George Salmon, Equity Analyst 10 May 2019
We all know watching TV is incredibly popular. But it might surprise you to know the average UK adult spends almost four hours a day in front of the box. It’s even more in the US, but that’s probably not as surprising.
While you can’t get square eyes from this amount of content, the amount of money involved might make your head spin. Historically, that’s been down to advertising.
Companies have always been prepared to pay to get in front of a national audience, but these days it’s not all about the ad space. 123 years since the first commercial cinema opened its doors, 21st century technology means a wealth of content can be streamed direct to your living room.
Now that’s a luxury people are willing to pay for.
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Streaming killing the video star?
As a pure play on streaming, Netflix is at the forefront of this trend. It’s also the biggest provider out there, with its latest quarterly numbers showing it’s got 148.9m subscribers. Netflix isn’t resting on its laurels either.
Netflix growth in subscriptions
That’s because scale is key to the group’s fortunes. Clearly, the more subscribers it has the more it should have coming in. But the nature of streaming means additional customers don’t come with extra costs attached. You don’t need to make a new show for every new customer.
The trouble is we’ve not reached that critical mass yet. Despite reporting a profit, Netflix is actually seeing cash walk out the door.
This accounting quirk is because of something called amortisation. The group’s single biggest cost is its content budget, which stretches to $13bn. Rather than take the hit against the income statement in a given year, Netflix spreads the cost over a longer time period. That means recorded costs are below the actual cash flows out.
Of course, there’s only so long cash flows can outstrip recorded costs. That makes the central question rather straightforward. Can Netflix increase revenues fast enough to offset the rising content costs?
Revenue growth has averaged 29% in the last 5 years and there’s plenty of white space on the map left to be filled. That means the prospects for subscriber growth remain strong. And with Netflix increasingly able to pull the pricing lever, its revenue per subscriber looks like it’ll be growing as well. That combination means the group is expecting its cash flows to start improving from 2020 onwards, despite the significant increase in spending.
In our view then, the group has an attractive operating model with great potential in a growing industry. With ticks in all the right boxes, what’s the catch?
Competing for a seat at the table
With hopes high, Netflix trades on 88 times expected earnings, and 7.5 times expected sales. That puts the pressure on it to deliver. And with plenty of others looking for a seat at the table, it’s not going to have it all its own way.
Disney’s streaming service is due to launch later this year.
Mickey Mouse & co has huge brand appeal and deep pockets. It’s also in control of major titles, including the Star Wars and Toy Story franchises to name but two, and has announced it’ll be pulling all its films from Netflix. Acting as both an established name and energetic upstart presents a threat.
By snapping up the rights to prime sports like the NFL and Premier League, Amazon is another major player looking for a slice of the action. Prime customers can get access to shows like Clarkson, Hammond and May’s The Grand Tour at no extra cost. But looking further afield, there’s clear potential to erect paywalls around premium content to drive revenue per user up.
Of course, we’ve no crystal ball, so we can’t say for sure who the winners will be.
There’s no reason all three can’t play together nicely, if the quality of entertainment is high enough. We’re spending an increasing amount on entertainment and experiences, as compared to physical possessions. And on a per minute basis, customers get impressive value for money.
However, it’s also easy to picture a world where pricing power is eroded by competition. While we think Netflix has clear merits, if investors are looking for an alternative option, we think Spotify deserves consideration.
Spotify – setting the tone
The Swedish sound cloud has only been listed on the stock market for little over a year. It might not have come to market at all were it not for private investors imposing conditions that increased the interest due on its bonds every year unless it came to public markets.
We’ve been impressed with what the group has had to say over the last year. Continued user growth in both premium and ad-supported offerings means the group has over 200m listeners, and a successful launch in India means growth is mushrooming there. The group added 1m more in less than a week following launch. It’s also signed a deal to expand its relationship with Samsung, which will see it pre-installed on millions more devices.
Still, like Netflix, Spotify is increasingly in competition with household names like Apple and YouTube owner Alphabet. That partly explains the extra product investments, particularly in podcasts, that are due to push the group into a loss next year.
But looking longer term, we think there are clear benefits of scale, which should mean the group’s into the black soon enough. And we can’t help but notice this attractive growth potential comes at just 3 times expected sales, compared to Netflix’s 7.5. That’s a significantly less-demanding valuation.
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