(This is Part IV of a five-part series. Part I. Part II. Part III. Part V.)

“Not all those who wander are lost.” -J.R.R. Tolkien.

When thinking about base rates, it is important to consider why they are what they are. For instance, the average long term 5%-6% growth rates seen in the base rate data shared in Parts II and III was made up of about 2%-3% unit growth and 2%-3% inflation. So, what happens if you are forecasting a company that you believe has the potential to raise prices really significantly over time?

We faced just this issue when we invested in Netflix in 2016. As we described in this post, we believe that Netflix is selling their service for far less than their customers are actually willing to pay. Our forward growth rate forecast for Netflix implies that they will materially outgrow most relevant base rates. However, if you were to decompose our growth forecast into the number of subscribers and the price paid per subscriber, you would find that our subscriber growth rate is not so different than a base rate analysis might imply. Rather it is our forecasted price increases that drive our super normal growth outlook.

(Click on the chart to enlarge)

Netflix’s business can be simplistically thought of as being made up of a mature US business and a still rapidly growing international business. Coming into COVID, US subscriber counts, which had been growing at quite high rates in years past, had seen growth slow into the mid-single digits, consistent with what a base rate analysis might suggest about a highly scaled media company’s growth opportunity. As the COVID impact fades, we expect US subscriber growth to continue at a low single digit rate, consistent with the 2%-3% base rate unit growth we noted above. So, there is nothing heroic about this part of our growth assumption.

Internationally, Netflix was seeing explosively high subscriber growth running at 50% or above five years ago. Consistent with what a base rate analysis of intangible based businesses might suggest, subscriber growth had slowed to about 30% by the end of 2019. As the COVID impact fades and we look into the future, we believe that there remains an unusually large opportunity ahead for Netflix. Yet we’re also aware that companies of this scale, very rarely are able to maintain highly elevated growth rates for long periods of time. We expect that international subscriber growth will slow into the mid-teens and continue to fade over time. Our inside view analysis of their subscriber growth opportunity supports our belief that the level and duration of Netflix’s international subscriber growth rate will likely continue to perform at the higher end of an appropriate reference class base rate distribution. But the base rate moderates our inside view-only analysis.

Remember, base rates don’t tell you what will happen. They tell you what has happened on average in the past. It is then incumbent on you to also take into account information related to your specific forecast.

Going back to our example in Part II of forecasting whether it will rain tomorrow in Seattle and Las Vegas, no matter how high the frequency of rain in Seattle is compared to Las Vegas, if it has been raining for a week straight in Las Vegas with no sign of a change in the weather, it would be naïve to think the probability of rain tomorrow was best estimated using the low long-term base rate.

But subscriber growth is only part of the total growth equation for Netflix. When forecasting their revenue, you also need to consider the price they charge their subscribers. For many companies, investors should assume that prices will rise more or less in line with inflation. Typically, if a company raises prices much faster, they will lose customers to its competitors.

But that is certainly not always the case and has not been the case for Netflix in the past because they have very strong pricing power. And the pricing power they have is sustainable because it comes from the way they delight their customers in an industry that is better known historically for commanding pricing power from having trapped and exploited their customers.

With Netflix, we believe the company charges a price well below what customers would be willing to pay. We believe this based on our own analysis of their value proposition, our research on what their customers say about how the value the service, and the historical record of them rising average prices in the US by approximately 9% a year, even while new subscribers flocked to the service adding 80% to their US subscriber count in the five years prior to COVID.

Notably, Netflix did not start raising prices for US subscribers until they had already built a sizeable business and proven to a large cohort of customers just how fantastic their service is. The international business serves a range of customers in developed and emerging markets with a wide dispersion in the amount of highly relevant content in different geographies. But overall, we expect Netflix to run the same playbook, where they scoop up tons of new subscribers at a very low price, use the newly generated revenue to invest heavily in outstanding new content, prove to their subscribers just how fantastic their service is, and then raise the price of the service over time to a level that better reflects the value they provide, even while they leave a huge amount of consumer surplus on the table for their subscribers.

Once you add together our base rate driven subscriber growth with the company’s relatively unique proven ability and ongoing opportunity to raise prices at an unusually high rate, you get a total revenue growth rate that is well above what most blunt base rate references classes might suggest.

Our forecast is not simply that Netflix will grow faster than most companies could be expected to grow. Rather it is that Netflix’s growth in subscribers will be constrained by the same forces that most large, growing, intangible asset-based companies face, but that the company has a relatively unique opportunity to dramatically raise prices without losing customers and, thus, report base rate breaking revenue growth for years to come.

This process does not in any way ignore base rates or suggest that Netflix is somehow immune from the forces that conspire to slow down corporate growth over time. Rather the combination of our inside view analysis of Netflix, and our outside view analysis of corporate growth rates, has been combined in such a way that results in a forecast that is at the high end of the historical experience of similar companies.

Of course, this does not guarantee our growth forecasts are correct. It may be that we should be tying ourselves more tightly to the mast and we run the risk of being lured by the siren song of growth. But the reverse is also true. It may be that we are too cautious in our outlook. The process we describe here is how we attempt to craft the best forecasts we can, not a magic trick that let’s us predict the future.

Base rates are not destiny. This example explains our analysis on a specific, unique company in which we sought to understand the nuances of an inside view and outside view analysis and integrate them. This is exactly what decision science researcher, Phil Tetlock, advocated for in his book Superforecasting.

In fact, Michael Mauboussin put together a chart of Tetlock’s framework for his own report Cultivating Your Judgement Skills.

(Source: Credit Suisse)

In our final post in this series, we’ll discuss a type of situation that occurs relatively infrequently that we believe gives rise to companies that have a materially higher than average chance to generate significantly elevated and long duration growth. With these companies, we’ve tried to peer beyond the “line of site” and assessed that probabilistically the companies in question are likely to grow much faster than a blunt base rate analysis might suggest.

Read Part V.

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