In the last two weeks we’ve had a set of tech earnings that has been a mixed bag. Of the so-called magnificent 7, six have reported earnings in the last week or so. Microsoft’s was received neutrally, Apple’s a little negatively, Alphabet’s negatively, Tesla’s quite negatively, and Amazon’s and Meta’s bullishly¹. A mixed bag, but markets remain near all-time highs.

I’m not interested in diving into the details of these earnings. Instead, I want to go back to an older formulation of the leading sexy tech companies, FAANG, and I want to look at what its recent earnings says about the longer journey, both as a stock and as a business. I’m talking about the one company that got dropped when market folks moved from FAANG to the Magnificent 7 – Netflix.

Netflix is a weird fit amidst these 8 companies because you could argue neither it or Tesla is like the others. The other six fundamentally create digital infrastructure for how we live our lives, ranging from search engines to cloud computing to messaging to the chips that power artificial intelligence. Tesla is, however it protests, just a car company, and Netflix is just an entertainment company.

But I want to use Netflix’s earnings as a way to put the company’s rise in context, and see how it achieved what looks like definitive victory. Was that knowable as an investment? What can we learn about the business, the stock, and investing? I’m not a Netflix or big tech expert, but I did some digging through the past ten years, and I have some conclusions.

(The most direct resources for this piece are Netflix’s shareholder letters and 10-Ks, though my podcast co-host Akram Razor’s writing on Netflix over the years was also invaluable background material).

Netflix’s Decade to Dominance

We’re looking at 10 years as a somewhat arbitrary time frame, but a useful one. Netflix’s earnings Q4 2013 shareholder letter has the company in early days of developing original content, and clearly on its path to be a streaming focused, content generating platform. This is after Qwikster, after the DVD business or killing Blockbuster, and after the sea change that House of Cards, Netflix’s first major original program, represents. This is a period of international expansion, of taking on billions of dollars of debt, of being questioned as an outsider, and then of being the incumbent in the streaming wars.

Netflix’s earnings Q4 2023 shareholder letter is our most recent point, but also a useful closing of the parenthesis. After a retrenchment in 2022, Netflix’s revenue growth, net income, EPS, operating income, subscriber growth, and share price all regained steam in 2023. The company’s guidance will have it free cash flow positive over a ten-year period, a period of heavy investment. And Netflix’s profitability looks strong going forward. Meanwhile, Netflix’s competitors are in various shambles.

Source; Netflix 10Ks

There’s no guarantee that Netflix will continue to dominate. The future is never promised. But I feel safe in saying that the current consensus is that Netflix won the streaming wars.

What can we learn from all this? I think four things stand out.

Remember the power of hindsight

It’s easy to declare a winner now. Netflix’s rise, from the vantage point of 2024, looks inevitable.

But there were a number of bumps along the way. Two periods stand out to me:

2018-2019 – Peak spending, peak competition

2018-19 – the start of the streaming wars. This marked a clear rise of competition. Disney +, HBO Max, Apple+, Amazon prime, Apple+, and many more either launched or reinvigorated their streaming services. These are legacy competitors with huge cred or intruders with huge pockets.

At the same time, Netflix’s cumulative free cash flow from 2014-2019 was negative $10.7B. Its net debt rose to a peak year-end level of $9.7B at the end of 2019. Even if we freeze the picture there, Netflix had just seen its share price rise 4.3% in 2019, a good market year, and its trailing GAAP PE was 83.1 on the day it filed its 10K. Poor performance at an expensive price.

It was hemorrhaging cash. While Netflix grew subscribers 20% in 2019, and other metrics more impressively, it was fair to wonder whether the company would have to spend in perpetuity.

Source; Netflix 10Ks

Of course, we didn’t know a pandemic would come that would both send more subscribers to Netflix and allow the company to spend less due to filming restrictions.

April 2022 – The Growth Story Changes Forever

You’re also dealing with the 2022 Q1 sell-off after Netflix’s earnings, where Netflix said its growth story was close to its end. It decided that it had to crack down on password sharing, a major cultural shift. Netflix also made clear an advertising subscription tier was coming, another major cultural shift. It seemed like Netflix had lost its edge. One major new investor, Bill Ackman², thought so, selling at what proved to be more or less bottom for the stock. 75% down from its highs less than 6 months earlier.

Those were the two sell opportunities that most stood out to me. And even at that 2022 bottom, shares sold at 16x eventual 2022 EPS, and 50x eventual 2022 free cash flow. Those numbers look much better for 2023. But we didn’t know that at the time.

There are certainly people who held Netflix shares throughout those 10 years. And you didn’t have to be a pie in the sky believer, or irrational, or a never sell type to do it. But remember that it’s much easier in hindsight to say you would have stuck with the shares. Be careful of survivorship bias.

The power of focus

One of the reasons you might have held Netflix’s shares throughout that time is that it was unique. Not as a video streaming service, not as a content company. But unique as the one player who had only one real business it cared about – selling subscriptions to watch video through the internet. It was clear even by 2013 that Netflix cared less about its legacy DVD business. It was clear the company would make original content to attract customers, and it would go global.

While its media competitors were bigger, they didn’t have that same focus or purity to its business model. And while Amazon and Apple could theoretically swallow Netflix, they had other businesses to think about too.

Sometimes the smaller competitor does get overwhelmed by the conglomerate. It needs enough muscle to be able to survive the big pockets of peers. Netflix has gotten lucky numerous times. Its fortunate ability to finance its growth with cheap debt is certainly an important example.

But from a business perspective, zeroing in on the competitor that doesn’t have to compromise within its organization structure, and that has to succeed in this field to survive can make sense as the right company to invest in.

I’m sure this is survivorship bias, and an easy counter example is Microsoft Teams. Microsoft Teams is a terrible product, but its size has allowed it to crowd out focused competitors like Zoom or Slack. But all things equal, I like that sort of showdown.

Valuation still matters

There’s a great saying that I saw on twitter at some point and can’t attribute. Maybe it was a major hedge fund guy, or just an anonymous source. It went: “I don’t need my analysts to tell me when a cheap stock is cheap. I need them to tell me when an expensive stock is cheap.”

Netflix shares, on the day it filed its 2013 10K, traded for 219x 2013 earnings. They traded for 93x 2014 earnings, 46x 2017 earnings, and 14x 2019 earnings, the first ‘reasonable’ multiple of the bunch. But if you held from that filing until the filing of the 2023 10K, you made 25.7% a year.

At the same time, we can do the same math from the 2018 filings. Those returns are much less attractive. 11.6%, which isn’t bad, but lags the indices (as Netflix points out in its newest shareholder letter, though its measuring points are year-end, so the numbers are slightly different). The three-year performance is worse, again depending on your precise starting point.

Which isn’t to argue Netflix is a bad investment over this time. If you had conviction, knew the story, and were holding over this time, you had chances to buy back in for cheaper. But it is a reminder that even with this triumphant growth story, it was possible to get buying decisions wrong.

Know what question you have to answer, for both business and stock

Which brings me to the last point. Understanding the company, and what stage it is in its business cycle, and what you should expect from the business and the stock.

Professor Aswath Damodaran, a if not the expert on valuing businesses practically and academically, developed the following graphic.

Source

Netflix’s decade illustrates the shift from high growth to mature growth. 10 years ago, your argument about owning Netflix shares would not be about cash payback. It would be about expansion internationally, subscriber growth domestically, creating a new category, overwhelming legacy categories, or all of the above. Subscriber growth that stayed above 18.4% for the next 7 years, 24% CAGR, would tell that story.

That sell-off in 2022 marked a point where subscriber growth was no longer going to be such a driver. It was also a point where the pandemic screwed things up, making 2021 and 2022 to some degrees an outlier.

At that point, you had to understand that Netflix’s subscriber growth dynamics were screwy, and that it would start making a lot more money. It was possible to do this, but you were solving for different variables.

Lifelong learning

I’d like to propose a fun paradox about investing. On the one hand, there is nothing new under the sun. The stories we see today have played out before, in different forms or details, but the same general paths. And at the same time, there’s always something new to learn.

Netflix’s 25 or so year lifetime has offered several business case studies. Dethroning Blockbuster and legacy video rental. How management should deal with short sellers. How to clean up major strategic missteps. And now, how to fend off bigger, legacy competitors while carving out a market lead in a new segment, streaming, while transitioning into the most profitable player left.

There’s a lot to learn from Netflix’s earnings and Netflix overall. And maybe I still haven’t learned my lesson – I’m just a dumb value investor who has never owned Netflix shares. But for all that, I think I’ve gotten plenty out of following the company. Even if that’s just a double dose of entertainment.

Interested in more from Middle Coast Investing? Or in talking to us? Get in touch.

Disclosure: Middle Coast Investing clients and portfolios have long positions in AMZN and AAPL. Positions may change at any time without notice. Nothing in this post is investment advice.

1. Nvidia, the last member of the Magnificent 7, has not reported earnings yet this quarter. ↩︎
2. Ackman has been in the news for much dumber or more insidious reasons recently, but it’s worth noting that his investment career, while full of high profile losses, has also been an impressive and successful one. ↩︎