6
Long-Term Debt 234.1 431.8 412.0 529.5 928.4 2,400.4 2,400.4
Deferred Taxes 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Other Long-Term Liabilities 69.2 769.5 1,135.3 1,395.3 1,607.4 2,049.5 8,149.5
Total Long-Term Liabilities 303.3 1,201.3 1,547.3 1,924.8 2,535.8 4,449.8 10,549.8
Total Liabilities $691.9 $2,426.4 $3,223.2 $4,079.0 $5,198.9 $7,979.4 $14,079.4
Minority Interest 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Shareholders' Equity
Preferred Stock 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Common Shareholders' Equity 290.2 642.8 744.7 1,333.6 1,857.7 2,223.4 2,223.4
Total Shareholders' Equity $290.2 $642.8 $744.7 $1,333.6 $1,857.7 $2,223.4 $2,223.4
Total Liabilities and Shareholders' Equity $982.1 $3,069.2 $3,967.9 $5,412.6 $7,056.7 $10,202.9 $16,302.9
Balance Sheet - Netflix, Inc.
26
Exhibit 5 – Calculating Beta and Cost of Capital Parameters
Inputs
Equity
Number of Shares outstanding = 428.08
Current Market Price per share = $95.5
Approach for estimating beta Multibusiness(Global)
If direct input, enter levered beta (or regression beta) 1.68
Unlevered beta = 1.06
Riskfree Rate = 2.00%
Approach to input ERP Operating regions
Equity Risk Premium used in cost of equity = 6.71%
Debt
Book Value of Straight Debt = $2,371.4 : From 10-K
Interest Expense on Debt = $132.7 : From 10-K
Average Maturity = 3
If actual rating, input the rating Ba2/BB
Pre-tax Cost of Debt = 5.65% : From Prospective analysis
Tax Rate = 30% : From Prospective analysis
Debt value of operating leases / long term liabilities = $10,262.2
Estimating Market Value of Straight Debt = $2,368.0
Value of Debt in Operating leases = $10,262.2
Levered Beta for equity = 1.29
Equity Debt Preferred Stock Capital
Market Value $40,881.6 $12,630.2 $0.0 $53,511.8
Weight in Cost of Capital 76.40% 23.60% 0.00% 100.00%
Cost of Component 10.65% 3.96% 7.14% 9.07%
Beta & Cost of Capital Calculations
27
BAV Exhibit 6 – Baseline forecast – Stock Price $95.50
BAV Exhibit 7 – Best Case Scenario – Stock Price $95.00
28
BAV Exhibit 8 – Worst Case Scenario – Stock Price $30.00
BAV Exhibit 9 – Most Likely Scenario – Stock Price $65.50
