Netflix: The Capital Cycle Strikes Again

For the film-lovers out there, there was a brilliant joke from the comedian Ricky Gervais when he was hosting the 2020 Golden Globe Awards. He brashly quipped:  ‘No one cares about movies anymore. No one goes to the cinema. No one really watches network TV. Everyone’s watching Netflix. This show should just be me coming out, and saying, “Well done Netflix. You win…everything. Good night!”’.

Imagine turning to Ricky Gervais in 2020, in the middle of the pandemic when Netflix was booming, and telling him: “two years from now, Netflix will be worth less than it was before the pandemic. In fact, Netflix will be worth less than it was in 2017”.

He would have probably given you tips on better comedy.

A decade-long darling of the US tech market, Netflix had delivered +1000% shareholder returns from 2014 to the end of 2021. In its relatively brief life, it supplanted much of the Hollywood ecosystem, from the way actors get remunerated, to the studio-producer relationships, and most crucially for us, the way we consume entertainment. Into common parlance came phrases like ‘Bingeing’, and ‘Netflix and Chill’. Netflix was more than a company; it was a Zeitgeist.

It turns out the market doesn’t care about Zeitgeist. Netflix now trades on a forward earnings multiple of 18x. So why did the market condemn Netflix quite so aggressively following the recent earnings?

The answer is that investors were, once again, wrong-footed by the Capital Cycle.

For those less familiar with the capital cycle’s impact on profits, the below is a brief schema:

  • A new service or product achieves superior product-market fit compared to incumbents, or opens up an entirely new market, attracting high revenue growth.
  • The lack of competition (first mover advantage) and the superior value proposition produce both high revenue growth rates and high pricing power, leading to higher profits.
  • This results in a period of super-normal profits.
  • These super-normal profits attract new entrants or additional investment from competitors. Specifically, they alter the ROI profile for players considering an entry (i.e. so high do the returns become that the payoff exceeds the capital requirement for a new player to enter).
  • New capital and new entrants flood into the market, tipping the balance between supply and demand towards the supply side.
  • This compresses any individual firm’s revenue growth (distributed between more players), and profit margin (less pricing power).

Over long periods of time, this dynamic can even reverse (hence the ‘cycle’). So aggressive can the profit compression become that it can lead to players exiting the market or going bust, which in turn makes the supply-demand balance become more favourable for the surviving firms, and so profits grow again. And so on…

Typically, investors think about capital in physical, tangible terms. This leads them to worry about the capital cycle dynamics in, for example, the oil & gas industry, or the semiconductor industry, or general manufacturing. The airline industry provides another fascinating historical example over many decades, which I won’t go into now.

The problem is (some – too many, even) 21st century investors haven’t updated their thinking to intangible capital and technology companies. As if the capital cycle does not apply to them.

Netflix is a company that sells an intangible service to the consumer and does not require a tangible capital-intensive supply chain to do so. This does not mean that a lot of investment is not required into other forms of capital: from software engineering to people capital (actors, directors, screenwriters, etc.).

To think that so-called “asset light” business models are immune to the capital cycle is a mistake. And to think that the capital cycle only affects incumbents and not disruptive “structural” growers, is another mistake. Money is money and investments are investments, whether it is spent on equipment, paying R&D engineer wages, marketing, or paying actors. And investments chase profits, whether these profits are in ‘structural’ or ‘traditionally cyclical’ growth industries.

One might even go further and say technology-reliant business models should be the most scrutinized for capital cycle risk. After all, technology is about lowering barriers to entry, is it not? And certainly, when it comes to consumer-facing D2C technology businesses like Netflix, Facebook, and Paypal (three of the worst performing large cap tech stocks this year – not a coincidence), we should remember how low the ‘switching costs’ are to the consumer. At zero cost I can switch between Netflix, and Amazon Prime; between Facebook, and Snapchat; between Spotify and Youtube; between Paypal and Apple Pay…it goes on. Needless to say, we are underweight D2C tech companies at Montanaro.

So while the growth investor may have been very pleased with Netflix’s growth at any point in the last decade, the Quality Growth investor has one central question: “How sustainable is this profit growth?”.

This comes down to two fundamental questions investors should ask: what is the underlying asset I’m investing in (is this a brand, a tech company, a network company, a content company?) And having identified it, what are the barriers to entry to replicating that asset? Another way I think of this second question is ‘what is the replacement value of the asset?’.

Netflix gives a lesson on both of these for the modern growth investor.

First: what’s the asset? To quote the well-known technology commentator, Benedict Evans, who is also an Advisor to the Montanaro Global Innovation Fund, ‘Netflix is not a tech company. Netflix is a television company using tech as a crowbar for market entry’.

Benedict then continues: ‘the tech has to be good, but it’s still fundamentally a commodity, and all the questions that matter are TV questions’.

Netflix’s key asset is not technology. Technology is there, sure, but it’s not the reason you value it at hundreds of billions. The key technologies the business model relies on are external: laptops and fibre optic broadband. And while there might be a level of proprietary engineering in the streaming technology, it’s meaningless in the grand scheme of things. The streaming quality of Sky, Amazon Prime, or BBC iPlayer, for that matter, cannot be told apart. When Benedict says Netflix is a television company, what he is saying is Netflix’s key asset base is its content library. You could even make the case that its huge network of subscribers is an asset in itself. Insofar as it incentivizes actors to work for Netflix which in turn creates more and better content, then I’ll accept that argument, too. But it’s not tech, it’s content.

Fine. So now we’ve identified the asset we would be investing in (let’s imagine it’s 2021 and the market cap is $250bn), we ask: how much would it cost to replace that asset? What are the barriers to entry for a new entrant to replicate that asset?

This is where the Netflix story unravels.

Unlike Uber, which is also not a tech company, but a transport company with a new business model (it exploits readily available technology like 4G, cloud computing, and Google Maps API, all of which aren’t proprietary to Uber), Netflix does not have a very difficult-to-replicate network effect. Uber’s network is two-sided, meaning: drivers don’t want to join the network unless there are millions of customers already on the network; but customers don’t want to join the network unless there are hundreds of thousands of drivers already on. This chicken-and-egg problem makes the network, once grown, hard to replicate. Although remembering the low technology switching costs point, the risk you run is that if and when a new network does come along, you can lose your own network quickly – think Uber Eats eating the lunch (couldn’t resist) of Deliveroo: both two-sided marketplaces.

People have argued that Netflix also has a difficult-to-replicate two-sided network effect, but this does not stand up to scrutiny. True, an actor is more willing to work for Netflix if they know they will be watched by millions. So, would a new entrant starting with zero subscribers be able to attract acting talent? Yes and no. Actors work for money, same as anyone; if you pay them enough, they will likely say yes. Like we learnt when Bolt entered Uber’s market, networks can be bought – they might come at a price, but they can be bought.

Admittedly this means that a new entrant would have to run losses for the interim period between it investing to create content, without a critical mass of users. That loss-making period in itself is a barrier to entry.

But this is where the capital cycle made Netflix’s investment case unravel in the pandemic. So high was the demand to pay for streaming content during the pandemic, that it hugely accelerated the return on invested capital for a new entrant (or challenger) weighing up investing in the space. Let’s suppose that if you’re wanting to get into streaming in 2019, it would have taken four years to make back in profits your unit of invested capital; in the pandemic that was cut down to, say, 12 months. What was a tough decision became a no-brainer.

Add to that the fact that your potential competition (companies with the resources to chase a global TAM, and with streaming technology capabilities: i.e., Apple and Amazon) is companies whose incremental customer acquisition is rock bottom, and you see that the replacement value of Netflix’s content library to a player like Amazon and Apple became negligible compared to their own market caps. Amazon Prime already has hundreds of millions of users. So, the incremental cost of customer acquisition for a new Amazon Prime service is zero. Same for Apple, who make the very devices people use to stream Netflix…

So, the point is simple. Thanks to the pandemic, Apple, Disney and Amazon spent orders of magnitude more money investing in their content libraries than ever before, because the unit economics of the pandemic-caused explosion in demand increased the ROI of their investments considerably.

So, weaving this story back to a conclusion. Consumer enters 2020 with a Netflix subscription. Consumer signs up to Apple TV, Disney + and Amazon Prime during the pandemic because they have more free time, more money, and these new challengers now have great content libraries. After the pandemic, the consumer decides to rationalise, and suddenly Netflix’s content library is no longer the 800lb peerless gorilla it used to be two years ago, so some consumers stay with Netflix, and it turns out, some cancelled.

There is no point in pretending that investing in high growth, innovative companies is free of risks, or easy (we would know; we have our fair share of mistakes here!). There is no way to quantify with total exactitude what the capital cycle risk is for any given company. But, as a technology analyst, being obsessively paranoid, asking the questions, studying the competition, and understanding that nobody is safe from the capital cycle, whether you’re a manufacturer or a software company or a disruptive internet company like Netflix, might help you pick the winners from the losers.

A discussion for another time might be how to defend against the capital cycle. High IP is an answer that the Montanaro Global Innovation fund might give to this question, but more on this in another post.

Oh, and Rickey Gervais jokes should not be interpreted as investment advice.

 

 

 

 

 

 

 

The views expressed in this article are those of the author at the date of publication and not necessarily those of Montanaro Asset Management Ltd. The information contained in this document is intended for the use of professional and institutional investors only. It is for background purposes only, is not to be relied upon by any recipient, and is subject to material updating, revision and amendment and no representation or warranty, express or implied, is made, and no liability whatsoever is accepted in relation thereto. This memorandum does not constitute investment advice, offer, invitation, solicitation, or recommendation to issue, acquire, sell or arrange any transaction in any securities. References to the outlook for markets are intended simply to help investors with their thinking about markets and the multiple possible outcomes. Investors should always consult their advisers before investing. The information and opinions contained in this article are subject to change without notice.

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