FBE 529 - Netflix Valuation Report Group Members Jiachen Ji Zijun Sun Yue Teng Yilei Wu Olivia Yi Netflix, Inc. is a media-services provider and production company founded by Reed Hastings and Marc Randolph in 1997. Netflix's initial business model included DVD sales and rental business. With the expansion of internet, Netflix only retained the DVD rental business and started to focus on streaming service in 2010. As Netflix gained great popularity and market share, the media and entertainment industry also began to shift toward digitalization as a result of technology disruption. Many traditional media companies have been dealing with issues in generating sales and profits because tech giants like Amazon and Apple are taking over the world. To cope with such problems, in 2012, Netflix entered the content-production industry and has played a more active role in the production and distribution of movies and television series since then. Netflix is now one of the key leaders in this new entertainment industry centered around tech and content and it has no intention to cease growing even with increasing amount of competition arriving. At the start of its business, the CEO of Netflix, Ted Sarandos, did his utmost effort to transform its service model to subscription-based membership and base its core competence on high quality original content. Netflix provides choices for different working-class people that can make them afford the membership at different price points. Netflix owns ‘first mover advantage’ and industry leading technique and strategy. Prior to transforming streaming, Netflix relied on online DVD rental. The business has accumulated a large number of homogeneous fans, and the fans are more smoothly channeled into its streaming service compared to Amazon’s ‘shopping oriented fans’. Also, its technology advantage improves customers’ experience and release ‘long-tail’ potential. Based on its accurate recommending algorithm, Netflix get higher user viscosity and reveal the consumption potential of ‘long-tail’, low price products. Not only limited to the domestic market, Netflix also set its sights internationally. The company delivers its services worldwide and all of its movies and shows can be accessed in more than 190 countries on any internet-enabled screen. Year 2019 seems a huge challenge to Netflix, especially after the appearance of competitor platforms like Disney+ and Apple TV+. However, we believe several essential assets like original content, huge video database and promises of no advertisement to memberships, which built up by Netflix over the years, are still leading itself to remain competitive in the industry. Based on our analysis, membership is still the dominant portion of revenue. Although there is a remarkable concern that the increase in the number of memberships will slow down this year domestically, it is boosting the number of memberships overseas due to a lack of international competitors. Meanwhile, Domestic DVD revenue has shown a huge declining trend as a fact that people do not watch DVDs so often nowadays. In terms of expense, we found out that Netflix is willing to invest over 80% of its revenue in its content development each year. We believe that Netflix may turn their negative cash flow to a positive in the future and have enough money to pay back to their shareholders. In order to assess the fair market value of Netflix as of today, we first develop a future performance forecast and a future free cash flow projection based on background provided above and assumptions of the company’s key revenue and expense drivers. Based on the historical data from 2016 to 2018, the revenue from domestic streaming grows about 20% each year. However, the business opportunity in the online streaming service market has attracted an increasing number of competitors such as the Walt Disney Company and Apple. With competition becoming fiercer in the online streaming market, we estimate that the growth rate of domestic subscription would slow down by 1% every year from 2019 to 2026 and stay at 16% in 2027 and 2028. We found that the annual growth rate of cost in domestic streaming is approximately 17% from 2016 to 2018. Due to pressures from peers, Netflix will continue to expand the collection of their original series while keeping the same amount on their content acquisition expense. Marketing expense for domestic streaming has grown by 10% of sales from 2016 to 2018. Since Netflix has already built up its brand awareness, its future marketing would be spent mainly on its new contents. Therefore, marketing expense will remain at 10% from 2019 to 2028. The revenue from international streaming grows about 50% each year from 2016 to 2018. Compared to domestic streaming, Netflix faces less competition in the international streaming service market for now, which leads to bullish growth rates. We estimated the revenue growth for international streaming to be 50% in 2019 and decrease 10% every year thereafter and remain in 15% since 2024. The cost of international streaming as percentage of revenue had been 95% in 2016 and continue to decrease. Since the international streaming service line is relatively new, we estimate the cost of revenue to stay high since We believe that the cost of revenue would maintain at about 50% of revenue once the international market matures. Marketing expense for international streaming is 21% of revenue in 2016 and performs declining earnings growth. Since Netflix is still developing its international service line, the marketing expense would stay at the same level. The domestic DVD seems to be an unpromising line of business. On top of its revenue decreasing by 17% in 2017 and continue decrease till 2028. The cost of revenues for domestic DVD is 48% of DVD revenue in 2016. Since Netflix has been decreasing expenses on DVD production, we expect the cost will decrease in future years. Addition to streaming content assets has been approximately 80% of the revenue. Since Netflix will keep adding content in the future, we estimate it to be 80% of the revenue in 2019 and keep decreasing, eventually remain 10% since 2024. Change in streaming content liabilities remains about 12% of total content liabilities in 2017 and 2018. We expect to keep this rate for change in streaming content liabilities from 2019 to 2028. We found that the acquisition of DVD content asset has been decreasing at 40% for years from 2016 to 2018. When forecasting the acquisition of DVD content asset from 2019 to 2028, we keep the 40% decrease each year. ▪ Based on the data from 2016 to 2018, We estimate the investment in working capital to be 7.5% of revenue. ▪ We project amortization of streaming content assets by adding 10% of the same year’s additions to streaming content assets to previous year’s amortization of streaming content assets. ▪ We project amortization of DVD content assets by adding 10% of the same year’s acquisition of DVD content assets to previous year’s amortization of DVD content assets. ▪ We project depreciation and amortization of property, equipment and intangibles by adding 10% of the same year’s purchases of property and equipment to previous year’s depreciation and amortization of property, equipment and intangibles. ▪ Purchase of property and equipment is 1.3% of revenue from 2016 to 2018. We keep the percentage rate for 2019 to 2028. ▪ The total content liability increases by 13% from 2016 to 2018. We kept this growth rate from 2019 to 2028. ▪ Technology and development for Netflix has decreased by 8.8% in 2016, 8.2% in 2017, and 7.7% in 2018. We believe that the spending on technology and development would be stable in the future. So, we decide it will be continuously decreasing and maintain at 6%. ▪ General and administrative cost is about 5.5% of revenue from 2016 to 2018. We keep this rate for years from 2019 to 2028. ▪ Interest Expense is about 3% of the revenue. ▪ Based on the data from 2016 to 2018, we set 0.4% of revenue to be the rate for forecasting. ▪ Provision for income taxes is 26%. (For more details of DCF assumptions, see Appendix 1) Based on our DCF assumptions, we found that Netflix has an enterprise value of $85,885,608 and per share equity price of $175.86 by Gordon Growth method, and an enterprise value of $210,980,345 and per share equity price of $462.38 by Exit Multiple method. For the exit multiple method, when we determine our EV/EBITDA for Netflix, we noticed that it had great fluctuation from 40x to 145x through past years, which might be a fact of the company’s negative cash flow. Therefore, we checked the industry EV/EBITDA for reference. The tech industry’s EV/EBITDA is around 12x and the entertainment industry’s EV/EBITDA is approximately 13x. We believe Netflix would perform well in the industry, therefore, we set Netflix’s EV/EBITDA to be 12.5x. From the DCF Sensitivity analysis, we found that the per share value is $380.50 at exit multiple of 10x, and $544.26 at exit multiple of 15x. Based on our WACC and capital structure analysis, Netflix’s weighted average cost of capital is 13.43%. We computed this number by using the company’s debt, equity, and the weighted average formulas. When we determine the target beta of Netflix, we took the tech industry’s beta for reference. The tech industry’s beta is around 1.5. Since Netflix is one of the leading companies in the industry, we set the beta of Netflix to 1.6. Also, we calculate that D/V ratio to be 11.3% and E/V ratio to be 88.7%. Although Netflix had a lot of debt, they got a much higher value of equity. In the view of industry, Netflix can be viewed a giant in the media and entertainment (M&E) industry of the new era, but it is also considered a competitive technology company as a member of the well-known FAANG companies. Therefore, the list of comparable companies (See Appendix 9) we came up with for Netflix consists of both M&E firms (The Walt Disney Company, Sony, CBS, AMC Networks, and World Wrestling Entertainment) and leading tech companies (Amazon, Facebook, Google, and Apple). It is natural to use comparable companies from both sectors when analysing and valuing Netflix because the M&E industry is greatly affected by major technology breakthroughs. However, we left out companies like Roku and Spotify as their target focuses are much narrower than Netflix. In comparison with its M&E peers, Netflix has superior revenue growth that is well above the average, yet it lacks advantage in gross profit margin as its expenditure in content creation continues to rise in the past 4 years. Netflix also has higher debt ratios than its M&E peers and the trend seems to continue in 2019 because it needs loads of cash to fuel its ongoing expansion. The high debt ratios and large expenditure in content of Netflix seems normal when compared to tech companies including the rest of FAANG, yet metrics including revenue growth rates and profit ratios fall behind. Netflix has impressive performance as a renovative entertainment tycoon but it is also in need of alternative strategies to further grow as a technology company. From the perspective of the comparable companies analysis, we attained the range from $125.65 to $319.45 per share by using the EV/Revenue multiples of the comparable companies. The reason why we decided to calculate the range by the EV/Revenue multiples instead of by the EV/EBITDA multiples is that we realized that the EBITDA of Netflix is relatively lower than that of comparable companies due to its high COGS on its exclusive content creation. For selecting comparable companies, we regarded the business of Netflix as a combination of M&E and technical company. Among M&E companies, we put large weights on The Walt Disney Company and World Wrestling Entertainment, Inc. since their business are similar to that of Netflix, with an untraditional M&E business model. The technical comparable companies we selected are Google, Facebook, Amazon, and Apple because all of them have their own online streaming or video services. Although the main business of these high-technology companies is not video or streaming services, their high expected growth and high profit margin can be applied to Netflix, operating a subscription-based model. As a result, we consider that compared to other standalone valuation methods, our comparable companies approach is the most practicable valuation on Netflix. We reached a range of $76.19 to $107.13 per share value for Netflix using EV/Revenue multiples of precedent transactions (See Appendix 10). The precedent transaction approach provides a valuation at the lower end of the football field because we used transactions in the media and entertainment industry who has lower multiples compared to tech sector because M&E has been disrupted by technologies to a large extent. It also provides limited reference on the intrinsic equity value of Netflix since no transaction target has the exact same business model as Netflix. Deals like Disney buying 21st Century Fox, AT&T buying Time Warner and Comcast buying NBC Universal are used as reference because the targets are major competitors of Netflix in terms of target customers. Yet the insights provided are limited because these target companies do not share a similar business model with Netflix as Netflix generates revenue solely from subscriptions. One can argue that the transaction of AT&T buying Time Warner gives the most information because HBO, creator of the content subscription business model, was included in the deal. However, HBO only operates as a subsidiary of Warner media and its scale might be too small for it to be considered an ideal competitor of Netflix. It is also worthy to point out that we only used strategic acquisitions as they are more common in the M&E sector because the current trend is for major players to merge and share content and resources such as studios and licences. It is also meaningful to assess the equity value of Netflix in the context of a strategic transaction. Considering that the current market value of Netflix is relatively high, a potential strategic buyer is Facebook. As the only member of the FAANG companies who do not have a platform focusing on subscription-based streaming service, Facebook can unlock great potential revenue with Netflix’s content and resources. However, high control premium, up to 25%, will be added to the deal as there is no explicit reason for Netflix to sell a promising business. Therefore, Netflix could be valued at $250 to $375 per share with 438.3 million shares outstanding in a strategic transaction. On the other hand, Netflix does not make a strong financial deal candidate due to its negative cash flow and high capital expenditure. Hence, it is less worthy to value Netflix in the context of a financial transaction. We also considered the future operating strategies and strategic alternatives for Netflix. Financially, Netflix should gradually spend less capital on its CD renting business to decrease expenses. One recommendation is to keep launching high-quality original series in a steady pace and broadening its overseas markets. Under the pressure of increasing competition, Netflix should also seek to establish product differentiation. We think Netflix could unlock potential benefits by branching out to the business of short videos created by its own users. The key of short video service is recommending algorithm and user activity. As we know, Netflix already owned great recommending algorithm system which releases its ‘long-tail’ potential and faces no problem in user retention. Hence, we suggest Netflix to look into the area of short video business. Implementation will focus on merging short videos and its current services together into one bundle for subscribers. In conclusion, we think that opening up short video service can provide extra growing opportunities to Netflix with a relatively low cost. Based on our football field analysis, we can see that the valuation by precedent transactions is the lowest among the three valuation methods. As we stated above, we used transactions in the media and entertainment industry who has lower multiples compared to technology field, whose transactions are not comparable to Netflix. Therefore, we agree that the low range of valuation by transaction comparables is reasonable and we should leave it out in this case. In our DCF model, due to the optimistic expected growth of its streaming and DVD services we put in our free cash flow forecast, we come up with a wide range of valuation for Netflix shares and we have to admit that it is overvalued in our DCF forecast. Among the three valuations, our comparable company analysis is the most practicable and reliable valuation because we selected comparable companies not only from M&E industry but also from technology industry. In addition, the selected weights we put into the comparables make our analysis more reasonable. As a result, we reach a range of $200 to $300 for our final valuation. Appendix 1—DCF assumption Domestic Streaming The growth rate of revenue from domestic streaming in 2019 is 22%, 21% in 2020, 20% in 2021, 19% in 2022, 18% in 2023, 17% in 2024, 16% in 2025, and remain 15% from 2026 to 2028. The growth rate of cost of revenues in 2019 is 17%, 17.5% in 2020, 18% in 2021, 18.5% in 2022, 19% in 2023, and remain 19.5% from 2024 to 2028. Marketing for domestic streaming remains 10% of the same year’s domestic streaming revenue from 2019 to 2020 and remain 9% from 2021 to 2028. International Streaming The growth rate of revenue from international streaming in 2019 is 50%, 40% in 2020, 30% in 2021, 20% in 2022, and remain 15% from 2023 to 2028. Cost of revenue from international streaming is 65% of revenue in 2019, 62% in 2020, 60% in 2021, 58% in 2022, 56% in 2023, 54% in 2024, 52% in 2025, 50% in 2026, 48% in 2027, 46% in 2028. Marketing for international streaming remains 16% of the same year’s revenue from 2019 to 2020 and keep the rate of 15% of the revenue from 2021 to 2028. Domestic DVD The revenue of domestic DVD decreases by 20% in 2019, 23% in 2020, 27% in 2021, 32% in 2022, 38% in 2023, and remain 45% from 2024 to 2028. Cost of revenues is 39% of the same year’s domestic DVD revenue in 2019, 36% of revenue in 2020, and remain 35% from 2021 to 2028. Addition to streaming content assets Addition to streaming content assets is 80% of the total revenue in 2019, 60% in 2020, 40% in 2021, 20% in 2022, and remain 10% from 2023 to 2028. Change in streaming content liabilities Change in streaming content liabilities remains about 12% of total content liabilities in 2017 and 2018. We expect to keep this rate for change in streaming content liabilities from 2019 to 2028. Acquisition of DVD content asset When forecasting the acquisition of DVD content asset from 2019 to 2028, we keep the 40% decrease each year. Investment in Working Capital ▪ Based on the data from 2016 to 2018, We estimate the investment in working capital to be 7.5% of revenue. Depreciation and Amortization ▪ We project amortization of streaming content assets by adding 10% of the same year’s cost on additions to streaming content assets to previous year’s amortization of streaming content assets. ▪ We project amortization of DVD content assets by adding 10% of the same year’s cost on acquisition of DVD content assets to previous year’s amortization of DVD content assets. ▪ We project depreciation and amortization of property, equipment and intangibles by adding 10% of the same year’s cost on purchases of property and equipment to previous year’s depreciation and amortization of property, equipment and intangibles. Other Accounting Items ▪ Purchase of property and equipment is 1.3% of revenue from 2016 to 2018. We keep the percentage rate for 2019 to 2028. ▪ The total content liability increases by 13% from 2016 to 2018. We kept this growth rate from 2019 to 2028. ▪ Technology and development for Netflix has decreased by 8.8% in 2016, 8.2% in 2017, and 7.7% in 2018. We believe that the spending on technology and development would be stable in the future. So, we decide it will be continuously decreasing and maintain at 6%. ▪ General and administrative cost is about 5.5% of revenue from 2016 to 2018. We keep this rate for years from 2019 to 2028. ▪ Interest Expense is about 3% of the revenue. ▪ Based on the data from 2016 to 2018, we set 0.4% of revenue to be the rate for forecasting. ▪ Provision for income taxes is 26%. Appendix 2 - Market Benchmarking Analysis Appendix 3 - Netflix Projection Appendix 4 - DCF Benchmarking Analysis Appendix 5 - DCF Exit Multiple Appendix 6 - DCF Sensitivity Appendix 7 - DCF Assumptions & Appendix 8 -WACC template Appendix 9 - Comparable Companies Approach Appendix 10 - Precedent Transaction Approach
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