Matt Franz : Zealous For Knowledge


I recently watched Bill Nygren’s Talk At Google and enjoyed the story of how he analyzed and bought Netflix. Micro Cap Club did a good re-cap of what he said.

The thesis hings on the idea that Netflix has untapped pricing power. Many subscription services, like HBO, Sirius Satellite Radio, Spotify, Hulu, etc cost more than Netflix does. Yet consumers say Netflix is their favorite.

Pricing power is extremely valuable and rare. Buffett said:

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

–Warren Buffett, 2011 (Financial Crisis Inquiry Commission)

John Huber at Base Hit Investing did a great post on pricing power you can check out for more.

With this in mind, I decided to work through Nygren’s analysis myself.

In their 2016 annual report Netflix reports 48 million domestic “members” (subscribers), 93 million total members, and $187 million of net income. The average monthly revenue per domestic member was $9.21 and the average monthly revenue for all members was $8.61. To keep it simple I assume that Netflix can raise its prices substantially without losing customers or increasing expenses.

If Netflix raised prices just in the U.S. to $15 per month it would increase revenue by $3,335 million (=12*(15.00-9.21)*48) which would bring its net income to $3,522 million.

If Netflix raised prices worldwide to $15 per month it would increase revenue by $7,131 million (=12*(15.00-8.61)*93) which would bring its net income to $7,318 million.

So if (a big if) Netflix can raise prices substantially without losing any subscribers or increasing their costs, it could make between $3.5 and $7.3 billion dollars per year. Applying a 15x multiple to this gets us to a market cap of $52-109 billion dollars. Today the stock has a market cap of $95 billion.

This is interesting because it shows that the market must either be valuing Netflix on the basis of its potential future pricing power or its ability to continue rapidly adding subscribers, or both. Either way, there’s clearly not a large margin of safety in Netflix shares at the moment as you have to make some big assumptions to get anywhere near its current valuation. Remember, the key to Buffett’s purchase of See’s Candy was that he didn’t pay anything for its untapped pricing power.

If you put a gun to my head, I’d say that I do think Netflix has some untapped pricing power. But I don’t think Netflix can simply double prices tomorrow (remember Mylan’s Epipens). I expect they will slowly but steadily raise prices at an above-inflation rate. I also think they will continue to add subscribers, but not at a pace anywhere near historical standards as they are already saturating their markets. Eventually Netflix will get to $15/month, but how far into the future? I’d bet many, many years. And I would also expect Netflix’s programming costs to continue to rise, so this won’t be 100% profit.

Netflix might start to get interesting at half its current price, but even there you’re paying a lot today for what you hope will happen tomorrow. That just isn’t my style.

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