Tuesday, May 22, 2018

Walmart's India (Flipkart) Gambit: Growth Rebirth or Costly Facelift?

On May 9, 2018, Walmart confirmed officially what had been rumored for weeks, and announced that it would pay $16 billion to acquire a 77% stake in Flipkart, an Indian online retail firm, translating into a valuation of more than $21 billion for a firm founded just over ten years ago, with about $10,000 in capital. Investors are debating the what, why and what next on this transaction, with their reactions showing up in a drop in Walmart’s market capitalization of approximately $8 billion. For Indian tech start-ups, the deal looks like the Nirvana that many of them aspire to reach, and this will undoubtedly affirm their hopes that if they build an India presence, there will be large players with deep pockets who will buy them out.

The Players
The place to start, when assessing a merger or an acquisition, is by looking at the companies involved, both acquiring and target, before the deal. It not only provides a baseline for any assessment of benefits, but may provide clues to motives.

a. Flipkart, an Amazon Wannabe?
Of the two players in this deal, we know a lot less about Flipkart than we do about Walmart, because it is not publicly traded, and it provides only snippets of information about itself. That said, we can use that information to draw some conclusions about the company:
  1. It has grown quickly: Flipkart was founded in October 2007 by Sachin and Binny Bansal, both ex-Amazon employees and unrelated to each other, with about $6000 in seed capital. The revenues for the company increased from less than $1 million in 2008-09 to $75 million in 2011-12 and accelerated, with multiple acquisitions along the way, to reach $3 billion in 2016-2017. The revenue growth rate in 2016-17 was 29%, down from the 50% revenue growth recorded in the prior fiscal year. Flipkart’s revenues are shown, in Indian rupees, in the graph below:
  2. While losing lots of money and burning through cash: As the graph above, not surprisingly, show, Flipkart lost money in its early years, as growth was its priority. More troubling, though, is the fact that the company not only continues to lose money, but that its losses have scaled up with the revenues. In the 2016-17 fiscal year, for instance, the company reported an operating loss of $0.6 billion, giving it an operating margin of minus 40%. The continued losses have resulted in the company burning through much of the $7 billion it has raised in capital over its lifetime from investors. 
  3. And borrowing money to plug cash flow deficits: Perhaps unwilling to dilute their ownership stake by further seeking equity capital, the founders have borrowed substantial amounts. The costs of financing this debt jumped to $671 million in the 2016-17 fiscal year, pushing overall losses to $1.3 billion. Not only are the finance costs adding to the losses and the cash burn each year, but they put the company’s survival, as a stand-alone company, at risk.
  4. It has had issues with governance and transparency along the way: Flipkart has a complex holding structure, with a parent company in Singapore and multiple off shoots, some designed to get around India’s byzantine restrictions on foreign investment and retailing and some reflecting their multiple forays raising venture capital.
While the defense that will be offered for the company is that it is still young, the scale of the losses and the dependence on borrowed money would suggest that as a stand-alone business, you would be hard pressed to come up with a justification for a high value for the company and would have serious concerns about survival. 

b. Walmart, Aging Giant?
Walmart has been publicly traded for decades and its operating results can be seen in much more detail. Its growth in the 1980s and 1990s from an Arkansas big-box store to a dominant US retailer is captured below:

That operating history includes two decades of stellar growth towards the end of the twentieth century, where Walmart reshaped the retail business in the United States, and the years since, where growth has slowed down and margins have come under pressure. As Walmart stands now, here is what we see:
  1. Growth has slowed to a trickle: Walmart’s growth engine started sputtering more than a decade ago, partly because its revenue base is so overwhelmingly large ($500 billion in 2017) and partly because of saturation in its primary market, which is the United States. 
  2. And more of it is being acquired: As same store sales growth has leveled off, Walmart has been trying to acquire other companies, with Flipkart just being the most recent (and most expensive) example. 
  3. But its base business remains big box retailing: While acquiring online retailers like Wayfair and upscale labels like Bonobos represent a change from its original mission, the company still is built around its original models of low price/ high volume and box stores. The margins in that business have been shrinking, albeit gradually, over time.
  4. And its global footprint is modest: For much of the last few years, Walmart has seen more than 20% of its revenues come from outside the United States, but that number has not increased over the last few years and a significant portion of the foreign sales come from Mexico and Canada. 
Looking at the data, it is difficult to see how you can come to any conclusion other than the one that Walmart is not just a mature company, but one that is perhaps on the verge of decline.

Very few companies age gracefully, with many fighting decline by trying desperately to reinvent themselves, entering new markets and businesses, and trying to acquire growth. A few do succeed and find a new lease on life. If you are a Walmart shareholder, your returns on the company over the next decade will be determined in large part by how it works through the aging process and the Flipkart acquisition is one of the strongest signals that the company does not plan to go into decline, without a fight. That may make for a good movie theme, but it can be very expensive for stockholders.

The Common Enemy
Looking at Flipkart and Walmart, it is clear that they are very different companies, at opposite ends of the life cycle. Flipkart is a young company, still struggling with its basic business model, that has proven successful at delivering revenue growth but not profits. Walmart is an aging giant, still profitable but with little growth and margins under pressure. There is one element that they share in common and that is that they are both facing off against perhaps the most feared company in the world, Amazon. 
a. Amazon versus Flipkart: Over the last few years, Amazon has aggressively pursued growth in India, conceding little to Flipkart, and shown a willingness to prioritize revenues (and market share) over profits:
Source: Forrester (through Bloomberg Quint)
While Flipkart remains the larger firm, Amazon India has continued to gain market share, almost catching up by April 2018, and more critically, it has contributed to Flipkart’s losses, by being willing to lose money itself. In a prior post, I called Amazon a Field of Dreams company, and argued that patience was built into its DNA and the end game, if Flipkart and Amazon India go head to head is foretold. Flipkart will fold, having run out of cash and capital.
b. Amazon versus Walmart: If there is one company in the world that should know how Amazon operates, it has to be Walmart. Over the last twenty years, it has seen Amazon lay waste to the brick and mortar retail business in the United States and while the initial victims may have been department stores and specialty retailers, it is quite clear that Amazon is setting its sights on Walmart and Target, especially after its acquisition of Whole Foods. 

It may seem like hyperbole, but a strong argument can be made that while some of Flipkart and Walmart’s problems can be traced to management decision, scaling issues and customer tastes, it is the fear of Amazon that fills their waking moments and drives their decision making.

The Pricing of Flipkart
Walmart is just the latest in a series of high profile investors that Flipkart has attracted over the years. Tiger Global has made multiple investments in the company, starting in 2013, and other international investors have been part of subsequent rounds. The chart below captures the history:
Barring a period between July 2015 and late 2016, where the company was priced down by existing investors, the pricing has risen, with each new capital raise. In April 2017, the company raised $1.4 billion from Microsoft, Tencent and EBay, in an investment round that priced the company at $11 billion, and in August 2017, Softbank invested $2.5 billion in the company, pricing it at closer to $12.5 billion. Walmart’s investment, though, represents a significant jump in the pricing over the last year. 

Note that, through this entire section, I have used the word “pricing” and not “valuation”, to describe these VC and private investments, and if you are wondering why, please read this post that I have on the difference between price and value, and why VCs play the pricing game. Why would these venture capitalists, many of whom are old hands at the game, push up the pricing for a company that has not only proved incapable of making money but where there is no light at the end of the tunnel? The answer is simple and cynical. The only justification needed in the pricing game is the expectation that someone will pay a higher price down the road, an expectation that is captured in the use of exit multiples in VC pricing models. 

The Why?
So, why did Walmart pay $16 billion for a 70% stake in Flipkart? And will it pay off for the company? There are four possible explanations for the Walmart move and each comes with troubling after thoughts. 
1. The Pricing Game: No matter what one thinks of Flipkart’s business model and its valuation, it is true, at least after the Walmart offer, that the game has paid off for earlier entrants. By paying what it did, Walmart has made every investor who entered the pricing chain at Flipkart before it a “success”, vindicating the pricing game, at least for them. If the essence of that game is that you buy at a low price and sell at a higher price, the payoff to playing the pricing game is easiest seen by looking at the Softbank investment made just nine months ago, which has almost doubled in pricing, largely as a consequence of the Walmart deal. In fact, many of the private equity and venture capital firms that became investors in earlier years will be selling their stakes to Walmart, ringing up huge capital gains and moving right along. Is it possible that Walmart is playing the pricing game as well, intending to sell Flipkart to someone else down the road at a higher price?
My assessment: Since the company’s stake is overwhelming and it has operating motives, it is difficult to see how Walmart plays the pricing game, or at least plays it to win. There is some talk of investors forcing Walmart to take Flipkart public in a few years, and it is possible that if Walmart is able to bolster Flipkart and make it successful, this exit ramp could open up, but it seems like wishful thinking to me.

2. The Big Market EntrĂ©e (Real Options): The Indian retail market is a big one, but for decades it has also proved to be a frustrating one for companies that have tried to enter it for decades. One possible explanation for Walmart’s investment is that they are buying a (very expensive) option to enter a large and potentially lucrative market. The options argument would imply that Walmart can pay a premium over an assessed value for Flipkart, with that premium reflecting the uncertainty and size of the Indian retail market.
My assessment: The size of the Indian retail market, its potential growth and uncertainty about that growth create optionality, but given that Walmart remains a brick and mortar store primarily and that there is multiple paths that can be taken to be in that market, it is not clear that buying Flipkart is a valuable option.

3. Synergy: As with every merger, I am sure that the synergy word will be tossed around, often with wild abandon and generally with nothing to back it up. If the essence of synergy is that a merger will allow the combined entity to take actions (increase growth, lower costs etc.) that the individual entities could not have taken on their own, you would need to think of how acquiring Flipkart will allow Walmart to generate more revenues at its Indian retail stores and conversely, how allowing itself to be acquired by Walmart will make Flipkart grow faster and turn to profitability sooner.
My assessment: Walmart is not a large enough presence in India yet to benefit substantially from the Flipkart acquisition and while Walmart did announce that it would be opening 50 new stores in India, right after the Flipkart deal, I don’t see how owning Flipkart will increase traffic substantially at its brick and mortar stores. At the same time, Walmart has little to offer Flipkart to make it more competitive against Amazon, other than capital to keep it going. In summary, if there is synergy, you have to strain to see it, and it will not be substantial enough or come soon enough to justify the price paid for Flipkart.

4. Defensive Maneuver:Earlier, I noted that both Flipkart and Walmart share a common adversary, Amazon, a competitor masterful at playing the long game. I argued that there is little chance that Flipkart, standing alone, can survive this fight, as capital dries up and existing investors look for exits and that Walmart’s slide into decline in global retailing seems inexorable, as Amazon continues its rise. Given that the Chinese retail market will prove difficult to penetrate, the Indian retail market may be where Walmart makes its stand. Put differently, Walmart’s justification for investing in Flipkart is not they expect to generate a reasonable return on their $16 billion investment but that if they do not make this acquisition, Amazon will be unchecked and that their decline will be more precipitous.
My assessment: Of the four reasons, this, in my view, is the one that best explains the deal. Defensive mergers, though, are a sign of weakness, not strength, and point to a business model under stress. If you are a Walmart shareholder, this is a negative signal and it does not surprise me that Walmart shares have declined in the aftermath. Staying with the life cycle analogy, Walmart is an aging, once-beautiful actress that has paid $16 billion for a very expensive face lift, and like all face lifts, it is only a matter of time before gravity works its magic again.

In summary, I think that the odds are against Walmart on this deal, given what it paid for Flipkart. If the rumors are true that Amazon was interested in buying Flipkart for close to $22 billion, I think that Walmart would have been better served letting Amazon win this battle and fight the local anti-trust enforcers, while playing to its strengths in brick and mortar retailing. I have a sneaking suspicion that Amazon had no intent of ever buying Flipkart and that it has succeeded in goading Walmart into paying way more than it should have to enter the Indian online retail space, where it can expect to lose money for the foreseeable future. Sometimes, you win bidding wars by losing them!

What next?
In the long term, this deal may slow the decline at Walmart, but at a price so high, that I don’t see how Walmart’s shareholders benefit from it. I have attached my valuation of Walmart and with my story of continued slow growth and stagnant margins for the company, the value that I obtain for the company is about $63, about 25% below its stock price of $83.64 on May 18, 2018.
Download spreadsheet
In the short term, I expect this acquisition to a accelerate the already frenetic competition in the Indian retail market, with Flipkart, now backed by Walmart cash, and Amazon India continuing to cut prices and offering supplementary services. That will mean even bigger losses at both firms, and smaller online retailers will fall to the wayside. The winners, though, will be Indian retail customers who, in the words of the Godfather, will be made offers that they cannot refuse! 

For start-ups all over India, though, I am afraid that this deal, which rewards the founders of Flipkart and its VC investors for building a money-losing, cash-burning machine, will feed bad behavior. Young companies will go for growth, and still more growth, paying little attention to pathways to profitability or building viable businesses, hoping to be Flipkarted. Venture capitalists will play more pricing games, paying prices for these money losers that have no basis in fundamentals, but justifying them by arguing that they will be Walmarted. In the meantime, if you are an investor who cares about value, I would suggest that you buy some popcorn, and enjoy the entertainment. It will be fun, while it lasts!

YouTube Video

Data Links
  1. Walmart Valuation - May 2018

Thursday, April 26, 2018

Amazon: Glimpses of Shoeless Joe?

It was just over two weeks ago that I started my posts on the FANG stocks, starting with Facebook, which I decided to buy, because I felt that notwithstanding its current pariah status, its user base was too valuable to pass by, at the prevailing market price. I then looked at Netflix, a company that has shown a remarkable ability to adapt to the challenges thrown at it, while changing the entertainment business, but is, at least in my view, in a content cost/user cycle that will be difficult to break out of. With Alphabet, the cash cow that is its advertising business is allowing it to invest in the big new markets of tomorrow, and even with low odds and very little substance today, these bets can make or break the investment. That leaves me with the longest listed and perhaps the most intriguing of the four stocks, Amazon, a company whose reach seems to expand into new markets each year. 

Revisiting my Amazon past
I valued Amazon for the first time in 1998, as an online book retailer, and much of what I know about valuing young companies today came from the struggles I went through, modifying what I knew in conventional valuation, for the special challenges of valuing a company with no history, no financials and no peer group. Out of that experience was born a paper on valuing young companies, which is still on my website and the first edition of the Dark Side of Valuation, and if you want to see some horrendously wrong forecasts, at least in hindsight, you can check out my valuation of Amazon in that edition. 

While I had a tough time justifying Amazon’s valuation, in its dot-com days, I always admired the company and the way it was managed. When I was put off balance by an Amazon product, service or corporate announcement, I re-read Jeff Bezos’ letter to Amazon shareholders from 1997, because it helped me understand (though not always agree with) how Amazon views the business world. In that letter, Bezos laid out what I called the Field of Dreams story, telling his stockholders that if Amazon built it (revenues), they (the profits and cash flows) would come. In all my years looking at companies, I have never seen a CEO stay so true to a narrative and act as consistently as Amazon has, and it is, in my view, the biggest reason for its market success.

I have valued Amazon about once a year every year over its existence, and I have bought Amazon four times and sold it four times in that period. That said, there are two confessions that I have to make. The first is that I have not owned Amazon since 2012, and have thus missed out on its bull run since then. Second, through all of this time, I have consistently under estimated not only the innovative genius of this company, but also its (and its investors') patience. In fact, there have been occasions when I have wondered, staying true to my Field of Dreams theme, whether Shoeless Joe would ever make his appearance

Amazon’s Market Cap Rise
Amazon’s rise in market capitalization has had more ups and downs than either Google or Facebook, but it has been just as impressive, partly because the company came back from a near death experience after the dot-com bust in 2001.

The more remarkable feature of Amazon’s rise has been the debris it has left in its wake, first with brick and mortar retail in the United States, but more recently in almost every business it has entered, from grocery retail to logistics. These graphs, excerpted from a New York Times article earlier this year, tells the story:

I know that this picture is probably is too compressed for you to read, but suffice to say that no company, no matter how large or established it is is safe, when Amazon enters it's market. Thus, while you can explain away the implosion of Blue Apron, when Amazon entered the meal delivery business, by pointing to its small size and lack of capital, note that the decline in market value at Kroger, Walmart and Target on the date of the Whole Foods acquisition was vastly greater in dollar value terms, and these firms are large and well capitalized. It is also worth noting that the decline in market cap is not permanent and that firms in some of the sectors see a bounce back in the subsequent time periods but generally not to pre-Amazon entry levels.  If Amazon represents the light side of disruption, the destruction of the status quo and everything associated with it, in the businesses that it enters, is the dark side.

Amazon: Operating History and Model
Rather than provide an involved explanation for why I call Amazon a Field of Dreams company, I will begin with a chart of Amazon's revenues and operating income that will explain it far more succinctly and better:
Amazon has clearly delivered on revenue growth, as its revenues have gone from $1.6 billion in 1999 to $177 billion in 2017, but its margins, after an initial improvement, went through an extended period of decline. In most companies, this would be viewed as a sign of a weak business model, but in the case of Amazon, it is a feature of how they do business, not a bug. In effect, Amazon has extended its revenue growth by expanding into new businesses, often selling its products (Kindle, Fire, Prime) at or below cost.  That, by itself, is not unique to Amazon, but what makes it different is that it has been able to get the market to go along with its "if we build it, they will come" strategy.

The mild uptick in profitability in the last three years has been fueled by Amazon's web services (AWS) business, offering cloud and other internet related services to other businesses, and that can be seen in the graph below, showing revenues and operating profits broken down by segment:
Amazon 10K
Over the last five years. AWS has accounted for an increasing slice of revenues for Amazon, but it is still small, accounting for 10% of all revenues in 2017. On operating income, though, it has had a much bigger impact, accounting for all of Amazon's profitability in 2017, with AWS generating $4,331 million in operating profits and the rest of Amazon, reporting an operating loss of $225 million.

To back up my earlier claim that Amazon's low profits are by design, and not an accident, let's look at two expenses that Amazon has incurred over this period that are treated as operating expenses, and are reducing operating profit for the company, but are clearly designed as investments for the future. The first is in technology and content, which include the investments in technology that are driving the growth in the AWS business and content, for the media business. The second is in net shipping costs, the difference between what Amazon collects in shipping fees from its customers and what it pays out, which can be viewed as the investment is making in building up Amazon Prime.
Amazon 10K
Not only are the technology/content and net shipping costs a large portion of overall expenses, amounting to 18.32% of revenues in 2017, but they have increased over time. The operating margin for Amazon would have been over 20%, if it had not incurred these expenditures, but with those higher, the company would have had far less revenues, no AWS business and no Amazon Prime today. To value Amazon today, I think it makes sense to break it up into at least three parts, with the first being its retail/media business globally, the second its AWS business and finally, Amazon Prime. In the table below, I attempt to deconstruct Amazon's numbers to estimate how much each of these arms is generated as revenues and created in operating expenses in 2017, as a prelude to valuing them.
Note that I had to make some estimates and judgment calls in allocating revenues to Amazon Prime, where I have counted only the incremental revenues from Amazon Prime members, and in allocating content costs. For Amazon Prime, for instance, I have used an assumption that Prime members spend $600 more than non-Prime members, to estimate incremental revenues, and added the $9.7 billion in subscription premiums that Amazon reported in 2017. The net shipping costs have been fully allocated to Amazon Prime and all of the operating expenses that Amazon reported for AWS are assumed to be technology and content. The remaining expenses are allocated across AWS and Amazon Retail/Media, in proportion to their revenues. In my judgment, both Amazon Retail/Media and AWS generated operating profits in 2017, but the latter was much more profitable, with a pre-tax operating margin of 24.81%. Amazon Prime was a money loser in 2017, but its margins are less negative than they used to be, and at 100 million members, it may be poised to turn the corner.

Amazon Business Model
If there are any secrets in Amazon's business model, they are dispensed when you read Amazon's 10K, which is remarkably forthcoming about how the company approaches business. In particular, the company emphasizes three key elements in its business model:
  1. Focus on Free Cash Flow: I tend to be cynical when companies talk about free cash flows, since most use self serving definitions, where they add "stuff" to earnings to make their cash flows look more positive. Amazon does not seem to take the same tack. In fact, it not only nets out capital expenditures and working capital needs, as it should, but it even nets out acquisitions (such as the $13.2 billion it spent on Whole Foods) to get to free cash flow.
  2. Manage working capital investment: Perhaps remembering times as a start-up when mismanaging inventory brought it to its knees, the company is focused on keeping its investment in working capital as low as possible, though that does sometimes involve strong arming suppliers.
  3. Use Operating leverage: Amazon is clearly conscious about its cost structure, recognizing that its revenue growth can give it significant advantages of economies of scale, when it comes to fixed costs.
There are two additional features to the company that I would add, from my years observing the company.
  1. Patience: I have never seen a company show as much patience with its investments as Amazon has, and while there are some who would argue that this is because of it's large size and access to capital, Amazon was willing to wait for long periods, even when it was a small company, facing a capital crunch. I believe that patience is embedded in the company's DNA and that the Bezos letter in 1997 explains why.
  2. Experimentation: In almost every business that Amazon enters, it has been willing to try new things to shake up the status quo, and to abandon experiments that do not work in favor of experiments that do.
There is no scarier vision for a company than news that Amazon has entered its business. If you are in that besieged company, how do you survive the Amazon onslaught? We know what does not work:
  1. Imitation: You cannot out-Amazon Amazon, by trying to sell below cost and wait patiently. Even if you are a company with deep pockets, Amazon can out-wait you, since it is not only how they do business and they have investors who have accepted them on their terms.
  2. Cost Cutting: There are companies, especially in the US brick and mortar retail space, that thought they could cut costs, sell products at Amazon-level prices and survive. By doing so, they speeded their decline, since the poorer service and limited inventory that followed alienated their core customers, who left them for Amazon.
  3. Whining: Companies under the Amazon threat often resort to whining not only about fairness (and how Amazon breaks the rules) but also about how society overall will pay a price for Amazon domination. There are seeds of truth in both argument, but they will neither slow nor stop Amazon from continuing to put them out of business.
While there is no one template for what works, here are some strategies, drawn from looking at companies that have survived Amazon, that improve your odds:
  1. Tilt the game: You can try to get governments and regulators to buy into your warnings of monopoly power and societal demise and to regulate or restrict Amazon in ways that allow you to continue in business. 
  2. Play to your strengths: If you have succeeded as a company before Amazon came into your business, you had competitive advantages and core customers who generated that success. Nourishing your competitive advantages and bringing your core customers even closer to you is key to survival, but that will require that you live through some financial pain (in the form of higher costs).
  3. And to Amazon's weaknesses: Amazon's favored markets have high growth and low capital intensity, and when they get drawn into markets that demand more capital investment, like logistics, it is because they were forced into them. If you can move the terrain to lower growth, higher capital intensity businesses, you can improve your odds of surviving Amazon.
None of these choices will guarantee success or even survival, and there are times where you may have to seek partnerships and joint ventures to make it through, and if all else fails, you can try some witchcraft.

Valuing Amazon
In my prior iterations, I tried to value Amazon as a consolidated company, arguing that it was predominantly a retail company with some media businesses. The growth of AWS and the substantial spending on Amazon Prime has led me to conclude that a more prudent path is to value Amazon in pieces, with Amazon Retail/Media, AWS and Amazon Prime, each considered separately.

1. Amazon Retail/Media
To value the heart of Amazon, which still remains its retail and media business, I used the revenues and operating margin that I estimated based upon my allocation at the end of the last section as my starting point, and assumed that Amazon will be able to continue growing revenues at 15% a year for the next five years, while also improving its operating margin (currently 9.09%, with technology and content costs capitalized) to 12%. The revenue growth assumption is built on Amazon's track record of being able to grow and the improved margin reflect expected economies of scale. The resulting value is shown below:
Download spreadsheet
Based upon my assumptions, the value that I attach to the retail/media business is about $289 billion. The key driver of value is the operating margin improvement, built into the story.

2. AWS
If Amazon's reported numbers are right, this division is the profit machine for the company, generating an operating margin of close to 25%, while revenues grew 42.88% in 2017. While I believe that this business will stay high growth and profitable, it is also one where Amazon faces strong competitors in Microsoft and Google, just to name two, and both revenue growth rates and margins will come under pressure. I assume revenue growth of 25% a year for the next 5 years, with operating margin declining to 20% over that period. The value is shown below:
Download spreadsheet
The value that I estimate for AWS is about $139 billion. The key for value creation is finding a mix of revenue growth and operating margin that keeps value up, since going for higher growth with much lower margins will cause value to dissipate.

3. Amazon Prime
To value Amazon Prime, I use the same technique that I used last year to value it, starting with a value of a Prime member, and building up to the value of Prime, by forecasting growth in Prime membership and corporate costs (mostly content). I updated the Prime membership number to 100 million (from the 85 million that I used last August) and used the 2017 financial statements to get more specific on both content costs and on the cost of capital. The value is shown below:
Download spreadsheet
Based upon the layers of assumptions that I have made, especially on shipping costs growing at a rate lower than membership rolls, the value that I estimate for Amazon Prime is about $73 billion. The key input here is shipping costs, since failing to keep it in control will cause the value to very quickly spiral down to zero.

Amazon, the Company
With all three pieces completed, I bring them together in my valuation of the company, incorporating the total debt outstanding in the company of $42,730 (including capitalized operating leases) and cash of $30.986 million, to arrive at a value per share of $1019.

At $1,460/share, on April 25, the stock is clearly out of my reach right now. Given that I have not been able to justify buying the stock at any time in the last five years, as it rose from $250/share to $1500, my suggestion is that you do you don't take my word, and that you make your own judgment. You can download the spreadsheets that I have for Amazon Retail/Media, AWS and Amazon Prime at the end of this post, and change those assumptions of mine that you think are wrong.

Investment Judgment
The FANG stocks represent great companies, but of the four, I think that Amazon has the most fearsome business model, simply because its platform of disruption and patience can be extended to almost any other business, one reason why every company should view Amazon as a potential competitor. I know that the old value adage is that if you buy quality companies and hold them forever, they will pay for themselves, but I don't believe that! There are good companies that can be bad investments and bad companies that can be terrific investments, as I noted in this post. Amazon has fallen into the first category for much of the last five years and continues to do so, at today's market price. But good things come to those who wait, and I know that there be a time and a price at which it will be back in my portfolio.

Post-post Update: I deliberately posted this before the earnings report, and the report that came out about two hours after the post was a blockbuster, with higher revenue growth than expect, a doubling of net income and an increase in the stock price of close to $100/share in the after market. Incorporating the effects into the valuations will have to wait until the full quarterly report is available, but the biggest part of the report,  for me, was the increase in Prime Membership fees to $119/year. You can modify the Amazon Prime valuation spreadsheet to reflect the increase in membership feels to $119/year (from $99/year). Doing so increases the value of Prime to almost $116 billion, increasing value per share by almost $100/share.

YouTube Video

Data Links

  1. Amazon 10K
  2. Valuation of Amazon Retail/Media
  3. Valuation of AWS
  4. Valuation of Amazon Prime
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Thursday, April 19, 2018

Alphabet Soup: Google is Alpha, but where are the Bets?

In my last two posts, I looked first at the turn in the market against the FANG stocks, largely precipitated by the Facebook user data fiasco and then at the effect of the blowback on Facebook's value. I concluded that notwithstanding the likely negative consequences for the company, which include more muted revenue growth, higher costs (lower margins) and potential fines, Facebook looks like a good investment, with a value about 10% higher than its prevailing price. I argued that changes are coming from both outside (regulators and legislation) and inside (to protect data better), and these changes are unlikely to be just directed at Facebook. It is this perception that has probably led the market to mark down other companies that have built business models around user/subscriber data and in these next posts, I would like to look at the rest of the stocks in the FANG bundle and the consequences for their valuations, starting with Google in this one.

The One Number
The value of a company is driven by a myriad of variables that encompass growth, risk and cash flows, which are the drivers of value. In a typical intrinsic valuation, there are dozens of inputs that drive value but there is one variable, that more than any other, drives value and it is critical to identify that variable early in the valuation process for three reasons:
  1. Information Focus: We live in a world where we drown in data and opinion about companies and unfocused data collection can often leave you more confused about the value of a company, rather than less. Knowing the key value driver allows you to focus your information collection around that variable, rather than get distracted by the other inputs into value.
  2. Management Questions: If you have the opportunity to question management, your questions can then also be directed at the key variable and what management is doing to deliver on that variable. 
  3. Disclosure Tracking: If you are invested in a company and are tracking how it is performing, relative to your expectations, it is again easy in today's markets to get lost in the earnings report frenzy and the voluminous disclosures from companies. Having a focus allows you to zero in on the parts of the earnings report that are most relevant to value.
In short, knowing what you are looking for makes it much more likely that you will find it. But how do you identify the key driver variable? In my template, I look for two characteristics:
  1. Big Value Effects: Changing your key driver variable should have large effects on the value that you estimate for a business. One of the benefits of asking what-if questions about the inputs into a valuation is that it can allow you to gauge this effect. 
  2. Uncertainty about Input: If an input has large effects on value, but you feel confident about it, it is not a driver variable. Conversely, if you have made an estimate of input and are uncertain about that number, because it can change either due to management decisions or because of external forces, it is more likely to be a driver input.
If you accept this characterization, there are two implications that emerge. The first is that the key value driver can and will be different for different companies; a mechanistic focus on the same input variable with every company that you value will lead you astray. The second is that there is a subjective component to your choice, and the key value driver that I identify for a company can be different from the one you choose for the same company, reflecting perhaps the different stories that we may be telling in our valuations. In my just-posted Facebook valuation, I believe that the key variable is the cost that Facebook will face to fix its data privacy problems and it manifests itself in my forecasted operating margin, which I project to fall from almost 58% down to 42%, in the next five years. Note that revenue growth may have a bigger impact on value, but in my judgement, it is the operating margin that I am most uncertain about. I will use this post to value Google and highlight what I believe is the driver variable for the company.

The Alphabet Story
If Facebook is the wunderkind that has shaken up the online advertising business, Google is the original disruptor of this business and is by far the biggest player in that game today. It is ironic that the disruptor has become the status quo, but until there is another disruption, it is Google's targeted advertising model, in world, and its search engine and ad words that dominate this business. Google has had fewer brushes with controversy, with its data, than Facebook, partly because its data collection occurs across multiple platforms and is less visible and partly because it does have a tighter rein on its data. 

1. A Short History
Google has been a rule breaker, right from its beginnings as a publicly traded company. It used a Dutch auction process for its initial public offering, rather than the more conventional bank-backed offer pricing model, and while it has had a few stumbles, its ascent has been steep:

The secrets to its success are neither hard to find, nor unusual. The company has been able to scale up revenues, while preserving its operating margins:

The most impressive feature of Google's operations has been its ability to maintain consistent revenue growth rates and operating margins since 2008, even as the firm more than quadrupled its revenues.

2. The State of the Game
To value Google, we start with the numbers, but in order to build a story we have to assess the landscape that Google faces.
  1. A Duopoly: The advertising business, in general, and the digital advertising business, in particular, are becoming a duopoly. In 2017, the total spent on advertising globally was $584 billion, with digital advertising accounting for $228.4 billion. Google's market share in 2017 was 42.2%, and Facebook's market share was 20.9%. Even more ominously for the rest of their competitors, they got bigger during the year, accounting for almost 84% of the increase in digital advertising during the course of the year.
  2. Google is everywhere: Google's hold on the game starts with its search engine, but has been enriched by its other products, Gmail, with more than a billion users, YouTube, which dominates the online video space and Android, the dominant smart phone operating system. If you add to this Google Maps, Google shared documents and Google Home products, the company is everywhere that you are, and is harvesting information about you at each step. During the last week, a New York Times reporter downloaded the data that Facebook had on him and while what he found disturbed him, both in terms of magnitude and type, he found that Google had far more data on him than Facebook did.
  3. Alphabet is still mostly alpha, very little bet: While Google's decision to rename itself Alphabet was motivated by a desire to let it's non-advertising businesses grow, the numbers, at least so far, indicate limited progress. In fact, if there is growth it has so far come from the apps, cloud and hardware portion of Google, rather than the bets themselves, but Nest (home automation), Waymo (driverless cars), Verily (life sciences) and Google Fiber (broadband internet) are options that may (or may) not pay off big time.

Google 2017 10K
The bottom line is that Google has changed the advertising business  and dominates it, with Facebook representing its only serious competition. It's large market share should act as a check on its growth, but Google has been able to sustain double digit growth by growing the digital portion of the advertising business and claiming the lion's share of that growth, again with Facebook. The wild  card is whether the data privacy restrictions and regulations that are coming will crimp one or both companies in their pursuit of ad revenues. As digital advertising starts to level off, Google will have to look to its other businesses to provide it a boost.

3. The Valuation
As with Facebook, I was a doubter on the scalability of the Google story, but it has proved me wrong, over and over again. In valuing Google, I will assume that it will continue to grow, but I set the revenue growth rate at 12% for the next five years, below the 15% growth rate registered in the last five, for two reasons. The first is that digital advertising's rise has started to slow, simply because it is now such a large part of the overall advertising market. The second is that data privacy restrictions, if restrictive, will take away one of Google's network benefits. I do think that the profitability of Google's businesses will stay intact over time, with operating margins staying at the 27.87% recorded in 2017. With those key assumptions, I value Google at $970, close to the price of $1030 that it was trading at on April 13.
Download spreadsheet
As with my Facebook valuation, each of my key inputs is estimated with error, and capturing that uncertainty in distributions yields the following outcomes:
Crystal Ball used in simulation
No surprises here. The median value is about $957 and at a stock price of $1.030, there is a 65% chance that the stock is over valued. As with Facebook, there is a positive skew in the outcomes, and that skew will get only more positive, if you build in a bigger payoff from one of the bets. 

4. The Value Driver
Google's value is driven by revenue growth and operating margins, and changing one or both inputs has a significant effect on value. 
The shaded cells represent the combinations that deliver values higher than the prevailing stock price of $1,030/share. In my judgment, Alphabet's bigger value driver is revenue growth, not margins, and it is on that input, this valuation will rise of fall. It is my view that while data privacy restrictions will translate into much higher costs for Facebook, partly because it has so little structure currently, it will result in lower growth for Alphabet. If the data privacy restrictions handicap Google so badly that it loses a big part of what has allowed it to dominate digital advertising for the next five years, Google's revenue growth and value will drop dramatically. However, Google is just starting to tap the potential in YouTube, and if it is able to position it as a competitor to Spotify, in music streaming, and Netflix, in video streaming, it could discover a new source of revenue growth, with strong operating margins.

5. The Google Bets
The least substantive part of Alphabet, at least in the numbers, is also its most intriguing from a value standpoint, and that is its investment in the other businesses, comprising the "bet" in Alphabet. Google has spent billions on Waymo, Verily and Nest, three of its higher profile other businesses, and while Waymo and Nest have received considerable public attention, they don't have much in revenues, and lots of losses to show for it. There are three views that one can bring to the Google bets, and which one you adopt will determine in large part, whether you will be tilted towards buy-ing Google:
  1. Founder Playthings: The most cynical view is that the billions invested in these businesses are not meant to make money, but instead were directed by founder interests in electric cars, health care technology and home automation. Those who take this view will likely point to Google Glasses, an expensive and ill-fated experiment that ended badly and to the effusive support from Brin and Page for these businesses. If you buy into this this view, not only will these businesses not add value to Alphabet, they will continue to drain value from the company, because of the spending that goes with them.
  2. Early Life, Big Market Businesses: The second and more optimistic view is that the Google bets should be viewed more as start-ups in potentially big markets, with industry-leading innovation. This is especially the case with Waymo, which if not at the cutting edge of the driverless car business is very close to it, and if successful, could be an entree into not just the driverless car market but also into ride sharing and car service. You could build business models for Waymo, Verily, Nest and Google Fiber that would resemble the models used to value young start-ups, with a bonus of access to Alphabet capital to survive for long periods, and add this value to the advertising business that remains Google's cash cow.
  3. Real Options: The third view, which splits the difference, is that while the bet businesses represent potential, that potential is not only far in the future, but may never materialize, either because of the evolution of technology, regulation or market demand. Thus, driverless cars may never quite make it into the mainstream, either because customers don't trust them or they turn out to be too risky. With this view, you can argue that the Google bets are out-of-the-money options, and since the value of an option is determined by potential revenues and uncertainty about those revenues, they are valuable, even though only one of the bets may pay off and the others will have to be written off.
In my valuation of Alphabet, I have implicitly assumed that the company will continue to spend billions in its bets, by leaving the margin at existing levels; remember that the operating margin of 27.87% is after the company's spending on its bet businesses. By not explicitly giving credit for the revenues that the bet businesses will create, it may seem like I am taking the cynical view of these businesses as playthings, but I am not. Much as I dislike the corporate governance ethos that Brin and Page have brought to Google, and helped to proliferate across the new tech sector with their dicing and slicing of voting rights, I don't see them as individuals who would spend billions on expensive toys. That said, I do think that trying to build business models from scratch, to value Waymo, Verily and Nest is difficult to do right now, given that the markets that they are going after all still in flux. I believe that these investments are options and valuable ones at that, but I will make that claim based upon their underlying characteristics (high variance, big markets) rather than with explicit option pricing models. As an investor, looking at Alphabet, here is how it plays out in my investment decision. My intrinsic valuation for Alphabet is $968, within shouting distance of the company's stock price, and I believe that there is enough option value in the bets, that if the stock is fairly or even under valued at its current price. While I am not yet inclined to buy, I have a limit buy order on the stock, that I had initially set at $950, but have moved up to $1000 after my bet assessment, and I, like many of you, will be watching the market reaction to the Alphabet earnings report on Monday. Perverse though it may sound, I am hoping that there are enough negative surprises in it to cause a price drop that would make my limit buy execute, but if not, it will stay it in place. 

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Data Links

Monday, April 16, 2018

Netflix: The Future of Entertainment or House of Cards?

For better or worse, Netflix has changed not just the entertainment business, but also the way that we (the audience) watch television. In the process, it has also enriched its investors, as its market capitalization climbed to $139 billion in March 2018 and even after the market correction for the FANG stocks, its value is substantial enough to make it one of the largest entertainment company in the world. Among the FANG stocks, with their gigantic market capitalizations, it remains the smallest company on both market value and operating metrics, but it has almost as big an impact on our daily lives as its larger peers.

The History

This may come as a surprise to some, but Netflix has been publicly listed for longer than Facebook or Google. The difference between Netflix and these companies is that it’s climb to stardom has taken more time.

Don't get me wrong! Netflix was a very good investment between 2003 and 2009, increasing its market capitalization by 33.36% a year and its market capitalization by about $3 billion, during that period. However, it became a superstar investment between 2010 and 2017, adding about $120 billion in value over the period, translating into an annual price appreciation of more than 50% a year.

The fuel that Netflix has used to increase its market capitalization is its subscriber base, as with the other FANG stocks, the company seems to have found the secret to be able to scale up, as it gets larger. That subscriber base, in turn, has allowed the company to increase its revenues over time, as can be seen in the picture below, summarizing Netflix’s operating metrics.

You can accuse me of over analyzing this chart, but it captures to me the essence of the Netflix success story. While Netflix has been able to grow revenues in each of the three consecutive five-year time periods, 2002-2006, 2007-2012 and 2013-2017, that it has been existence, the company has been faced with challenges during each period, and it has adapted.
  1. DVDs in the Mail: In the first five-year period, 2002 through 2006, the company mailed out DVDs and videos to its subscribers, challenging the video rental business, where brick and mortar video rental stores represented the status quo, and Blockbuster was the dominant player. 
  2. The Rise of Streaming: It was between 2007 and 2012, where the company came into its own, as it took advantage of changes in technology and in customer preferences. First, as technology evolved to allow for the streaming of movies, Netflix adapted, with a few rough spots, to the new technology, while its brick and mortar competitors imploded. Second, while Netflix saw a drop in revenue growth that was not unexpected, given its larger base, it also saw its content costs rise at a faster rate than revenues, as content providers (the movie studios) starting charging higher prices for content. 
  3. The Content Maker: In hindsight, the studios probably wish that they had not squeezed Netflix, because the company reacted by taking more control of its own destiny in the 2013-2017 time period, by shifting to original content, first with television series and later with direct-to-streaming movies. The results have upended the entertainment business, but more critically for Netflix, they show up in a critical statistic. For the first time in its existence, Netflix saw content costs rise at a rate slower than its growth in revenues, with operating profit margins, both before and after R&D reflecting this development. 
The State of the Game
We can debate whether Netflix is a good or a bad investment, but there is no argument that the way movies and television get made has been changed by the company’s practices. It is the rest of the entertainment business that is trying to adapt to the Netflix streaming model, as evidenced by Disney’s acquisition of BAM Media and Fox Entertainment. If I were to summarize where Netflix stands right now, here would be my key points:
1. It's a big spender on content: In 2017, Netflix spent billions on the content that it delivers to its subscribers, and the extent of its spending can be seen in its financial statements. The way that Netflix accounts for its content expenditures does complicate the measurement, since it uses two different accounting standards, one for licensed content and one for productions, but it capitalizes and amortizes both, albeit on different schedules, and based upon viewing patterns. The gap between the accrual (or amortized) cost (shown in the income statement) and the cash spent (shown in the statement of cash flows) on content can be seen in the graph below.
Netflix 10K - 2017
In 2017, Netflix spent almost $9.8 billion on content, though it expensed only $7.7 billion in its income statement. If this divergence continues, and there is no reason to believe that it will not, Netflix’s profits will be more positive than their cash flows by a substantial amount. Note that this divergence should not be taken (necessarily) as a sign of deception or accounting game playing. In fact, if Netflix is being reasonable in its amortization judgments, one way to read the difference of $2.14 billion ($9.8 in cash expenses minus $7.66 billion in accrual expenses) is to view it as the equivalent of capital expenditures at Netflix, since it is expense incurred to attract and keep subscribers.
2. An increasing amount of that spending goes to original content: The decision by Netflix to produce some of its own content in 2013 triggered a shift towards original content that has picked up speed since that year. In 2017, the company spent $6.3 billion on original content, putting it among the top spenders in the entertainment business:
Biggest Spenders on Entertainment Content in 2017
The pace is not letting up. In the first quarter of 2018, Netflix introduced 18 new television series and delivered 12 new seasons of existing series, prodigious output by any studio’s standards. There are three reasons for the Netflix move into the content business.
  • The first, referenced in the last section, is to gain more control over content costs and to be less exposed to movie studio price hikes. 
  • The second is that Netflix has been using the data that it has on subscriber tastes not only to direct content at them, but to produce new content that is tailored to viewer demands.
  • The third is that it introduces stickiness into their business model, a key reason why new subscribers come to the company and why existing subscribers are reluctant to abandon it, even if subscription fees go up.
Netflix has moved beyond television shows to making straight-to-streaming movies, spending $90 million on Bright, a movie that notwithstanding its lackluster reviews, signaled the company’s ambitions to be a major player in the movie business.
3. Netflix has been adept at playing the expectations game: One feature that all of the FANG stocks trade is that rather than let equity research analysts frame their stories and measure their success, they have managed to frame their own stories and make investors and analysts play on their terms. Netflix, for instance, has managed to make the expectations game all about subscriber numbers, and every earnings report of the company is framed around these numbers, with less attention paid to content costs, churn rates and negative cash flows. After its most recent earnings report in January, the stock price surged, as the company reported an increase of 8.3 million in subscribers, well above expectations.
4. The company is globalizing: One consequence of making it a numbers game, which is what Netflix has done by keeping the focus on subscribers, is that you have to go where the numbers are, and for better or worse, that has meant that Netflix has had to go global, with Asia being the mother lode.

At the end of 2017, Netflix had more subscribers outside the US than in the US, and it is bringing its free spending ways and its views on content development to other parts of the world, perhaps bringing Bollywood and Hollywood closer, at least in terms of shared problems.

In summary, Netflix has built a business model of spending immense amounts on content, using that content to attract new subscribers, and then using those new subscribers as its pathway to market value. It is clear that investors have bought into the model, but the model is also one that burns through cash at alarming rates, with no smooth or near term escape hatch.

The Valuation
In keeping with the focus on subscriber numbers that is at the center of the Netflix story, I will value Netflix with the subscriber-based approach that I used to value Spotify a few weeks ago and Uber and Amazon Prime last year.

Cost Breakdown
The key to getting a subscriber-based valuation of Netflix is to first break its overall costs down into (a) costs for servicing existing subscribers, (b) the cost of acquiring new subscribers and (c) a corporate cost that cannot be directly related to either servicing existing subscribers or getting new ones. I started with the Netflix 2017 income statement:

Since Netflix does not break its costs down into my preferred components I made subjective judgments in allocating these costs, treating G&A costs as expenses related to servicing existing subscribers and marketing costs as the costs of acquiring new subscribers. With content costs, I started first with the $2,146 million difference between the cash content cost and expensed content cost and treated it also as part of the cost of acquiring new subscribers. With the expensed content cost of $7,600 million, I assumed that only 20% of these costs are directly related to subscribers and treated that portion as part of the cost of servicing existing subscribers and that the remaining 80% would become part of the corporate cost, in conjunction with the investment in technology and development. One key difference between the Netflix and Spotify cost models is that most of the content costs are fixed corporate costs for Netflix but almost all content costsare variable costs for Spotify, since it pays for content based upon how its subscribers listen to it, rather than as a fixed fee.

Value of an Existing Subscribers
My decision to treat most of the content content costs as a corporate cost has predictable consequences. The costs associated with individual subscribers are only the G&A costs and 20% of content costs, and the number is small, relative to the revenues that Netflix generates per subscriber:
Download spreadsheet

A strength that Netflix has built, perhaps with its original content, is that it has reduced it's churn rate (the loss of existing customers), each year since 2015. In 2017, the annual renewal rate for a Netflix subscription was about 91%, and that number improved even more across the four quarters. In my subscriber-valuation, I have used a 92.5% renewal rate, for the life of a subscriber, assumed to be 15 years. I will assume that Netflix investments in original content will give it the pricing power to increase annual revenue per subscriber (G&A and the 20% of content costs), which was $113.16 in 2017, at 5% a year, while keeping the growth rate in annual expenses per subscriber at the inflation rate of 2%. I estimate after-tax operating income each year, using a global average tax rate of 25%, and discount it back at a 7.95% cost of capital (estimated for Netflix, based upon its business and geographic mix, and debt ratio) to derive a value of $508.89 subscriber and a total value of $59.8 billion for Netflix’s 117.6 million existing subscribers.

Value of New Subscribers
To value a new subscriber, I first estimated the total cost that Netflix spent on adding new subscribers by adding the total marketing costs of $1,278 million to the capitalized portion of the content costs of $2,142 million, and then divided this amount by the gross increase in the number of subscribers (30.84 million) during 2017, to obtain a cost of $111.01 for acquiring a new subscriber. I then net that number out from the value of an existing subscriber to arrive at a value of $397.88/new subscriber right now; I assume that this value will increase at the inflation rate over time.
Download spreadsheet

I assume that Netflix will continue to add new subscribers, adding 15% to its net subscriber rolls, each year for the first five years, and 10% a year for years 6 through 10, before settling into a steady state growth rate of 1% a year. Discounting the value added by new subscribers at a higher cost of capital of 8.5%, reflecting the greater uncertainty associated with new subscribers, yields a total value of $137.3 billion for new subscribers.

The Corporate Drag
The final piece of the puzzle is to bring in the corporate costs that we assumed could not be directly linked with subscriber count. In the case of Netflix, the  technology & development costs and 80% of the expensed content, that we put into this corporate cost category amounted to $6.13 billion in 2017 and the path that these costs follow in the future will determine the value that we attach to the company.
Download spreadsheet

I assume that technology & development costs will grow 5% a year, but it is on the content cost component that I struggled the most to estimate a growth rate. I decided that the accelerated spending that Netflix had in 2017 and continued to have in 2018 reflect Netflix’s attempt to acquire standing in the business, and that while it will continue to spend large amounts on content, the growth rate in this portion of the content costs will drop to 3% a year, for the next 10 years. Note that even with that low growth rate, Netflix will be consistently among the top five spenders in the content business, spending more than $100 billion on original content over the next ten years. Discounting back the after-tax corporate expenses back at the 7.95% cost of capital, yields a corporate cost drag of $111.3 billion.

The Netflix Valuation: The One Number
To value Netflix, I bring together the value of existing and new subscribers and net out the corporate cost drag. I also subtract out the $6.5 billion in debt that the company has outstanding and the value of equity options granted over time to its employees.
The value per share of $172.82 that I estimate for Netflix is well below the stock price of $275, as of April 14, 2018. My value reflects the story that I am telling about Netflix, as a company that is able to grow at double digit rates for the next decade, with high value added with new users, while bringing its content costs under control. I am sure that your views on the company will diverge from mine, and you are welcome to use my Netflix subscriber valuation template to come to your own conclusions. 

It is worth taking a pause, and considering the differences between Netflix and Spotify, both subscription-based business models, that draw their value from immense subscriber bases.
  1. By paying for its content, both licensed and original, and using that content to go after subscribers, Netflix has built a more levered business model, where subscribers, both new and existing, have higher marginal value than at Spotify, where content costs are tied to subscribers listening to music. 
  2. The Netflix model, which is increasingly built around original rather than licensed content, provides for a stronger competitive edge, which should show up in higher renewal rates and more pricing power, adding to the value per subscriber, both existing and new. 
  3. The Netflix model will deliver higher value from subscription growth than the Spotify model, but it comes with a greater downside, because a slackening of that growth will leave Netflix much deeper in the hole, with more negative cash flows, than it would Spotify. 
Now that both companies are listed and traded, it will be interesting to see whether this plays out as much larger market reactions to subscription number surprises, both positive and negative, at Netflix than at Spotify.

In my earlier post on Google, I noted that every company has a value driver, one number that more than any of the others determines value. In the case of Netflix, the key value driver, in my view, is content costs. My value per share is premised not just on high growth in subscribers and continued subscriber value, but also on content costs growing at a much lower rate (of 3%) in the future. To illustrate the sensitivity of value per share to this assumption, I varied the growth rate in content costs and calculated value per share:
To illustrate the dangers to Netflix of letting content costs grow at high rates, note that the company’s equity value becomes negative (i.e., the company goes bankrupt), if content costs grow at high rates, relative to revenue growth, with double digit growth rates creating catastrophic effects. If Netflix is able to cap the costs at 2017 levels in perpetuity, the estimated value per share is approximately $216,  at the base case growth rate of 15%, and if it is able to reduce content costs in absolute terms over time, it is worth even more. In my view, investing in Netflix is less a bet on the company being able to deliver subscriber and/or revenue growth in the future and more one on the future path of content costs at the company.

The Decision
There is no doubt that Netflix has changed the way we watch television and the movies, and it is changing the movie/TV business in significant ways. By competing for talent in the content business, it is pushing up costs for its competitors and with its direct-to-streaming model, putting pressure on movie theaters and distribution. That said, the entertainment business remains a daunting one, because the talent is expensive and unpredictable, and egos run rampant. The history of newcomers who have come into this business with open wallets is that they leave with empty ones. For Netflix to escape this fate, it has to show discipline in controlling content costs, and until I see evidence that it is capable of this discipline, I will remain a subscriber, but not an investor in the company.

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Data Links
  1. Valuation of Netflix - April 2018