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Analysis & Valuation

For MGMT E-2620, Prof. Dalko

TEAM - 10Brian Schoenherr, Anirudh Udayashankar, Junyao Zhao, Alegra N Horne & Larry Montello

Netflix Company ProfilePioneer and leader of the on-line TV market. 75M subscribers in over 190 countries.125 million hours of viewing per day.Affordable no-commitment monthly fee.Personalized recommendations based on sophisticated user monitoring.DVD rental is very profitable but an ever smaller contributor to their business.

First Mover AdvantageVery Competitive Landscape

(Source: Premium Prospects for OTT in the USA study from MTM, Ooyala and Vindicia)

Threat of New EntrantsHybrid ServicesNiche offerings

MEDIUMThreat of SubstitutesCable Live streamingOpting outsideFree alternatives

HIGHBargaining Power of BuyersLow cost alternativesLow switching cost

HIGHBargaining Power of SuppliersSupplier-CompetitorsStrategic Alliances

HIGHDegree of Rivalry among CompetitorsAmazon & HuluHBO, CBS, FoxApple, Google, RokuHIGH

Industry Analysis - Porters Five Forces

Netflix Competitive Strategy48% share, more than twice as big as the next competitor (Amazon 20% and Hulu 10%).Differentiation Strategy: offering superior content to the global video streaming market.Sophisticated monitoring capability to understand their customers preferences and select winning content.

Largest Opportunity for the US # 1 Online TV provider is with the rest of the world

Netflix Corporate Strategy AnalysisThree reportable segments: domestic streaming, International streaming and Domestic DVD. Started with DVD rentals and built its knowledge of (and tools to measure) winning content.Planned growth of customer base from 75M today to 150M by 2020. Primary investments:Global Expansion: Serving 190 countries world-wide$5B investment is developing their own content.

Strategy Analysis ConclusionsNetflix is number 1 in video streaming and are making investments to maintain their market leadership.NFLX stock is trading at a very high premium over what might be predicted with fundamental analysis. This is typical of a market leader in a new emerging high tech market.We predict Netflix will regress to the market growth rate of 20% and face higher content and delivery costs as they expand internationally.

Netflix Accounting AnalysisRevenue stream: Subscription fees onlyNo advertising revenue

Asset RecognitionLibrary of DVD and streaming contentGlobal networkMostly straight line amortization - discretionary

Netflix offers content on a subscription basis only, and does not derive any advertising revenue (as does most of the industry).

One key measure of Netflixs success is its vast library of streaming and DVD content, which can currently be accessed globally.This is represented as current and non-current content assets on the balance sheet and we agree with this practice as the content earns future cash flows for the company.While the individual contracts for titles is impossible to determine, Netflix amortizes the content assets (licensed and produced) in Cost of Revenues on the Consolidated Statements of Operations.The amortization period typically ranges from six months to five years.The rate of amortization is discretionary to management, and a potential red flag with future growth in content assets.

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Netflix Accounting AnalysisLiabilities recognition: Subscription fees onlyFixed costs for content licensing v/s variable subscription fees; gross margin liabilitiesFuture contracts of $6.1 billion currently discussed, but unaccounted forGrowing international business exchange rate volatility-$331 million impact in 2015

While Netflixs revenues are variable per the number of user subscriptions, the contracts for streaming licenses are fixed which gives rise to gross margin liabilities which we should be watchful for.

Currently about $6.1 billion of future streaming assets and corresponding liabilities are not included on the balance sheet, as viewers cannot access them as yet. We believe this is correct, as it would have otherwise artifitially inflated the size of the balance sheet, with no gain to net operating assets.

With a growing international business segment, we should also account for Forex volatility, as all revenues net are translated into USD for accounting purposes.10

Netflix Accounting AnalysisOpinionDetailed MD&AAccounting reflective of:Future growth potentialInherent customer acquisition risksImpact of technological changes

In analyzing the financial statements we found that Management discussions are extremely detailed regarding all inherent risks to the future growth of the company - both in terms of customer acquisition and technological advancements - and has proven to be reliable in representing the business in the correct light, allowing investors to make calculated assumptions about opportunities on hand.

We concur with Netflixs claims to manage balance sheet to lower blended cost of capital over time, while maintaining financial flexibility.

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Financial Analysis Ratio AnalysisOverall ProfitabilityYear Ended 201020112012201320142015ROE53.3%35.2%2.3%8.4%14.4%5.5%ROA 15.8%7.4%0.4%2.1%3.8%1.2%Financial Leverage3.384.775.334.063.804.59

Sales and Net Income GrowthYear 20112012201320142015Sales Growth48.2%12.6%21.2%25.8%23.2%Net Income Growth46.1%-92.4%555.8%137.3%-54.0%

Netflixs sales growth has been more than 20% each year except 2012. The high growth is due to the rapid growth of new subscribers globally, but the companys ROE is significantly decreased.

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Financial Analysis DuPont ModelDECOMPOSING PROFITABILITY: DUPONT ALTERNATIVEYear Ended Dec-10, (MM USD)201020112012201320142015 NOPAT / Sales7.7%7.5%0.8%3.0%5.5%3.5% x Sales / Net Assets12.3 11.5 8.8 6.6 4.7 2.9 = Operating ROA94.5%85.5%6.9%19.8%25.9%10.3% Spread104.7%89.0%10.3%22.7%31.5%-117.7% x Net Financial Leverage-39.0%-57.0%-45.0%-50.0%-37.0%4.0% = Financial Leverage Gain-41.2%-50.4%-4.6%-11.4%-11.5%-4.8% ROE 53.3%35.2%2.3%8.4%14.4%5.5%

The declined in ROE is due to the decline of operating ROA. Netflix significantly increased their assets in the form of building and content library, and the growth rate of asset outpaced the growth rate of sales, result in the low asset turnover. IN the meantime, The NOPAT margin is also decreased because of the increased operating and content expenses.The dupont also shows that Netflix has negative gains from its financial activities, but the trend is increasing shows that they become more efficient with the use of debt.

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Financial Analysis OperationEVALUATING OPERATING MANAGEMENTYear Ended Dec-10, (MM USD)201020112012201320142015 Sales / Sales100.0%100.0%100.0%100.0%100.0%100.0% Cost of Sales / Sales47.1%37.5%26.3%20.0%17.6%15.4% Gross Margin52.9%62.5%73.7%80.0%82.4%84.6% SG&A / Sales24.4%24.3%25.1%23.5%24.5%27.8% Amortization & Depreciation expense/ Sales15.7%26.2%47.2%51.2%50.5%52.3% Investment Income / Sales0.0%0.0%0.0%0.0%0.0%0.0% Other Income, net of Other Expense / Sales0.2%-0.2%0.0%-0.6%-0.1%-0.5% Minority Interest / Sales0.0%0.0%0.0%0.0%0.0%0.0% EBIT Margin13.0%11.8%1.4%4.6%7.3%4.1% Net Interest Expense (Income) / Sales0.9%0.6%0.6%0.7%0.9%2.0% Pre-Tax Income Margin12.1%11.2%0.8%3.9%6.4%2.1% Taxes / Sales4.9%4.2%0.4%1.3%1.5%0.3% Net Income Margin7.2%7.1%0.5%2.6%4.9%1.8%

Using the top-down analysis to evaluate Netflixs operating management, we see that Netflix increased their efficiency in procurement of contents and production process represented by decreasing rate of COGS, but the profits are offset by the high operating costs mainly from SG&A, amortization and depreciation expenses.

The high SG&A expenses on the other hand shows that Netflix is competing on a differentiation strategy. 14

Financial Analysis Investment EVALUATING INVESTMENT MANAGEMENTYear Ended Dec-10, (MM USD)201020112012201320142015 Working Capital Management: Operating Working Capital / Sales-4.4%-5.9%-5.0%-6.7%-6.0%-6.0% Operating Working Capital Turnover-22.6-16.9-20.0-14.8-16.7-16.6 Accounts Payable Turnover4.61.30.70.50.40.3 Days' Payables79.8281.2558.4785.6871.71063.3 Long-Term Asset Management: Net Long-Term Assets Turnover8.06.86.14.63.72.5 Net Long-Term Assets / Sales12.6%14.6%16.4%21.9%27.4%40.1% RP&E Turnover7.02.72.22.01.91.5 Depreciation & Amortization / Sales15.7%26.2%47.2%51.2%50.5%52.3%

For the investment analysis, the working capital management has improved in the form of longer Days Payable. But the net Long-term Asset turnover is decreased because of increase in contents assets as well as infrastructures.

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Financial Analysis FinancialEVALUATING FINANCIAL MANAGEMENTYear Ended Dec-10, (MM USD)201020112012201320142015 Short-Term Liquidity: Current Ratio1.71.51.31.41.51.5 Debt and Long-Term Solvency: Liabilities-to-Equity2.43.84.33.12.83.6 Debt-to-Equity0.80.70.60.40.51.1 Interest Coverage Ratio: Interest Coverage14.619.02.56.98.02.1

Netflix has increased the use of debt to support their business expansion.By the end of 2015, the company has the debt over equity ratio of 1.1,but shows good liquidity and interest coverage ratio.

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Other RatiosYear Ended Dec-10, (MM USD)201020112012201320142015 EBITDA Margin28.7%38.0%48.6%55.8%57.8%56.4% Sustainable Growth Rate53.3%35.2%2.3%8.4%14.4%5.5%

Dividend policy: Netflix has not declared or paid any cash dividends, and has no intention of paying cash dividends in the foreseeable future.

On July 14, 2015, Netflix exercised a 7:1 stock split in the form of a stock dividend to all shareholders.

Financial Analysis Other Ratios

by adding back depreciation and amortization, the EBITA Margin indicates the high profitability of Netflixs business, and a sustainable growth rate of 5.5% at the end of 2015.

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Cash Flow Analysis

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Statement of Cash FlowsYear Ended Dec-10, (MM USD)201020112012201320142015 Net Income160.85226.1317.15112.40266.80122.64 After-tax net interest expense (income)11.6112.6011.2419.1538.35114.72 Non-operating losses (gains)-10.500.000.000.000.000.00 Long-term operating accruals-101.32-1,487.96-782.48-808.22-980.54-2,207.38 Depreciation and amortization340.07839.621,702.082,241.682,781.803,547.05 Content expenses-441.39-2,327.58-2,484.56-3,049.90-3,762.34-5,754.43 Operating cash flow before working capital investments$60.64-$1,249.23-$754.09-$676.67-$675.39-$1,970.02 Net (investments in) or liquidation of operating working capital227.371,579.55788.09793.65730.221,335.30 Operating cash flow before investment in long-term assets$288.01$330.32$34.00$116.98$54.83-$634.72 Net (investment in) or liquidation of operating long-term assets-116.09-265.82-245.91-255.97-42.87-179.19 Free cash flow available to debt and equity$171.92$64.50-$211.91-$138.99$11.96-$813.91 After-tax net interest expense (income)11.6112.6011.2419.1538.35114.72 Net debt (repayment) or issuance-1.78195.98-2.62270.05398.911,499.45 Free cash flow available to equity$158.53$247.88-$225.77$111.91$372.52$570.82 Dividend (payments)0.000.000.000.000.000.00 Net stock (repurchase), issuance, or other equity changes49.78219.563.66124.5667.6295.61 Net increase (decrease) in cash balance$208.31$467.44-$222.11$236.47$440.14$666.43

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Baseline forecast Assumptions for current stock price $95.50 Maintain sales growth > 25% per annum NOPAT Margin > 7.4% per annum Increase from 5.5 million subscribers (2015) to 15 million new subscribers each year for 5 years.

-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Assumptions suggests Netflix can maintain its competitive advantage in a very competitive industry. We think the current set of assumptions are unrealistic..

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Netflix Prospective Analysis

Netflix Scenario Analysis

Best case scenario $95Most likely scenario $ 65Worst case scenario $30

Valuation using Price Multiples Time Warner Cable Price/Earnings: 28.7Price/Book ratio: 5.85 Comcast Price/Earnings: 17.4Price/Book ratio: 2.64Netflix, Inc. Price /Earnings ratio: 398 Price /Book ratio: 18.3

Overall RecommendationWe assign a Sell rating to Netflix stock.

Netflix current stock price: $95 a shareMacro factors: Increased competition Company factors: low margins, increasing debt, negative cash flowsFair value at $65 a share

The end. Thank you.