04.12.18 | The case for Netflix (a cash burning stock).

By Jessica Sier 10 December 2018 5 min read

Question: Why are investors cool with investing in tech companies that don’t actually turn a profit?

Answer: The financial benefits of entrenching your company into everyone’s digital lives are so big that even losing billions of dollars to get there can be worth it.

Let’s talk about Netflix, which spends a lot more money than it makes.

This is how the business works in a nutshell:

  • Netflix borrows (and raises) a tonne of money;
  • Netflix pays money to obtain the rights to TV shows and movies;
  • it also pays money to make its own TV shows and movies;
  • it pays thousands of people to maintain a website (platform) where those TV shows and movies can be watched;
  • you and I pay a bit of money every month to watch those TV shows and movies;
  • Netflix has proprietary technology (meaning only Netflix owns it) that teaches itself what we say we like to watch (high brow documentaries saved to our wishlists) and what we actually like to watch (Legally Blonde) and serves us up new TV shows and movies whenever we want, as many as we want, tailored to our tastes (but not too much!);
  • we all share our login accounts with our friends so only one of us has to pay the subscription fee;
  • Netflix doesn’t seem to mind; and
  • it becomes a verb.

In this scenario there is a lot more money outgoing than incoming.

In fact:

Netflix (expects to) spend $US13.8 billion in 2018.

Netflix made $11.7 billion in revenue in 2017, but lost $2.02 billion on a free cash flow basis.

(Free cash flow represents how much cash a company makes after its paid for operations and everything else it does.)

But the market capitalisation (how much investors think the business is worth) went from $US80 billion 12 months ago to $US124 billion this week.

But still, Netflix didn’t make any money. (The same goes for Uber, Spotify, Twitter, WeWork etc).

Why are investors so stoked with this?
The answer lies in the future.

When we buy shares in a company, we are buying the chances of them making money in the future. We are buying a slice of their future cash flows.

When we buy Rio Tinto, we reckon in the future it will dig up some more iron ore, sell it to the Chinese, make money and we will get a slice of that money.

When we buy Alphabet, we reckon in the future it will charge advertisers for exposure on its search engine, make money and we will get a slice of that money.

When we buy Apple, we reckon it will keep selling iPhones in the future (or be secretly inventing some crazy unknowable new product), make money and we will get a slice of that money.

When we are buying - or selling - shares we are thinking about the potential future cash flows.

The difference is, Netflix isn’t making money now.

But when we buy their shares, we’re doing it because we think they'll figure out a way to make money in the future.

Their losses now are part of the much bigger and broader plan to become profitable.

Let’s talk about this plan:

As of October, Netflix had 137 million subscribers.

Who all pay between $US7.88 and $US13.99 per month for the service.

But it also has to account for the people who think Netflix sucks and unsubscribe.

This is called churn.

Netflix doesn’t release its churn figure, but there are plenty of estimates, and they generally conclude it’s fairly low.

Netflix wants to make more money per month, so it has to focus on getting more subscribers.

It’s doing that by expanding their offering into other markets. It decides these markets based on how fast the internet is becoming in those regions.

So Netflix spends billions of dollars to make TV shows and movies for those audiences. It runs them on the platform and gets instant, genuine feedback about which shows people like and which they don’t.

This makes Netflix’s proprietary technology more valuable and their production mechanism efficient.

Subscriber growth is the key metric investors are interested in (when it comes to businesses like Netflix). They want more people to sign up, so more money is coming in the door.

But wait, you say. Sure, Netflix is scooping up hundreds of millions of eyeballs and making cool shows for everyone on earth but they’re still only charging the price of a Wham O Pro Classic Frisbee per month to watch it.

When are they going to turn around and make more money than they are spending?

And you’re right, creating value (fab TV shows) or build a sexy streaming website is not enough, you have to capture some of that value in order to be a successful business.

So let’s say there are 137 million subscribers on Netflix’s platform.

Who all pay $15 a month.

And you raised the price by $1, that’s an extra $137 million. Every month.

Imagine if you raised it by $2?

Also imagine, you’ve got a reputation as an authentic producer of high quality programming and you’ve also incidentally got access to 137 million sets of eyeballs.

Imagine you closed the loophole that allows people to share Netflix accounts, and passwords and things.

Would some of those people throw up their hands and say, “Drat! I really enjoy the cultural acceptance and easy ice-breakers new TV shows offer me in social situations so I’ll have to get my own $15 a month account now!”

Of course, people might be outraged, refuse to use Netflix and that churn figure will jump.

But that’s a calculated risk the company might take.

Also imagine high speed internet connections spread further and further around the world, and the television habits of folks living in emerging markets turns to streaming.

Which platform is likely to be in a good position to offer them something pretty extraordinary for really not that much money?

With a diverse range of options and perhaps not just a saturation of American programming?

Imagine if they opened up one advertising slot somewhere on its website. Imagine if there was a pre-roll advertisement?

I wonder how much advertisers would pay to have access to those 137 million sets of eyeballs?

And most importantly, making original Netflix shows and movies is a fixed cost.

It will always cost what it costs to make a show, but the more subscribers you have the more you can spread that cost across each person.

Meaning, the more subscribers you have - the fixed cost Netflix incurs for making that show becomes cheaper per subscriber.

How much money Netflix will make in the future is difficult to quantify and which method (or combination of methods) it might choose are unknown.

But those that buy the shares now are betting it will be more than enough to cover its debts and spending now.

Which granted, is a lot. But they stand to make a lot.

So: why are investors cool with buying tech companies that don’t actually turn a profit?

Answer: The financial benefits of entrenching your company into everyone’s digital lives are so big that even losing billions of dollars to get there can be worth it.

And the more subscribers you get, the less it costs to run the tech company's business because fixed costs are spread across each subscriber.

And, each subscriber becomes more valuable as they stick around, as they’re providing the tech company with data which helps the company to develop products and services that the subscribers want (and will pay for!).

Spaceship investment team think Netflix will manage to do that.

Which is why shares in Netflix are held in the Spaceship Index Portfolio and Spaceship Universe Portfolio now. So members of that portfolio can get a slice of the money in the future.

No one knows exactly when that flip will happen. Lots of people speculate, wildly, about, this. But when it comes to long-term investing, sometimes you just sit back and watch a company do its thing.

The idea behind investing is giving your money to someone who can do more with it than you can.

Words by
Jessica Sier Right Chevron

Jessica Sier is a financial journalist. Prior to that she led content at Spaceship and was a reporter at the AFR where she discovered that breaking down financial jargon was a public good.

04.12.18 | The case for Netflix (a cash burning stock).