The Business Of

Movies | Netflix | What Do They Do With Their Profits?

Morning All!

So, yesterday we put together Netflix’s cost structure with their revenues. Let’s have a little recap…

• Revenues - have grown at ~25% per year for the last decade. With subscriber growth contributing ~20% per year. And pricing growth ~5% per year.

• Costs - cost of revenues (majority of which is content amortisation) makes up ~60% of revenues. This is the cost of getting content on the platform.

• EBIT - despite the cost of content rising, Netflix’s stellar ~25% revenue growth has translated into an even more impressive ~40% EBIT growth.

And the margins of Netflix stand up pretty well vs the 6 companies we’ve seen so far…

So $31.6bn in revenues. 18% margin. Means $5.6bn EBIT. Where does all this EBIT go? Let’s find out now!

Content… Keeping Subscribers Content

Right so, let’s talk about cash use. Does Netflix mainly reinvest cash back into their business? Return cash to shareholders? Or add cash to their balance sheet?

Well, the chart below gives us the answer. And it’s a clear winner. Netflix reinvests pretty much all their cash back into the business!

And what do Netflix reinvest in? Content. And their commitment to this has been unwavering. As the chart shows, content spending (called ‘additions to content assets’ in Netflix reports) has grown from $3bn in 2013 to $16bn in 2022! And from 2013 to 2019, Netflix were actually spending more on content than they were making in cash in those years! The excess spending on content was covered by raising debt.

But let’s stop for a moment. Because we’ve talked about content a lot this week. But why is it so important for Netflix to reinvest in content? Well, let’s quickly think back to Tuesday and remember how the company makes money…

For Netflix (and any company), in order to improve their business and grow profits, growing revenues is crucial. And we saw on Tuesday that there are two ways Netflix can grow their revenues. (i) Increasing their number of subscribers. (ii) Increase their subscription prices.

But why would more and more people subscribe to Netflix? And why would people stay with Netflix despite price rises? Well, pretty much the only reason people are subscribing to, and staying with Netflix is because of the content! They want to see great content. It’s as simple as that. And so - in order to increase revenues, Netflix need to continuously grow and retain subscribers. And to do that, Netflix needs to continuously spend money on acquiring and creating the best shows/films.

Netflix management to their content creation team…

But do they really have to spend ALL the cash they make in a year on content? Well, like we saw yesterday, content licensing and content creation are expensive! Netflix are reportedly paying Sony $250m/year to license content. And creating original content is even more expensive! With Netflix spending $200m on creating just one film - Red Notice. And they’ve spent $520m so far on creating The Crown!

So what does all this mean? Will Netflix continue to take out debt to fund their huge content creation efforts? Well thankfully, no. Since 2019, Netflix have been spending less than 100% of their cash on adding content. And the company themselves have said that they no longer need to take out debt for their content additions! But will the company still spend close to 100% of their cash on content? No doubt. As the streaming wars heat up, Netflix will be doing all they can to stop subscribers leaving for Disney+ and co!

Dividends? What Dividends…

Okay, so reinvesting cash is clearly the major way Netflix uses their cash. But what about returning cash to shareholders? We saw Tesco, Man United, Ninety One, and LVMH all have dividend policies to return cash to their shareholders. And dividends are great for shareholders because it’s a return on their investment. So, what about Netflix?

Well, Netflix doesn’t give any dividends to their shareholders…

Now, you may be asking why? And it’s a fair question. Netflix clearly make a lot of money, they’re profitable - why don’t they return cash to their shareholders? Well, to answer this question, we need to look at more than just dividends. We need to look at capital gains. Because remember, there are two main ways a shareholder can make a return on their investment.

1. Capital gains - investor buys a stock. The stock price goes up. Investor sells the stock and makes a profit.

2. Dividend income - investor buys a stock. The company they’ve invested in gives out cash every year to their shareholders (in the form of a dividend).

So first, let’s see how Netflix shareholders have done from capital gains. And this will help uncover the mystery of the no dividend! The chart below shows us Netflix’s share price since the company IPO’d in 2002.

If you bought Netflix shares when the company IPOd @ $1.21. You would have made 274x your initial investment. This equates to a 32% return per year for 20 years! Not bad. Even if you bought 10 years ago when the company was well established @ $27, you would have made 12x your initial investment. Which is 28% return per year for 10 years.

To put that in comparison, the S&P500 index has returned 7% per year since Netflix IPOd. And 10% per year over the last 10 years. So to put it gently, Netflix shareholders have done incredibly well from owning Netflix shares.

Now, why have Netflix shares gone up 29% per year for the last 10 years? Well the main driver for shares is profits. And more specifically profit growth. So is it reasonable to think Netflix’s profits have also increased by a similar % per year? Yes. And if we look at the chart below, it shows us that Netflix’s EBIT has increased by an extraordinary 32% per year since 2014.

So,

How have Netflix shares done so well? Strong EBIT growth.

How have Netflix been able to manage such strong EBIT growth? More subscribers.

How have they got more subscribers? Better and original content.

How have they got better content? Using cash for content acquisition - not dividends!

So, let’s go back to our original question. Why don’t Netflix give dividends to their shareholders? And the answer is - because whilst dividends are great for shareholders most of the time. They’re not great all the time. Because if you’d been a shareholder in Netflix over the last decade, you’d rather the company spend their cash on content acquisition. Rather than giving it to you as a dividend. Because the return you’d make on capital gains would far exceed the return from a dividend! And in fact, this is what we’ve seen activist investors tell Disney about Disney+!

13th Apr 2023

Nigel Jacob CFA