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Will Ashworth at InvestorPlace wrote an intriguing article highlighting 7 companies exhibiting pricing power as a core feature to their business models, including two that Ensemble Capital has owned for client portfolios, Netflix (NFLX) and Apple (AAPL). Pricing power lies at the core of most great businesses — a point often talked about by legendary investors Warren Buffett and Charlie Munger.

In his profile of Netflix, Ashworth quotes our Senior Investment Analyst Arif Karim’s recent Intrinsic Investing post discussing Netflix’s Pricing Power:

“What’s less talked about is the strong pricing power Netflix has shown over the past 5 years since announcing its first price increase in May 2014, growing pricing globally at a 5% clip (7% in the US) since,” Arif Karim, senior investment analyst at Ensemble Capital, stated in a must-read October article in Intrinsic Investing. “Despite this increase in prices, it has continued to show very strong momentum  in signing up new customers for its service around the world.”

Ashworth goes on to note: “Since 2011, Netflix has grown subscribers by 30% compounded annually. In Q3 2018, it increased paid memberships by 5.4% from Q2 2018 and 25% year over year. While the U.S. growth has slowed, international streaming grew by 39% year-over-year with plenty of the world still to cover.”

Netflix’s pricing power has indeed been a topic that has not been discussed much in the public sphere, but one which we believe is an important driver of both the company’s future business strategy (helping fund the build out its moat and global subscriber base) and its future value.

In addition, Ashworth also discusses Apple’s pricing power and offers an apt recent quote from Warren Buffett, who is listed as the second largest owner of company shares [via control of Berkshire Hathaway (BRK/A) as of 6/30/2018]:

“I have a plane that costs me a lot, a million dollars a year or something of the sort. If I used the iPhone — I use an iPad a lot — if I used the iPhone like all my friends do, I would rather give up the plane,” Buffett said on CNBC in August. “Now it’s got competition so you can’t push the price, but in terms of its utility to people and what they get for a thousand dollars…you can have a dinner party that would cost that, and here this is, and what it does for you, it’s incredible.”

Arif discussed Apple’s iPhone franchise, the great utility it offered its users, and its positioning as a luxury brand with pricing power in our discussion about the sustainability of Apple’s iPhone franchise in 2016, when many public discussions were being had about the death of innovation at Apple with a market valuation that reflected those doubts:

“This brings the focus on the well-designed device, its capabilities couched in a simple intuitive interface, its elegance, and the daily needs it fulfills as well as aspirations it can help the user attain. It’s a brilliant strategy that emphasizes the brand and emotion that creates the connection with its users while de-emphasizing the technology that can be threatened by the latest, greatest, cheapest competing gadget… while expensive at a face value of $650-$850, the iPhone and smartphones in general, are the most important and personal discretionary device the consumer owns. They serve as the gateway to your entire digital life that has grown to be a very important part of yourself. It is your most used device and will only increase in importance over time.

And, with a life span of two to three years, the cost of the average iPhone translates to less than $1 a day. This is an incredible value per hour of usage for the average smartphone user in any developed country as well as a significant number of users in emerging market countries. Given how much time owners of smartphones spend using their devices and how important a part of their lives they play, paying up for a premium, more secure, easier to use smartphone is one of the most practical luxuries they can pay for.”

For other great examples of companies with pricing power, we invite you to learn more by reading Will Ashworth’s article posted below.

7 Stocks to Buy for Real Pricing Power

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of  Apple (AAPL) and Netflix (NFLX). The company represents only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

Netflix’s Pricing Power

18 October 2018 | by Arif Karim, CFA

Netflix (NFLX) has demonstrated a torrid pace of growth since launching its stand-alone streaming video service in 2011, with paying subscribers growing at a 30% CAGR through the end of 2018. What’s less talked about is the strong pricing power Netflix has shown over the past 5 years since announcing its first price increase in May 2014, growing pricing globally at a 5% clip (7% in the US) since. Despite this increase in prices, it has continued to show very strong momentum  in signing up new customers for its service around the world.

Figure 1: Netflix’s Subscriber Growth

Source: Ensemble Capital Management and Netflix, Inc.

We’ve talked in the past about our thesis on Netflix and its powerful moat characteristics.  According to Warren Buffett, the definition of a good business is one that has pricing power. We believe Netflix has it in spades, and expect that they will announce regular price increases over time that will allow revenue to grow faster than subscribers. This is partly the result of its history of being a classic disruptor, offering a “good enough”, low price service to win customers.

However, over time, it has transformed into a great service by leveraging the capabilities of the new medium over which it serves its customers, the Internet for direct distribution and a variety of devices outside the television for consumption of media. In the process, it has increasingly won over large swaths of new customers by being the better experience and investing heavily to build the breadth and quality of its content that has earned it a place next to the longstanding leader in quality content, HBO.

Despite steadily increasing the quality of its service for customers, Netflix’s pricing has lagged the growth of that consumer value leading to the build up of a large consumer surplus. That surplus, or the excess consumer value over the price of the service, is an important factor that has driven such a rapid rate of growth for the service. The bigger the surplus, the better the deal for the consumer. But this also results in a sub-optimal return for the shareholder, at least in the short run, which can look like an inferior business model if you don’t look more carefully.

Figure 2: Consumer Surplus Creation

Source: Ensemble Capital Management

The power of the model is to realize that the consumer surplus represents latent pricing power that can be reallocated via price increases or reinvestment changes towards future profits for shareholders. In Netflix’s case, we believe this is an important lever in managing the rate of its growth and returns. By offering a compelling value proposition to incremental consumers, Netflix drives subscriber growth because it is a fantastic deal at $10/month. The consumer surplus is an investment in Netflix’s rapid growth, an implicit subscriber acquisition expense in the form of foregone revenue and profit, intentionally leveraged to quickly scale so that nearly all traditional media incumbents would be left too far behind when they awoke to the direct to consumer global scale streaming video opportunity. It’s clear at this point that this strategic goal has either been accomplished or nearly has.

Over time, we believe prices can be raised substantially to improve the economics of the business, potentially to the detriment of subscriber growth because it will be a less compelling offer. If the service has stickiness to it (we believe it does), then the vast majority of existing customers are unlikely to churn off as that surplus decreases. The result will be higher prices, higher profits, but slower growth. However, that assumes the value of the service remains constant. In Netflix’s case, by continually reinvesting a substantial portion of incremental revenue into improving the service experience and increasing its catalog of quality content, it is continually increasing the value of the service for all of its subscribers, which plays into a classic network effect moat. When coupled with a content scale moat, it becomes an increasingly tougher barrier for competitors to overcome.

Figure 3: The Netflix Flywheel

Source: Ensemble Capital Management

And that is really the secret sauce to Figure 1 that shows accelerating subscriber additions even as prices have risen over the past 5 years, while Figure 2 shows how consumer surplus can increase even with higher prices for the consumer, so long as value creation rises faster.

Netflix has continually increased the value of its service even as it has asked its customers to pay more, which has maintained its torrid growth rate at a massive global scale with 100MM+ subscribers and forecasted to grow by 28MM subscribers by the end of this year. That is an incremental $4B in revenue in 2018 alone enabling (via cash generation and capital market access) $7B in funding towards additional content, subscriber growth and scaling initiatives, and improved service investments. This also fits another of Buffett’s requirements for a great business, i.e. Netflix is a business that is focused on growing its moat every day. And management has proven itself highly competent in both understanding the levers they  need to command to do so, while also focusing on the right decisions for the business to maximize its value for the long term.

Figure 4: Netflix Cumulative Global Adds by Week

Source: Netflix, Inc.

As Netflix approaches mature levels of growth in specific markets (like the US), we believe it will make a rational shift in both pricing strategy and incremental reinvestment allocations towards a more balanced sharing of the value it delivers between its customers and shareholders, resulting in much greater profitability than is currently observed in reported numbers. To this point, the company has committed to growing its annual operating margin moderately going forward, a position that plays to our view on the strategic trade off between growth, profitability, and pricing while allowing the company to continue investing in maximizing the development and capture of the global long term growth opportunity in streaming video content.

As a simple illustrative exercise of how profitable the business could be if it were to price its service closer to the value it provides its current base of customers, we did a sensitivity analysis of the incremental profitability of average monthly pricing ranging from $15-25 per month:

Figure 5: Theoretical Netflix Price-EPS Normalization

It’s hard to argue that the service isn’t worth more than its current $10/month based on objective data like viewer engagement, content quality and breadth, price-user analysis, and anecdotal evidence. There is a growing proportion of people that are “cutting the cord” in favor of online entertainment choices, the leader among them being Netflix or, as is more often the case in international markets, discovering and signing up to view talked about differentiated original content on Netflix.

Therefore, an assumption that the service’s value to consumers as it currently stands could be worth $15-20/month and growing to $25+ over the next decade does not seem wildly optimistic to us. And if you were to believe that, then paying an average of 20x normalized current earnings for the disruptive runaway leader in the global scale media business, growing over 20%/yr with a long growth runway, scaling moat, and increasing profitability looks reasonable in our view.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of  Netflix (NFLX). The company represents only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

Netflix (NFLX) has been one POWERHOUSE of a stock with incredible performance, up approximately 3700% since 2012 vs the S&P 500 up 113% and five leading Media companies up nearly 200% on average (Jan 2012-Jun 2018).

Source: Bloomberg

Examining a few charts showing the fundamental momentum of the service makes it easy to see the reason for investors’ enthusiasm for Netflix stock relative to the incumbents:

Netflix has grown Subscribers and Revenue significantly and sustainably over the past decade, with an acceleration over the past 5 years…

Source: Kleiner Perkins Internet Trends 2017 Report

It’s done this by offering an over-the-top (of the Internet or OTT) streaming video subscription service, using the CLASSIC DISRUPTOR PLAYBOOK TO AN OVER-SERVED MARKET, that is significantly cheaper and more customer friendly than existing incumbent services in the US…

Source: Kleiner Perkins Internet Trends 2017 Report

Drawing significant consumer attention away from the traditional Media networks and demonstrating strengthening customer engagement (audience viewership in total and per subscriber)…

 

Source: Matthew Ball and REDEF

Source: Matthew Ball and REDEF

Boiling down these data leads to the conclusion that Netflix users spend about 10% of what their Pay TV spend would be on a Netflix subscription but spend 40-50% of their TV viewing time there, for a 75-80% cost advantage per hour of viewing.

Making matters worse, the trend among younger generations points to an accelerated decline in relevance of the traditional television media industry in the US…

Source: Matthew Ball and REDEF

Source: Matthew Ball and REDEF

 

(TV) VIDEO KILLED THE RADIO … Will OTT Kill Pay-TV?

Traditional Pay TV service is literally dying off unless it can change this trend. Not many could have predicted such change and performance prospectively 5 years ago, but we think it is generally indicative of the underlying value that Netflix has accrued in creating the first global scale media company by leveraging the inherent advantages stemming from internet distribution, global scale, and direct customer to content relationships.

Over the phenomenal period of returns and fundamental business performance, controversy has surrounded the company due to what had initially seemed like a limited and low-quality catalog, undifferentiable business model (reselling licensed content over the Internet), unsustainable/unscalable niche (media companies would stop licensing and kill it when it got too big), and its cumulative cash burn that continues at increasing levels even still. We were among them until we delved into the fundamental industry dynamics playing out a couple of years ago that led us to change our minds. We’ll address these issues in our discussion.

NETFLIX TAKES MEDIA AROUND THE WORLD… THE RISE OF GLOBAL SCALE MEDIA (more…)

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

The Many Ways to Mortgage a Moat

11 February 2019 | by Todd Wenning, CFA

When investors worry about a company’s eroding moat, they’re usually focused on external threats. A new competitor with a revolutionary technology or offering.

But the external threats often come after a company has mortgaged its moat.

Over the edge

Companies mortgage their moat when they press their advantage too hard and alienate stakeholders in the process. This practice can be particularly tempting for executives aiming to maximize short-term performance at the expense of long-term durability.

To illustrate, a recent Wall Street Journal article talked about how many of the big consumer packaged good brands are aggressively raising prices despite falling volumes. We think this is a dangerous strategy in product categories where there are reasonable substitutes, as it could make loyal customers shop around and try other branded and private-label offerings.

Companies with strong family ownership often take a different approach. According to Credit Suisse, public companies with meaningful family ownership, as a group, tend to outperform the market. They also tend to have more conservative balance sheets and post better fundamentals than their peers. One reason for this could be that family-owned companies care more about the firm’s legacy over generations than meeting quarterly targets.

To illustrate, we heard notes of this in Ferrari’s capital markets day in September, which we attended in person. Here’s CEO Louis Camilleri:

“Beyond the numbers, you can rest assure that the entire management team and all the men and women of the Ferrari family will work continually and incessantly with the relentless dedication and, yes, with passion to excel and delight our customers, shareholders, and racing fans.”

Cutting into muscle

Well-meaning executives can also mortgage their moat by “over-optimizing” their operations, depriving the company of oxygen needed to deliver on its long-term strategy.

Analysts herald companies that announce cost-cutting initiatives, yet we see little discussion of the non-obvious yet important impacts of those costs. A company slashing SG&A costs, for example, may be harming employee morale by reducing benefits. A company cutting back on R&D may impair its ability to compete during the next product cycle.

Conversely, companies that ramp investments and expenses to the detriment on quarterly margins often get criticized by investors. (And to be fair, sometimes for good reason.) When we believe a company has high returns on incremental invested capital, however, we want them to invest more and widen the moat.

Bottom line

Here are some ways that companies can mortgage their moat in relation to basic moat categories.

If the moat source is… …beware of
Network effect Poor user curation, alienating one side of the network
Switching costs Taking customers for granted with a lack of innovation and service, Raising prices too aggressively
Intangible assets Cutting back on investments to support brands (marketing) and new products (R&D), Raising prices too aggressively on search-cost brands.
Cost advantages Dismissive of new methods and technology, Sticking with what always worked so as to not frustrate legacy employees and systems
Efficient scale Pursuing a volume-over-price strategy

By focusing on the sources of the company’s economic moat, we hope to more quickly recognize situations in which management may be mortgaging their moat. If we do this correctly, we stand a better chance of getting out of the castle before the siege.

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Ferrari (RACE). This company represent only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

Weekend Reading

9 February 2019 | by Mike Navone

A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

Fox executive calls rival netflix’s viewership figures misleading (Joe Flint, @JBFlint, The Wall Street Journal)

Netflix has experienced explosive growth over the past decade and there are now more Netflix subscribers in the US than traditional cable subscribers.  With that kind of growth, there’s bound to be some skeptics and 20th Century Fox executive John Landgraf is one of them.  Landgraf purports that Netflix has been releasing misleading viewership numbers to inflate the popularity of their programming.  Netflix has proven to be able to sustain growth with consistent 20%+ price increases in their monthly plans without significantly impacting their subscriber numbers.

Showcasing the power of startup women’s health brands, P&G buys Thhis is L (Jonathan Shieber, @jshieber, TechCrunch)

Few legacy consumer brands can have dominant share in their marketplace, especially for things like retail products for women’s healthcare.  As competition increases, legacy brands are deciding the solution is to acquire younger, smaller and more innovative companies.  That’s what happened with P&G and their $100M acquisition of This is L, a startup retailer of period products and prophylactics.  Jonathan Shieber talks about the financial outcome and the deal’s implications for mission-driven companies.

UK new car sales fall as electric and hybrid cars surge in popularity (Alyana Vera, City A.M.)

Sales for diesel engine cars dropped in the UK last year while the demand for electric and hybrid plug in cars surged.  Electric cars continue to gain popularity despite the UK government slashing subsidies for the electric cars.  The outcome of this increased demand could be a win for both the environment as well as the manufacturers.  Ensemble President and Chief Investment Officer, Sean Stannard-Stockton gave a presentation about auto sensor producing giant Sensata in his Sensata Technologies Presentation which includes a discussion of the company’s sensors for electric vehicles.

JPMorgan says 2020 ‘might not be year to think about recession’ (Joanna Ossinger, @ossingerj, Bloomberg News)

The fourth quarter of 2018 had many investors worried that the US economy was on the brink of a recession but following the recovery in the market so far this year, some might say those thoughts are long gone.  JP Morgan analysts noted the recent change in tone from the Federal Reserve and stated “That means investors shouldn’t be driven by fears of recession now.”  In this article, Ossiger discusses cyclical indicators and global economic growth and how these are related to recession risk.  Ensemble President and Chief Investment Officer, Sean Stannard-Stockton wrote about his thoughts on a recession in a recent article We Might Not Have A Recession…For A Long Time

 

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.