Netflix: During our fourth quarter portfolio update, we profiled portfolio holding, Analog Devices, Inc. (ADI). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.

We last discussed Netflix three years ago. At that time, five months into the COVID pandemic shutdowns in 2020, Netflix had added 26 million new subscribers to its service and went on to add 10 million more for a total of 36 million, ending the year with 204 million subscribers. Then in 2021, the company added 18 million subscribers culminating with 8 million new subscribers added in 4Q 2021, aided by the global success of the Korean produced show Squid Game.

The share price hit a record high of $687 in November 2021 before commencing a steep decline in December and January, presaging a significant reversal in its fortunes. Subscriber losses of 200,000 and 1 million in Q1 and Q2 of 2022, the first such net subscriber loss in Netflix’s history, caused shares to fall 75% from the November 2021 peak to its bottom six months later. As it turned out, through all of 2022, Netflix grew subscribers by 9 million or 4%, a big drop compared to the 20% average growth over the previous five years, but less than the worst fears.

Inflation had taken off in 2021 causing central banks around the world to pivot their view of it being a transitory phenomenon into a more ingrained process. Russia invaded Ukraine in February 2022 further pressuring energy and food prices globally. The ensuing aggressive increase in interest rates led to a recalibration in liquidity and market multiples, with those companies that missed expectation punished even harder. From peak to trough, Netflix went from a market capitalization of $300 billion to just $75 billion.

Netflix’s gross subscriber adds, i.e., the number of new subscribers signing up for the service, stalled in all geographies in a manner that even the management team seemed at a loss to explain. The market narrative shifted, and with it future financial expectations, from a company with a seemingly unstoppable business model accelerated by the COVID pandemic to one that had saturated its market and succumbed to burgeoning streaming competition from legacy media companies.

From our perspective having a major war break out in Europe’s borders and another major global economic shock so soon after the COVID shock seemed the most likely explanation for why people abruptly paused in signing up for a new Netflix subscription en masse. We had seen regional changes in new sign-ups historically when people’s attention had been drawn to certain events like the World Cup or the Olympics, only to see additions rebound in subsequent quarters, but we had not seen a globally synchronized pause before.

This was the second time in Netflix’s history as a public company that it had faced a crisis of confidence among investors, where management’s ability to adapt was tested. It had faced a similar test when it pivoted its business model from a very profitable DVD by mail service into a money losing streaming service back in 2011, resulting in a similar fall in its share price before regaining investor trust over the next 2 years and increasing its value over 10x thereafter.

This time it was the inexplicable stall in subscriber growth that led the company to pivot its business model from a pure subscription video service into one that incorporated both advertising as a new revenue source and monetizing the 100 million engaged viewers that were borrowing someone else’s password by implementing tighter password security. This complimentary approach of tightening user password sharing and offering a new lower priced, economically accretive ad-supported plan (or additional add-on subscriber fee) opened up a large pool of already engaged users to reenergize revenue and profit growth rather than solely depending on new to Netflix sign-ups.

This effectively multiplies the total available market (TAM) for Netflix over a subscription-only model, while also raising the ultimate pricing umbrella for the service over time. For context, US TV advertising revenue was about $67 billion in 2022 compared to Pay TV subscription revenue of $86 billion. This amounts to advertising increasing the total revenue from TV content by 80% over subscription rates alone.

Furthermore, Netflix continued investment in its nascent games business, which has the potential to expand the TAM even more. Globally, gaming is a $213 billion market. The net result of all of these service extensions multiplies Netflix’s monetization value for each subscriber dramatically, especially as the adjacent services revolve around the same end user and complement one another.

One other pivot by management was on capital allocation in relation to content. Netflix’s strategy on content spending had been to “overinvest” in content in order to grow the scale of its catalog ahead of subscribers along two vectors – category expansion and geographic expansion. This in turn drove new subscriber additions in existing and new geographic markets. With subscriber growth slowing drastically under indefinite macro-geopolitical circumstances, management rationally adapted and reprioritized the scale of that investment. The result is faster growth in free cashflow generation, now on track to surpass $6 billion this year.

With Netflix letting its foot off the content pedal for the first time in a decade, we fully expected competing streaming services to see blood in the water and get more aggressive. While we did not believe that competition was a factor in the subscriber growth slowdown as the common narrative believed, we did assume that scaling competitors like Disney (whose courage and humility in copying the Netflix growth strategy we were impressed by) or Warner Bros Discovery could get more aggressive and use the content growth strategy to win a greater share of new streaming subscribers, eventually eroding some of Netflix’s scale dependent competitive advantage.

To our surprise, both companies announced their own cutbacks in content spending and increased prices aggressively for their own streaming services, finally finding the breathing room Netflix’ reduced aggressiveness allowed to improve the profitability of their own money losing streaming services rather than trying to take share from Netflix.

This was great news to us as investors as it allowed Netflix to become less aggressive on its content growth strategy, drive higher positive free cash flow, while retaining its relative moat advantage as it adapted its business model. The company has been clear that as revenue reaccelerates to its goal of double-digit growth, it will become more aggressive again in content investment to drive further subscriber gains, to the extent it’s justified.

In retrospect, Disney and Warner Brother Discovery’s reactions made sense given their financial circumstances of high debt loads and weakening linear TV revenue, traditional media’s cash cow. US Cable TV subscribers, the main source of their linear TV subscription and advertising revenue, has seen its subscriber defections accelerating to a record pace of -7% as of 3Q 2023.

Despite Netflix’s nickname from only a couple of years ago being “Debtflix” as it took advantage of low-cost debt to “overinvest” in scaling its own content catalog, it never put[…]

During our fourth quarter 2023 portfolio update, Ensemble Capital’s Chief Investment Officer Sean Stannard-Stockton, and Senior Investment Analysts Arif Karim and Eileen Segall discuss current market and economic conditions as well as Netflix (NFLX). There’s a Q&A with the team at the end of the presentation.

Below is a replay of the full webinar as well as a link to Ensemble Capital’s QUARTERLY LETTER.

Each quarter, Ensemble Capital hosts a webinar to discuss the current market, economic conditions, and a few of our portfolio holdings. This quarter, we’ll be talking about the dramatic disinflation occurring in the US, how our portfolio holdings are adopting AI, and providing an update on Netflix (NFLX).

The event will use a webinar format. Participants will have a chance to ask live questions of the research team during the Q&A portion of the event.

This quarter’s webinar will be held on Tuesday, January 9 at 1:30 pm (PST)

We’d love for you to join us, which you can do by REGISTERING HERE.

If you’d like to listen to our previously-held quarterly updates, an archive can be FOUND HERE.

We hope to see you there!

Each year, Ensemble Capital hosts client day events in San Diego, LA, Seattle, and the San Francisco Bay Area. At these events, we share a presentation that explores some interesting facet of investing, financial markets, or the economy. In late September, we hosted these events for 2023.

While these are private events for our clients, we are happy to share the core presentation with the wider readership of our Intrinsic Investing blog. This year’s presentation focused on the emergence of “filter bubbles” that pollute investors’ ability to make accurate judgements, explored the surprising ways that the human mind processes information, and described our approach to overcoming these challenges.

This presentation was designed for a broad audience and so while it addresses complex economic and financial market concepts, it does so without jargon and uses a common sense framework that does not rely on the viewer having any prior detailed understanding of the topic.


During our third quarter portfolio update, we profiled portfolio holding, Analog Devices, Inc. (ADI). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.

Analog Devices: Analog Devices, known in the industry as ADI, makes semiconductor chips that predominantly operate at the boundary of the physical world and the digital world, more commonly referred to as analog and mixed signal chips. These chips usually play a supporting role to the sexier “digital brain” that is the latest and greatest processor from Nvidia, Intel, AMD, Apple, or Qualcomm. While the digital brains get a lot more media attention, the supporting analog chips are as vital as those big expensive digital processors in driving value in electronic devices, which are becoming ubiquitous and intelligent throughout our lives.

Anything with an on-off switch requires lots of these analog chips if it is going to relay input and output information with the physical world as well as manage the electrical power supply feeding the device. While these analog chips are relatively inexpensive to manufacture and distribute, it takes a long time to design and build a catalog of literally thousands of specific products to create the scale that makes them economically attractive businesses with a reputation of dependability and quality.

What’s unique about this class of chips is that companies making them do not need to make the huge investment bets that digital chips require in both R&D and manufacturing to stay ahead on the Moore’s Law performance treadmill. Analog chips usually use manufacturing equipment that’s several years or even decades old, which are much cheaper to buy than the latest and greatest that digital chips require.


In addition, consolidation has reduced the number of players in the semiconductor industry to a few big players globally and just a handful in the US, with analog chipmakers demonstrating a focus on strong returns on invested capital, high levels of free cashflow, and good competitive advantages built on scale, reputation, and a cornered talent resource of specialized analog engineers that we’ll explore further.

To understand why we believe ADI is both different and valuable, we have to delve a little bit into the technicalities of semiconductors. While we think of chips as “thinking” in ones and zeros, the real world does not operate on ones and zeros. The forces in the physical world have more of a continuous analog waveform that is not binary – examples of these are light color and brightness, sound frequency and volume, pressure, temperature, etc.

Mixed-signal chips will take those continuous signals and transform them into digital data that digital processors and memory chips can understand. Then the digital chips can operate on that data to compute new information or activate an output signal, which are translated back for consumption in the physical world by a mixed signal chip. Analog chips perform a similar role, but usually in the realm of power regulation and communication. Analog and mixed signal chips are often made by the same companies and sometimes referred to interchangeably.

As technology has broadly penetrated our world and everyday lives, semiconductors have also done the same as the underlying hardware substrate. Moore’s Law has allowed their capabilities to grow, and their cost and energy consumption to fall at an exponential rate, which has driven their adoption and use in a broad range of applications in all industries, bringing us to where we stand today, on the verge of ubiquitous connected intelligence.

As devices are able to do more and become more intelligent, their semiconductor content has increased, relying on more sensors, power management, and communications capabilities. These devices and systems are dispersed throughout our lives… from smartphones to computers, cars, planes, microwaves, ultrasound machines, HVAC systems, cellular radio towers, data centers, factories, etc. Given their role, it’s important to recognize that the more powerful and capable the main digital processor is, the more data it needs to bring new applications and value to market.

A lot of these applications also leverage connected devices – think your smart bulbs or fridge or cars – and all of these applications that can do more, generally require more analog chips to do the “sensing” that creates the data that feeds the application or main processor. In the case of the latest cars, those with adaptive cruise control, fancy smart LED lights, and electric vehicles – which are basically getting close to becoming computers on wheels – the number of chips required is multiples that of vehicles just a few years ago and is 10-100x as many as traditional products we think of as technology products like iPhones, PCs, and game consoles.

Therefore, we believe that the analog segment of the semiconductor market can see faster growth ahead, but without the risk and high levels of ongoing cash reinvestment necessary for the sexy digital brain part of the industry. In analog, the pace of technological change is slower and product cycles are much longer, spanning decades in many cases. This results in sustainably higher returns on R&D and manufacturing investments, along with more consistent secular forecastability. In addition, the markets they sell into are global and across all industries making them relatively less dependent on one or two end markets, like smartphones or the data center.

Companies like ADI and Texas Instruments (which the industry refers to as TI), two of the largest analog companies, have built broad portfolios of tens of thousands of products, each with over a hundred thousand customers who make millions of products that sell billions of units. The product needs and lifecycles across all industries can vary from a year to decades, which is why ADI derives half of its revenue from products that are over ten years old! Historically, the prices of these chips have ranged from less than a dollar to a few dollars while volumes in the billions of chips result in $10-20 billion dollars of revenue for each of these companies at operating profit margins of 30-50%.

Once these chips are designed into customer products, it is generally uneconomical to switch them out for a competing chip because the average selling price is so low relative to reengineering costs, especially when you consider software that is built on top of the designed in hardware. This makes ADI’s products sticky once they are designed in, resulting in a competitive moat that spans across the scale of products and distribution, switching costs, and service capability.

Another source of competitive advantage and value to customers is that unlike digital chip design, there is a lot of “art” or experience-based know-how that goes into analog and mixed signal chip engineering that deals with its own unique set of design challenges. This results in an engineering talent pool that is hard to replicate at new companies or even at customers’ product design teams. Consolidation in the industry has meant that these resources are even more concentrated at the largest companies, which enable them to drive further efficiencies in product development.

Taken together, in most end markets outside of consumer electronics,[…]