The good, the bad and the ugly

When we think about technology and some new era, we absolutely see disruption. Flashes. Products. New reality. We really believe that a brave new world is coming and everything around it will be destroyed. And in the same place some more beatiful, colored and usefull will florish, making our lives easier and better. Until a new and improved techonolgy brings us life again.

It is something that repeats from time to time. It’s been part of the natural revolution of people, and maturity of Economy. Industries rise and fall, being substituted by another industry. Actually, the circle is clear: someone spread an idea, lots of people create an industry, and after some time the better start growing, swallowing the other and, finally, we have concentration and a kind of monopoly.

And the, innovation comes. And innovation means rupture, new ways to doing things, cheaper and faster and a new era, with new companies and the overthrow of the old fat giants. Like a TV show! But sometimes it’s not true. Sometimes the big fat giants are too giants and prepared to think and react so fast that the innovation is something beautiful, useful, but is swallowed and well digested by the majors.

Don’t be silly: sometimes, the Bad is not too Ugly, and the Good is not so Lovely and Strong.

Let’s talk about some new darlings of the entertainment, which have been changing the way people consume culture: Netflix and Spotify.

I don’t need to explain about the change imposed by Netflix and Spotify in the entertainment industry, with different impacts and different agreements. Netflix represents rupture, showing us another way to consume videos, fighting against majors and becoming a real competitors producing content. On the other side, Spotify came to organize a market that was in trouble. Piracy, selling albums declining quickly, artists and record companies looking for a way to bring money back. Spotify has grouped all of the stakeholders in the same nest, and organized it.

But if they are critical and audience success, financially speaking they are not selling out tickets.

Let’s talk about Netflix, and look at the chart below, where you can find some financial highlights.

We can see almost two different companies looking at these figures, based on business model. Until Dec/11 Netflix was mostly a company that rent videos, in a kind of trading business: from one side purchasing rights from studios, and on the other side renting it by a month fee. Simply like that. Good margins, no debt, no working capital pressure. But the market has started challenging the company, discussing about the the use of internet and awakening studios to develop their own streaming structure. So, the way to compete was developing content, and Netflix has started producing it. The result: increasing costs, reducing EBITDA, raising Debt. Simultaneously, because the business has changed. From 2012 onwards Netflix added a new business to its structure: content production, which has a different financial cycle, different risks, and a different way to be financed. But the way they use to make money remains the same: month subscription.

To add a pinch of pepper in this sauce, there is a perverse cycle inside the Netflix business model: to add more subscribers Netflix has to release more products; to produce them the company needs more money; but there’s a ceiling in terms of adding new subscribers. So, to raise revenues there are two ways, considering usual methods: i) raising subscriptions fees; ii) advertisement. How possible is that to put them in place?

So, the company started a new business model in terms of costs but hasn’t changed the way they make money! Of course this is a way to be in trouble. From a 48% ROE in 2011 to 7% in 2017, but from no debt to 5,25 Net Debt/EBITDA, in a risky business. Is it good enough to say that the market cap of this company is US$ 125 billions? Investors are looking at the future cash flow, but to achieve that the company has to cross a river of troubled water in terms of credit.

Part of it has been provided by capital increase, but an important portion comes from debt. The new debt is supposed to be paid by free cash flow our capital increase. But considering revenues structure, probably the repayment don’t come from the activity, which means that more capital will be necessary.

Let’s compare Netflix to others potential competitors. I am calling them “potential” because an important part of theirs businesses are content prodution and broadcasting, or even network supply (i.e. telecom carrier).

Thinking about competition, there’s a huge difference in terms of size of the business. While Netflix generate around US$ 0,5 bi in EBITDA, the smallest company from this peer group generates USD 1,6 bi, in other words, CBS is at least 3 times largest than Netflix, pottencially speaking.

While the leverage – measured by Net Debt/EBITDA – is substantially lower for Time Warner and Disney, CBS is higher, but in the last 3 years company purchased more than US$ 4 bi in self stocks, to leave in treasury. So, the leverage was supposed to be lesser than Netflix leverage.

What I’m trying to say is that, despite the fact that Netflix is gaining relevance in terms of development of content, the challenge to become a real and strong competitor financially speaking is really complex. A difficult market, with large competitors, difficulties to change revenues structure, high risks in develop content.

But, of course, we have capital markets. We have stock exchange. We have a world where real life is just part of everything. In this place, Netflix is a new frontier, it doesn’t matter if in the near future the winter is coming. Let’s see how Netflix stocks behaved recently.

The company’s market cap is around US$ 131 billions! From the end of Deecember’2017 until now the price increased 58%, jumping from US$ 191/shate to US$ 303/share.

Then, let's see the quartely performance. But, isolating it we cannot see a great evolution in the numbers to justify the jumping we’ve seen in the stock price.

So, again and again, expectation is more important that reality. But for the real world Netflix is far from a comfortable place.

Next week: Spotify and the magic of the music.