Netflix Investment Thesis Aug 2023

Published on 08/17/23 | Saurav Sen | 6,283 Words

The BuyGist:

  • Last time we did a full-fledged investment thesis on Netflix, we didn’t have the Buycaster to do the heavy lifting for us.
  • In this thesis, we put NFLX through the Buycaster wringer.
  • Then we looked at the story – it’s strategy, competitive advantage etc. – to determine if the Buycaster analysis needs any subjective overwrites.
  • We looked at the adjusted Rationality Rating of Netflix and give it a full subjective crosscheck.
  • Finally, we ended our analysis with a definitive conclusion on NFLX: buy, hold, or sell.

Buycasting Netflix

Our investment process is a tango between the qualitative and quantitative. Numbers can only get us so far. And stories without numbers are not actionable. It needs to be a give-and-take, a dance. In this dance, the Buycaster is our primary Numbers Tool. It’s usually our first cut when we analyze potential investments, or current holdings. And it’s also our last cut once we’ve dug into the story – competitive advantage, economic moat, management strategy and all that good stuff. We’re posting this analysis because Netflix is a current holding, and we hadn’t yet given it a full Buycaster treatment. NFLX has appreciated a lot since that dark day in April 2022. So, what does the Buycaster say?

The following charts are reproductions of what you’d see in the Buycaster (as of August 12th, 2023) when we selected the following:

  1. Select Stock: Netflix | NFLX
  2. Select Desired Return: 80% cumulative in 5 years (12.5% CAGR)

The Buycaster then crunches the numbers to:

  1. Back solve towards “what needs to happen in the business to – rationally – expect that desired return. It’s what we call “the Buycast”.
  2. Answer the question, “Is this Buycast believable?”

The charts below depict a step-by-step process as shown in the Buycaster – we’ve reproduced the charts here for better resolution images, and to fit your screen appropriately. Below each chart, we’ve pasted the explanations that you’d find in the Buycaster. So, sit back. Relax. And enjoy the Buycast!



Buycaster Explanation:

We consider buying stocks with ratings of 9 and above. NFLX's rating is much lower. The LOW Rationality Rating  tells us that it is IRRATIONAL to expect the stock to deliver 80% cumulative return in 5 years (12.5% CAGR). The current stock price is just too high to deliver that return in the next 5 years - given the business economics of the company today. To consider buying the stock, we would need to believe that Netflix Inc.'s business economics – revenue growth, cost structure, and profit margins – will improve drastically over the next 3 to 5 years. Without a high degree of confidence in such a drastic transformation, we would sell NFLX if we held it in our portfolio. Just to reiterate, this analysis does not make an absolute proclamation like "NFLX is a good or bad buy" ; instead it quantifies the likelihood of NFLX delivering 80% cumulative return in 5 years (12.5% CAGR).

Everything starts with that Desired Return. From there, we back-solve towards "what needs to happen in the business" to - RATIONALLY - expect our desired return. That's what the rest of the dashboard is about.


Buycaster Explanation:

NFLX has a BUYCAST of 21.2% – our measure of ‘what we need to believe about the business to consider buying NFLX today’. The BUYCAST is measured in terms of future Annualized Revenue Growth (ARG). So, to consider buying NFLX, we need to believe that Netflix Inc.'s revenue will grow at an average of about 21.2% per year for the next 5 years. Compared to the company's actual historical revenue growth numbers, this BUYCAST looks like an irrationally exuberant scenario. But we need more information to quantify the believability of the Buycast...



Buycaster Explanation:

We measure SANITY by quantifying the believability of the Buycast against the company's historical performance. But we've also introduced 2 new variables here: 1) The average Wall Street Analysts' 5-year Revenue CAGR forecast, and 2) The DOWNCAST, which is our best estimate of a pessimistic revenue CAGR. The Downcast takes into account the actual historical revenue growth numbers and the Wall Street number. We usually apply a margin-of-safety discount to those numbers to get the Downcast. The believability of the BUYCAST depends on the DOWNCAST. 

NFLX's DOWNCAST is 9.9%, which is uncomfortably low compared to its BUYCAST of 21.2%. The gap between 'what we need to believe' and 'what could happen in a pessimistic growth scenario' is uncomfortably large. The Downcast is dragged down primarily by relatively low recent revenue growth. This is why NFLX gets a LOW SANITY RATING. More on SANITY later. But first, let's quantify RISK. The Downcast is also the fulcrum between the Buycast and Risk.


Buycaster Explanation:

What if we buy NFLX today by IGNORING its LOW SANITY Rating...only to see the stock price drop precipitously because our investment thesis (or leap of faith) did not pan out? What sort of losses should we expect if we we're wrong? In NFLX’s case, we estimate the POTENTIAL LOSS to be around -42.7% (cumulative, within 5 years), which is UNDIGESTIBLE for us, even in a diversfied portfolio of at least 20 stocks. This is why NFLX has a LOW SAFETY RATING.. More on the SAFETY RATING in the next chart.

This Potential Loss estimate is a direct consequence of the DOWNCAST scenario. If that low-growth scenario comes to pass, the chart above depicts the only risk that matters to us investors - permanent loss of capital. We start wit the Downcast Revenue Growth Scenario and work our way down the cash flow waterfall to finally arrive at a Downcast Price. The Downcast Price of NFLX is around $241.5. The last closing price was $421.7. Therefore, the POTENTIAL LOSS estimate is -42.7%. For more details, please see the Appendix Section.. Now that we've got all the insights we need to calculate an overall Rationality Rating. One more step.


Buycaster Explanation:

Mechanically, the SANITY RATING is just a scaled up (to a scale of 10) number representing the gap between the BUYCAST and the DOWNCAST - it quantifies the believabiity of the BUYCAST. In NFLX's case, the SANITY RATING turns out to be 5.9 out of 10, which is LOW on our scale. Remember, it all starts with our desired or required return. The Sanity Rating quantifies how, well, sane it is to believe that this stock will get us our required return. A Sanity Rating of 9/10 is considered "High", above 8/10 is conseidered "OK", and anything below 8 is considered "Low". Generally, we don't consider potential investments with Low Sanity Ratings.

The SAFETY RATING is a scaled up number (on a scale of 0 to 10) representing the severity of that -42.7% loss number from the previous chart. Mechanically, it's a simple scaling exercise. The POTENTIAL LOSS estimate of -43%  falls within the VERY RISKY ZONE on our Potential Loss Scale, which ranges to -10% to -80%. -10% corresponds to the best Safety Rating (10.0) whereas -80% corresponds to the worst rating (0.0). It’s easy to get from NFLX's Potential Loss estimate of -43% to its LOW SAFETY Rating of 5.3 out of 10. For more details, please see the Appendix Section.

NFLX's LOW Rationality Rating of 5.6/10 is the average of its Sanity Rating (5.9/10) and Safety Rating (5.3/10).

There’s a lot going on behind the scenes in the Buycaster. But we need to point out one table in the Buycaster Appendix that lists the key assumptions behind the charts you see above. We bring it up because we will be overwriting one of these assumptions. Remember, the Buycaster is one part of a tango between numbers and stories. We did the first cut. Then we looked at the story. And the rest of this analysis is the last cut.

Here’s that table of key assumptions:

In the next few sections, you’ll see which assumptions will get a subjective overwrite, and how that affects:

  1. NFLX’s Rationality Rating
  2. Our decision – buy more, hold, or sell NFLX?
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