“A key part of successful investing is the ability to keep emotions in check in the face of adversity. One example is when one of the stocks in your portfolio drops sharply. This kind of event precipitates what has been called a “man overboard” moment. These moments demand immediate attention, are stressful, and require swift action.” -Michael Mauboussin, Managing the Man Overboard Moment

Last week, Netflix, a stock we’ve owned for five and a half years, and which is one of our largest positions, reported quarterly earnings causing the stock to fall 22%. In this post, we will explain our analysis of their reported results and guidance and explain our rationale for remaining confident in the company’s long-term opportunity and ongoing place within our top portfolio holdings.

We will seek to make three objective arguments based on the information that has been reported, which we believe refutes three points of concern being discussed in the media and among investors.

• We do not believe the evidence supports the contention that Netflix has saturated their available market and, thus, no longer has the opportunity to grow their subscriber base substantially over the next decade.
• We do not believe the evidence supports the contention that Netflix is suffering from a significant increase in competition.
• We do not believe the evidence supports the contention that the company’s guidance – while clearly weak – is catastrophic or justifies a 22% drop in the share price.

We will also offer our subjective analysis of the company’s weak guidance and offer our thoughts on what issues may be crimping the company’s near-term growth opportunity.

Before we jump in, we want to reflect on the quote that opens this post. It is an excerpt of a paper published in 2015 by Michael Mauboussin, one of the most prolific and insightful investment and decision-making researchers operating today. In the report, titled “Managing the Man Overboard Moment: Making an Informed Decision After a Large Price Drop” (PDF here), Mauboussin articulates why these moments are so challenging for investors to manage well.

“If you are the portfolio manager, you might feel frustrated, upset about the hit to returns, and worried about the business implications. If you are the analyst, you might feel anger, disappointment, and shame. None of those feelings are conducive to good decision making.”

It is impossible for investors to be immune to emotions like these during challenging investment periods. But at Ensemble we attempt to inoculate ourselves against the way that these emotions can undermine rational decision making by utilizing a systematic approach to assessing both the value of the stocks we own, as well as the degree of confidence we have in our analysis. We then use the quantitative scores generated by this system to determine how much of any given stock we want to buy, hold, or sell. We have and will remain disciplined in implementing this approach as we make decisions regarding the trades we have or may place in Netflix based on the new information.

Now let’s tackle the issues at hand. First, we’ll look at the two key data points, the number of new subscribers reported in the fourth quarter of 2021 and the company’s guidance for the number of new subscribers they expect in the first quarter of 2022.

The chart below shows Netflix’s guidance and their actual reported new subscribers for each quarter between 2017 and 2021. We’ve added a green box around their best quarterly results (excluding the huge 15.8 million subscribers they added when the world sheltered-in-place at home during the initial COVID wave) and a red box around their worst results during that time period.

(Source: Netflix, Ensemble Capital Management)

The 8.3 million new subscribers that the company added in the just completed fourth quarter ranked alongside the best results in the company’s history. These were strong results for the company.

The 2.5 million new subscribers that the company is forecasting for the first quarter of 2022 would be a result that has already been seen in three of the last sixteen quarters. This would be a weak outcome. But not one that is unprecedented or that would be inconsistent with a strong full year 2022 result. Indeed, in the second quarter of 2019 the company reported just 2.7 million new subscribers, yet still reported 27.8 million new subscribers for the full year. This 27.8 million new subscribers for 2019 is identical to the 27.8 million average annual new subscribers the company has added during the past four years.

An important point about Netflix’s approach to guidance is that unlike many public company management teams that attempt to “manage investors’ expectations,” Netflix has long said that “the quarterly guidance we provide is our actual internal forecast at the time we report.”

As you can see in the chart above, the company’s own internal forecast is far from perfect. It has not been uncommon for actual results to materially exceed or come in below the forecast. This is simply a function of how hard it is to predict the future. To make their best possible forecast, the company examines the trends they are seeing at the end of the prior quarter and the first few weeks of the new quarter that occur before they report earnings and offer guidance. They then take other known inputs into account (such as the timing of upcoming big releases or planned price increases) and offer up the best forecast they can.

So, it is clear that the company’s data from the last few weeks of December and first few weeks of January showed weak growth trends, although not dissimilar trends as was seen during some past quarters, even as they experienced rapid growth across the full time period in question.

With these facts established – that the company reported a strong fourth quarter and guided to a weak first quarter – we can turn to the validity of the concerns these results have sparked in financial markets, which caused the stock to fall 22%.

Saturation

Netflix currently has 222 million subscribers around the globe. At some point, when nearly everyone who might be a potential Netflix subscriber has already signed up, the company will have “saturated” their “total addressable market.” The company’s most mature market is the US and Canada (UCAN), where they have a total of 75 million subscribers.

At some point Netflix will saturate their market. But despite claims to the contrary, there is no evidence in the company’s financial results that suggests that time has arrived.

Because UCAN is Netflix’s most mature and, thus, most saturated market, we will focus on this geography. If Netflix has not yet saturated UCAN, it is nonsensical to suggest they have saturated other, less mature regions, where they have an even lower share of households with enough discretionary income to consider subscribing.

In theory, almost all UCAN households are potential Netflix subscribers. Most every household in this region has a television or device on which to watch TV and movies. Nearly everyone at every income level in this geography can afford the $10 a month basic plan if they choose to. Today, Netflix only has a US subscriber count equal to about 2/3rds of the number of households that subscribed to pay TV at the peak, before cord cutting began as households switched from cable TV to Netflix.

The other 1/3 of pay TV households who do not subscribe to Netflix plausibly might not actually be interested in ever doing so. Netflix doesn’t offer sports or live TV and maybe that’s all those households care about. Or maybe some households just enjoy the linear TV experience, find the ads interesting, and would rather pay more than 5x the price of a premium Netflix subscription for the pay TV service they are used to. If so, then Netflix has indeed saturated their total addressable market in the US.

This seems very unlikely to us. But we have always expected that US subscriber growth would be slow going forward, because the company has already won over a large portion of the market. In October of last year, we wrote a series of posts that looked at how we forecast growth rates for our portfolio holdings. We used Netflix as an example on one point and wrote:

“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.”

Here is a chart showing the company’s subscriber base in each geographic region they serve, as well as their net new subscriber additions for each quarter over the past four years. Because the chart is so wide, the summary image below only shows annual data, but you can click on the link below the image to open a new tab with full quarterly data.

(Click here to open table with quarterly data)

In 2021, Netflix grew their UCAN subscriber base by 2%, right in line with our longer-term expectations, despite having grown by 9% in 2020 when the initial wave of COVID pulled forward new demand. In the just released fourth quarter of 2021, the company added 1.2 million new UCAN subscribers. Other than the surge of new subscribers seen during the initial wave of COVID, this was the highest number of new UCAN subscriber additions since the first quarter of 2019. To grow at 2%-3% a year in the UCAN region, Netflix only needs to add about 1.9 million subscribers at today’s run-rate and the fourth quarter result represents nearly 2/3rds of that amount.

Far from showing saturation, the company’s reported results show that growth trends in Netflix’s most mature market accelerated. Total global subscriber additions came in at a strong level, consistent with high levels of ongoing growth. To the extent some regions were on the weaker side, these regions are even less penetrated than UCAN.

To the extent that the weak guidance of 2.5 million new subscribers for the first quarter causes investors to worry about saturation, it is important to recognize that market saturation is not something that occurs over a period of a few weeks. Citing a few weeks of slow growth trends as evidence of market saturation reveals a fundamental misunderstanding of total addressable market analysis and the process by which markets become saturated.

The claim that Netflix has suddenly saturated their total addressable market is not supported by the evidence.

Competition

Another issue raised as a concern worthy of sending Netflix’s stock down 22% in a single day is the idea that they are facing newly intense competition. Advocates for this point of view cite a statement in the company’s shareholder letter in which they wrote “While this added competition may be affecting our marginal growth some…”

Netflix faces lots of competition. In the first place, they face competition from traditional linear TV services. They also face competition, mostly in the US, from a range of streaming services such as Hulu, YouTube, HBOMax, Amazon Prime Video, Disney Plus and a bunch of much smaller services now that every traditional linear TV business has realized they dropped the ball on streaming, and they must launch a streaming service asap. Outside of the US, the streaming competition is much less, with only Disney Plus and Amazon truly competing on a global scale in the paid, streaming video market.

In 2018, despite competition, they brought in 28.6 mil new global subscribers. In 2019, even as competition intensified, they brought in 27.8 million new global subscribers. While 2020 and 2021 saw unusual quarterly patterns due to COVID triggered demand pull forward, over the two-year period the company brought in an average of 27.4 million new global subscribers. These incredibly steady and strong results are not indicative of significant competitive concerns.

Importantly, to the extent there is significant new competition, it is primarily in the US. Myopically US-centric investors may look around and see the rise of new streaming services and worry. But we already established above that the fourth quarter results showed accelerating growth trends in UCAN during the 4^th quarter, and the newer streaming services available in the US are not available on a global basis.

The statement in the shareholder letter that competition “may” be affecting their incremental growth “some” considering their observed weak recent growth trends is more of a statement of the obvious, rather than an admission of competitive intensity worthy of a 22% stock price decline. Because the observed growth trend has slowed, it is true that competition “may” be part of the reason.

But let’s look at the full explanation for the weak guidance offered in the shareholder letter and in remarks made on the earnings call.

• “We think [slower new subscriber additions] may be due to several factors including the ongoing Covid overhang and macro-economic hardship in several parts of the world like LATAM [Latin America].”
• “No structural change in the business that we see.”
• “Healthy retention with churn down, healthy engagement with viewing up. Acquisition [of new subscribers] just growing but a bit slower than pre-COVID levels, just hasn’t fully recovered.”
• “It’s tough to say exactly why our acquisition hasn’t kind of recovered to pre-COVID levels. It’s probably a bit of just overall COVID overhang that’s still happening after two years of a global pandemic that we’re still unfortunately not fully out of, some macro-economic strain in some parts of the world like Latin America in particular.”
• “We can’t pinpoint it or point a straight line [but] when we look at the data on a competitive impact there may be some kind of – more on the marginal kind of side of our growth – some impact from competition. But which again, we just don’t see it specifically.”
• “There’s more competition than there’s ever been. But, we have had Hulu and Amazon for 14 years. So it doesn’t feel like any qualitative change there.”

Netflix isn’t quite sure why growth has slowed down. All businesses see fluctuations in their growth rates. The level of new subscriber additions the company is forecasting is weak but is also similar to other weak periods they’ve experienced even as they’d added over 110 million new subscribers over the last four years, doubling their global subscriber base.

Competition could be one factor. Netflix isn’t a monopoly after all. But if competition was such a factor, why did the company just report one of their strongest quarters of new subscriber additions of the last four years? Why is churn (the rate at which subscribers cancel their membership) down? Why is engagement (the number of hours a subscriber watches Netflix) up? These are not the results that would occur if competition were an intensifying issue. And the idea that somehow competition intensified on a global basis in just the last few weeks reveals a fundamental lack of understanding of global corporate competitive analysis.

The claim that Netflix is suddenly facing intense new global competition to the degree that it is fundamentally eroding their long-term growth opportunity is not supported by the evidence.

Catastrophic Guidance?

The investment analyst who told MarketWatch that Netflix’s guidance was “borderline catastrophic” gave voice to the concerns of investors who sent the stock spirally down 22% on Friday, to price levels it traded at back in mid-2018. This sort of decline, which brought the stock to down 34% for the year, and down 43% since its all-time high just two months ago in mid-November, is not something the stock has experienced in the past when the company has guided to or reported low single digit million new subscriber numbers, as illustrated in the red box in the chart near the top of this post.

The fourth quarter results were strong and the first quarter forecast, based on slow current trends, was weak. This is not a catastrophe. This is how business works. Sometimes conditions are strong and sometimes they are weak. Netflix’s long-term opportunity to bring their best in class content to viewers all around the globe has not suddenly come to an end due to a few weeks of slow growth.

Reactions like this are exactly what Mauboussin’s Man Overboard report warns against when he writes, “You might feel frustrated, upset… and worried. You might feel anger, disappointment, and shame.” But as Mauboussin warns, “none of those feelings are conducive to good decision making.”

The fact is, that Netflix’s long-term opportunity to add subscribers over the next decade is mostly about growth outside of the US. Over the last four years, 85% of all new subscribers have come from international markets. We expect that between now and the end of the decade, over 90% of new subscriber additions will come from international regions.

Netflix knows this and has planned for it for a long time. For seven years now, the company has been investing in film and TV produced outside of the US for non-US audiences. Today, these investments are paying off in spades, with the Korean produced show Squid Games becoming the most viewed television show in history. This wasn’t a one-off event. It follows on the heels of big global hits like Lupin from France, and La Casa de Papel (Money Heist) from Spain.

As Netflix wrote in their shareholder letter, “We’ve learned that big hits can come from anywhere in the world… But our goal with non-English originals is to first and foremost thrill audiences in their home country.” The scope of Netflix’s ambition here is enormous. Unlike Disney, which for decades focused on making English language, US produced content and then seeking to convince people around the globe to watch it, Netflix seeks to be a truly global media company that makes relevant content for people in every region of the world. It is this ambition, and their gangbuster success to date, that illustrates just how large the long-term total addressable market actually is.

You don’t have to take our word for it that this is the right strategy. After first imitating Netflix’s pricing strategy in rolling out Disney Plus at a below market price point, Disney announced just last week that they will now attempt to chase Netflix, seven years later, in focusing their efforts on developing local and regional content for non-US subscribers.

Has Netflix’s long-term opportunity changed in any fundamental, structural way? No. The claim that Netflix’s weak first quarter guidance signals a catastrophic development is not supported by the evidence.

So, what is going on with the weak guidance?

While we do not think that claims of market saturation, rapidly intensifying competition, or catastrophic developments are supported by objective analysis. We do believe that Netflix’s first quarter guidance is weak.

During the past four years, while they’ve brought in an average of 28 million new subscribers a year, they’ve brought in an average of about nine million subscribers in the first quarter of each year. Because Netflix’s results are often discussed in terms of new quarterly subscribers, rather than year over year growth rates in total subscribers, even small changes in growth trends can look magnified.

For instance, 2.5 million is just 28% of the nine million subscribers they have typically brought in during the first quarter, and that is indeed a very large downside deviation. But if they do bring in 2.5 million subscribers, then they will have grown their global subscriber base by 8% over the prior year (a period that included the “hangover” of low growth after the hyper growth fueled by the initial COVID wave in 2020). If instead, they brought in nine million subscribers, their year over year growth rate would be 11%.

Imagine if another company, for which you had been expecting 11% unit growth, warned that instead growth was likely to be 8%. Would you deem this catastrophic? Would it cause you to completely reassess the long-term growth opportunity of the company? Most certainly not.

Yet we still want to understand what is causing the slowdown in growth. Netflix’s own commentary points to “several factors including the ongoing Covid overhang and macro-economic hardship in several parts of the world like LATAM.”

Remember, around 90% of Netflix growth comes from outside the US. The US economy is booming, to the extent that the primary worry is that growth is coming too fast and is triggering inflation. It seems nearly everyone who wants a job is finding one and wages are growing at the fastest rate in a very long time. Minimum wages are going up and the fastest wage growth is seen among people in the lowest quartile of income.

But this is not the economy seen in much of the rest of the world, particularly not in many emerging economies. In Latin America, which Netflix refers to as LATAM, there was no huge government support for households. Unemployment rates are still very high. COVID vaccines have not been broadly distributed. Energy price inflation is crimping the budgets of many households who were already at the low-end of having the discretionary income needed to consider subscribing to Netflix.

While nearly 6 million new Netflix subscribers signed up in Latin America in 2018 and 2019, only an average of 4.3 million signed up in 2020 and 2021. After a surge of new subscribers was witnesses in every region around the world at the beginning of COVID, Latin America’s new subscriber additions have been weak ever since.

The fourth quarter of 2021 saw 7.3 million new subscribers globally from all regions, excluding Latin America, vs 6.7 million new subscribers from these same regions in the fourth quarter of 2019. But the Latin America region saw just 1.0 million new subscribers this last quarter vs 2.0 million in the same quarter of 2019. If the Latin American region had seen the same growth vs pre COVID levels as the rest of the world, Netflix would have reported 9.5 million fourth quarter new subscribers, nearly tied with its all-time best, non-COVID result reported in the first quarter of 2019.

You don’t need to posit any sort of mysterious shift in competitive dynamics, or an overnight saturation of Netflix’s address market to understand what is happening. COVID wrecked the global economy and while the economy is healing, the recovery is highly uneven. Outside of the US, where our uniquely powerful fiscal and monetary tools were used to support and even supercharge household income and balance sheets, across much of the developing world, households are still suffering major economic distress.

Yet, in 2021 and in the fourth quarter, Netflix still grew in every region around the globe. They grew streaming revenue by 19% and earnings before interest and taxes by 35%. The global economy will not be weak forever. The US economy is unique in that the primary concern right now is that we are growing too fast. This is a concern that most of the world wishes they had. With most of the world not yet recovered even back to pre-COVID levels of output, jobs and wages, Netflix and other global businesses that sell products and services that are affordable for large swaths of households are experiencing the reality of doing business with households who are economically distressed.

But despite this economic distress, Netflix is still growing quickly. Disney is still trying to imitate them, now by getting into the game of producing local content for a global audience. Interest in video content is unchanged and today a shockingly high number of people around the globe have access to internet connected screens on which they want to watch quality content. Netflix viewing is up, and cancelation rates are down.

In addition to the medium term economic issues, there are four short term issues that are likely weighing on the guidance for the first quarter.

• Squid Games was released at the very end of the third quarter. As the most watched TV show in history, it is very likely to have caused a surge of new subscribers in October and November. This may have caused a pull forward in demand, with people who might otherwise have signed up in December or January (the period that Netflix uses to forecast first quarter guidance) doing so earlier in the fourth quarter.
• Despite already seeing slow trends, Netflix management had the confidence to go ahead and raise prices in UCAN shortly before announcing earnings. Price increases are a key part of our thesis and something the company has been able to do regularly without damaging medium term demand. But historically price increases have caused a temporary slowdown in new subscriber additions that lasts for a quarter or two.
• Big new hit shows are a key driver of new subscriber additions. Netflix said that the first quarter would see a relatively light release schedule, with new series of hit shows like Bridgerton, dropping near the end of the quarter. But we are confident that their full content slate for 2022, which will include mega hits such as Stranger Things, will continue to drive subscriber interest.
• The narrative for some time has been that COVID is a positive for Netflix. However, it is the need to shelter in place at home that drove huge demand for Netflix subscriptions. The Omicron wave, which rose during the period Netflix uses to forecast the first quarter, is being accompanied in the US and around the world not by shelter in place orders, but rather broad based acceptance that societies need to adapt to live with COVID. This means that there is the negative impact of short term economic weakness and uncertainty, but not the positive impact of people staying home and watching more TV.

2022 may be a bumpy year for global economies and the companies that operate in them. Netflix’s quarterly results, like those of most companies, are somewhat unpredictable even in good economic environments. But managing this uncertainty, and the emotionally taxing experience of extreme stock price volatility, is the price that investors must be willing to pay if they hope to capture superior long-term investment returns.

Our analysis of Netflix, like our analysis of every company in our portfolio, is always a work in progress. Our articulation of our point of view in this post is meant to share with our clients and the interested public how we are processing the new information and how we intend to act on it. But we will make every effort to keep digging, to keep seeking the best understanding we can develop of what the future of Netflix might hold. Should our views on the company change, we will act quickly and decisively to reposition the amount of capital we have invested in the company or even exit our investment all together.

But today is not that day.

—–

Man Overboard Appendix

Mauboussin’s excellent report offers a framework for understanding how stocks that experience large price drops have historically tended to perform going forward. His data is intended to be used as a set of base rates, offering investors a historical baseline for how stocks that experience large one-day price drops have historically performed after the event.

His analysis demonstrates that on average, most stocks that have a large, one day price drop, outperform the market over the next quarter. The drop itself is not indicative of future near-term underperformance.

This is particularly true if the stock in question was not a hot, high performing stock that had been benefiting from upwardly revised earnings revisions during the prior quarter.

In the case of Netflix, the stock certainly did not exhibit strong share price momentum over the prior year. While it has greatly outperformed the market over the long-term, it underperformed the S&P 500 over the year prior to the large price drop and Wall Street analysts had been slightly reducing their revenue and earnings expectations over the last quarter.

As we described in a series of posts last year, when making forecasts and decisions, we seek to incorporate “base rates” or historical outcomes of a relevant reference class into our decision making process, even while we focus on the detailed specifics of the situation at hand.

In this case, while our investment decision making related to Netflix is primarily based on our specific analysis of the company and current situation, we also know that history shows that on average stocks that have experienced a situation like Netflix have typically outperformed in the subsequent period. If the base rate data had demonstrated the reverse, that large price declines of stocks like Netflix had tended to decisively signal further underperformance ahead, we would have used this knowledge to increase the bar we set for our specific analysis of Netflix to convince us otherwise.

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