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Netflix and United Continental Earnings -- What Lies Ahead for Investors?

By Chris Hill – Apr 24, 2017 at 3:54PM

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The two companies reported solid quarters, but investors are focused on the future, which could include some turbulence for both businesses.

On this episode of Market Foolery, Chris Hill is joined by Motley Fool analysts Jim Mueller and David Kretzmann as they discuss two widely-held stocks that delivered earnings last week: Netflix (NFLX 1.07%), and United Continental (UAL 0.04%).

The streaming video giant had a fair first quarter, but new subscriber numbers lagged expectations, and they'll be issuing more debt to pay for all that new and original content. Meanwhile, the airline beat expectations, but with the controversy surrounding its treatment of a passenger, the markets wait to see whether public outrage translates into lower ticket revenue or profits.

And finally, the team dips into the mailbag to answer a listener question regarding the value of owning a sports team or stadium naming rights.

A full transcript follows the video.

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This video was recorded on April 18, 2017.

Chris Hill: It's Tuesday, April 18. Welcome to Market Foolery. I'm Chris Hill. Joining me in studio today, from Supernova, David Kretzmann, and from Stock Advisor and Motley Fool Options, Jim Mueller. Happy tax day, gentlemen. Everybody got their taxes paid up? Based on your reaction, David, I'm thinking ... [laughs] 

David Kretzmann: No, I think I did, but there's something about tax day ...

Jim Mueller: I filed mine a month and a half ago.

Hill: Jim is the responsible adult in the room.

Kretzmann: We need to be more like Jim.

Mueller: I do it early when I get a refund. I wait until the last minute when I have to pay taxes.

Hill: Smart, very smart. We're going to dip into the Fool mailbag, but Earnings-palooza is under way, so we're going to start with Netflix. First-quarter profits came in higher than expected, but subscriber growth, a little bit lower than projected, and there's a bunch of things we can get into here. But Jim, I'll start with you, then David. What's your headline for this quarter?

Mueller: The headline for this quarter, I think, is they're going to be raising more debt. When they reported in the end of last year, earlier this year, they projected they're going to spend $2 billion in free cash flow. Negative-$2 billion free cash flow. That's because they're still buying a lot of content to run that virtuous cycle. More members, more money, more good content, more members, and so on. As long as that works, they'll be fine. They're profitable. Their operating profit came in really nice at 9.7%, higher than the 7% target they have for the year. This is the first year where management is actually targeting and actually saying, "OK, we're going to start becoming profitable. We've been running for so long, we're going to become profitable." But, they were saying 7% target for the year, so they're going to ramp up spending a little bit in the second quarter to bring that back down, from 9.7% back to the 7% target. But it's free cash flow. Companies are in business to generate cash. If you're not generating cash, you're going to have to raise cash somehow, which means they're going to be raising more debt. A line from the release letter, that's what they call it, dear shareholders, they --

Hill: That's so quaint.

Mueller: Yeah. [laughs] They think their leverage ratio is just fine.

Hill: I'm sorry, leverage ratio?

Mueller: No, they actually call it debt to total cap. And it took me a while. I thought for a moment they meant debt-to-capital, which is a common ratio. Debt to total capital invested in the business, that's debt and shareholder equity. No, what they're talking about is debt to market cap. That set me back. They're well under 10% compared to peers that are at 30%, 70%, in that range. And that's true. Time Warner, 31% debt to market cap. But Netflix has a debt to capital ratio of over 50%. It's about 53%.

Kretzmann: You're talking about the first definition you mentioned?

Mueller: Yeah, debt to invested capital. They're about 53% while Time Warner sits at 48%. So they can say, "We can leverage up because Time Warner is leveraged up." But it makes me a little nervous, really.

Hill: David, what's your headline?

Kretzmann: Similar to Jim's, Netflix is reiterating that they will be in investment mode for years to come. Like Jim mentioned, in the letter, they said, "Yeah, free cash flow is negative, and it will be negative for years to come."

Hill: Many years.

Kretzmann: Yeah, many years. I don't know if that was something Wall Street was necessarily expecting. I think people would hope that the free cash flow would eventually become positive, sooner rather than later. But Netflix right now, this year, they're spending $6 billion producing original content. And that number will continue to tick up for the foreseeable future. And the numbers that Jim mentioned, the numbers that Netflix highlighted in the letter, right now, they have about 10% of their market cap is in debt, compared to Lions Gate or Starz --

Mueller: Actually, it's closer to 5%.

Kretzmann: OK. So, it's under 10%. Compared to Discovery Communications or Time Warner, yeah, Netflix has a lower amount of debt compared to those companies. But those other companies are also producing positive free cash flow. I feel like management is stretching their definitions a little bit to say, "No, it's totally OK, don't worry, we'll continue to bring on billions of dollars of debt, don't worry about it." It's like, you guys aren't producing positive free cash flow. Your burn rate is actually increasing. So really, it comes down to the original content they're producing, is it good enough, quality enough to bring in new subscribers, continue to keep that subscriber growth going, and retain existing subscribers? That is what it comes down to. I think most people would say, yeah, their original content tends to be pretty good, it's an effective investment. But there are a lot of risks with the cash flow situation there.

Hill: They went out of their way to highlight the fact that -- they have a deal with Adam Sandler -- is it over 500 million?

Mueller: Right.

Hill: "500 million hours of Adam Sandler movies have been watched by our customers."

Mueller: Since The Ridiculous 6, I think is the name of the film, which was first of their deal, and they just extended the deal with Sandler, too.

Kretzmann: I haven't met anyone who thought that was actually a good movie, but apparently a lot of people have watched it. And I did watch it.

Hill: My reaction was the same as you two in this moment, was, I just started laughing, I said, are you kidding me? Five hundred million hours worth of Adam Sandler movies have been watched? But the more I thought about it, the more I think it was smart of them to call that out, because one of the signals that sends to Wall Street, if you think about it, is, "We know what our customers are watching. We know what they're watching. We know what they want to watch. And all you people who made fun of us when we struck the deal with Adam Sandler in the first place, 500 million hours watched. How do you like me now?"

Kretzmann: In the letter, they also highlighted a couple of movies or shows that flopped. One of them that they mentioned was the sequel to Crouching Tiger, Hidden Dragon, where they said, this is one that didn't work out so well. So they are admitting that not everything they're producing is a hit. Going forward, when they're investing this amount of money, when they're burning this amount of cash and raising that amount of debt, it really does sting for them to have content that doesn't resonate well with audiences. I think that'll be something to watch.

Mueller: I like to hear that, too. If everything is a massive success, then they might loosen their controls on what they decide to invest in. So I like to hear that something doesn't work out as golden as most of the stuff.

Kretzmann: They're paying attention to it. They're not just throwing money blindly. So it is good to see them focusing on that.

Hill: There was a point in time with Netflix where international growth was being watched closely, and the number of countries that they were in was a point of focus. Now, it seems like since we've run out of countries for them to actually go into, now the opportunity and the challenge for Netflix is getting more subscribers in those countries. Jim, can you look at this stock and say, OK, even with everything we've already said about the free cash flow, even with the fact that this is kind of still a pricey stock, is there still an enormous opportunity overseas? Because it kind of seems like there is.

Mueller: Honestly, I think there is. Full disclosure, Netflix is my single largest position in my portfolio, and I've held shares since early 2007. So I have a nice basis on these shares. That might be coloring my viewpoint a little bit, because so much of my investments are tied up in this company. But having said that, I think the addressable market, which is what your question is about, Chris, is still quite large. So they're recently penetrated in the U.S. about 50% or so into all of the households in the U.S. David Wells, CFO, mentioned that in the call, that some of their earlier international markets, they didn't name them, but probably Canada or Latin America, maybe, but I was thinking probably Canada, are reaching that level as well. That does demonstrate that it can be popular enough, and they can figure out that combination of [phone rings] -- I don't know why my phone rings, I don't know why it's audible. Apologies. They do figure out, in Europe and Australia, in Latin America, in Canada, they have figured out the mix of content, locally grown, international, from Hollywood and the U.S. or whatever that brings in subscribers and keeps them coming. And they're still working on that in Africa and Asia and the countries they launched in last year. But that launch last year was in 120, 130 countries, was mostly mobile launch. There are a bunch of mobile broadband accounts in the world, something like 3 billion of these things. If they can get the penetration in that, there's still a very big opportunity for the company.

Kretzmann: I think HBO now has 128 million subscribers, and management says they expect Netflix to cross 100 million streaming subscribers this weekend. So there's still room for them to catch HBO, potentially, in the next couple years. And, from there, as Jim mentioned, it's just a matter of grabbing more subscribers there. And management really is focusing on creating that local content, whether it's Mexico, Brazil, France, you name it, and trying to find the right proportion of local content, as well as the global content that's available in every country. I think another deal that will continue to really help Netflix is their deal with Disney. This year, Rogue One will be streaming on Netflix, and future Star Wars films will be streaming on Netflix, a lot of the Pixar and Disney animation movies are already on there. I think that will help to continue to attract some new subscribers.

Mueller: Certainly here in the U.S. That deal with Disney the movie releases is U.S. and Canada only. So they might renegotiate to get the worldwide rights to those things. But playing off your comment on productions in Mexico, their Spanish content is not just Latin America, but the entire Spanish-speaking world across the planet. Their international content, their internationally produced content, is playing pretty well all around the world.

Hill: Jim, you were talking about mobile. That reminded me that last week, went with the family up to New York City for a few days, took the train up, taking the train back on Friday, crowded train, one of those situations where you take any seat that's available, so I just let my kids fend for themselves. It's like, "You're on your own! Dad needs to get a seat!" So I'm sitting next to this guy, and I get settled, and I plug in my earbuds and start listening to a podcast, and I close my eyes, and I lean back, and the train is moving along, and the guy next to me -- my eyes are closed -- I feel him shaking a little bit. And I thought to myself, "He's probably moving around in his seat, getting comfortable." And then it happened again, and it happened a third time. So I open my eyes and sit up. I'm hoping the guy's OK, but I'm also thinking, "Do I need to say something to this guy? Like, what's your problem?" And I open my eyes and look over, he's moving around because he's shaking with laughter because he has his phone out, he's streaming Louis C.K.'s latest Netflix comedy special, and he is silently shaking with laughter at how funny it was. I was like, "You know, I can't begrudge the guy that."

Kretzmann: That's a good sign. One other thing I will quickly mention is Rick Vinera is our fellow Fool on Twitter -- he mentioned that Netflix now has less than 4 million DVD-by-mail subscribers. Remember, Netflix used to do that. 

Hill: Yes. We like to call that the Quikster part of the business.

Kretzmann: [laughs] Right. That's the first time it's been below 4 million subscribers since the third quarter of 2005. So, 12 years. It goes to show, it would be riskier for Netflix to not be making those investments, because if Netflix had not made that transition to streaming or original content, the company would be far less relevant today. So they are paying a price for those investments, but it's probably a smart way to go.

Hill: Let's move on to United Continental Airlines. First-quarter profits came in higher than expected, and I don't know about you guys, but I almost don't care about this quarter. I know that technically, this quarter for United included the incident with the doctor getting dragged off the plane. But I am already looking forward to three months from now, to see ... isn't that really the big question that's on the mind of certainly anyone who focuses on the business media, and anyone who is investing? I think this is one of the most interesting questions that's going to play out in the short term right now. How tangible is this outrage? There was plenty of outrage online over the doctor being dragged off the plane and coming back on the plane and being bloody and all that. Does that translate into a meaningful decline in United Continental's business?

Mueller: You're both looking at me. [laughs] 

Hill: I'm looking at both of you. And I don't know, I look at this and think, part of me -- and I don't own shares of this or any other airline, but we talked a little bit about this earlier, David, part of me is rooting for them to get a little bit of pain here.

Kretzmann: Yeah, they need to feel some sting, some pain after that.

Hill: Yeah. But it also would not surprise me, given the way the airline industry runs as a whole, it would not surprise me if, three months from now, we were talking about, "Yep, it was another good quarter for United Continental."

Mueller: I don't think it's going to matter one bit, to tell you the truth. I was doing some reading before coming in the studio. There was an episode of Freakonomics from last June called "Why Does Everyone Hate Flying?" The answer is probably because it has become like mass transit. The cost of a flight, all in, including everything -- inflation, baggage fees, buying a meal, everything -- is half of what it was 30 years ago. The safety record of airlines is tremendously good. The last two accidents with major U.S. airlines, the last one was the Asiana flight coming into San Francisco -- three people died, and one of them was killed on the ground after being hit by an emergency vehicle. So only two passengers died from the crash. Before that, it was 2001, some 12 years earlier, when there were 265 people killed on the American Airlines flight out of JFK. Now, for a while, people were thinking it was shot down, that one. In that 12-year span, 442,600 people were killed on U.S. roads. Mass transit is what airlines are. When you get that, you get low fares, which is very important for a lot of people, but you also get a lot of inconvenience and, occasionally, you get beaten up. [laughs] 

Kretzmann: [laughs] That's what we learned a couple weeks ago.

Hill: And along those lines, a big part of the story with United was the whole really shining a light on airlines overbooking. But once the statistic started to come to light, you find out that yes, technically, this still goes on. It goes on a lot less than it used to.

Mueller: That's true.

Hill: So I don't know. Again, I feel like nothing would shock me three months from now in terms of results, in part because one X-factor at play here is the United States Congress, which, it would not surprise me at all if they decided, "You know what's going to make us look good?" Because few things have as low of an approval rating in America as the United States Congress. "What's going to make us look good is hauling Oscar Munoz, the CEO of United Continental, in front of us at a hearing and beating him up for a while."

Mueller: That's probably going to happen. But what I think would be better for the industry, and for passengers, too, is if competitors started coming out with ways to mitigate a lot of this bad press that everybody is getting. It's not just United. United is in the crosshairs right now, but they all do this, and the carriage of contracts, which is what the ticket is, allows them to do almost anything they want to. But if they're smart, they're going to say, to differentiate themselves, "We don't do this."

Kretzmann: We don't beat you up. [laughs] 

Mueller: I've heard the food is coming back to one of them, [Delta Air Lines], maybe, coming back to the economy class, and you don't have to buy. Your ticket is going to go up a little. But a lot of people grumble about having to buy the box of three-week-old bread or whatever.

Hill: I mentioned this to each of you individually this morning. We've seen businesses in other industries do very well with loyalty programs. We see it, certainly, with food and beverage. Why don't airlines go bigger into the loyalty programs? When I'm on a flight and they make the obligatory announcements about, "If you want our frequent-flyer card, we'll give you 10,000 miles." Why don't they just right out of the gate astonish everyone with "We're going to give you a 100,000 miles," just to get you into that program? To go back to Netflix for a second, one of the mistakes I think investors make about Netflix is in thinking that video streaming is a zero-sum game. It's not like buying a car. When you go out to buy a car, one automaker is going to win your business, and all the others are going to lose. When it comes to video streaming, yeah, you're going to have an Amazon Prime account, you're going to have a Hulu account, you're going to have a Netflix account. In terms of the airlines, I feel like if one of them gets smart and figures out a way to lock people into some sort of loyalty program that rewards customers, they're going to be a big winner.

Kretzmann: I think you're describing Southwest, at least more than any of the other major airlines in the U.S. And Southwest has been an incredible performer not just in airlines, but across the S&P 500. It's one of the best-performing, if not the best performing, over the last 30 years since it went public in the late '70s. Southwest has locked down that loyalty program. I have a Southwest card. I prefer to fly Southwest if they have a route between the cities I'm flying to. And I think that's an important point, because for me, I lose track of United, Delta, American. It's like, I know I booked with them, I'm probably going to get delayed, I'll probably get some warm orange juice on the flight, it's not going to be a pleasant experience, but it will get me where I need to be, probably just a little bit later than I would like.

And I actually had a friend who came up to me last week and said, "Did you see that video of what happened on the Delta flight?" I was like, "Do you mean the United flight?" I don't think there's a whole lot of brand differentiation at the end of the day with some of those airlines. But I think Southwest has done a good job with that loyalty program. One of the perks of that is, Southwest doesn't make their flights available on third-party platforms like Expedia or Priceline. People have to go to Southwest's site, and it reinforces the brand that way. When you have a positive experience, I think you get a loyal customer base.

Mueller: And I think therein lies the answer to your question, Chris, is commoditization. Those airline miles that can be transferred across airlines, you can get them from almost any credit card you want. They're so cheap, and they are no longer worth what they used to be worth.

Hill: From Brooke McCoy: "The playoffs have started in the NHL and NBA. Most major arenas are named after a public company, and in some cases, public companies actually have ownership stakes in the teams themselves. MSG owns the New York Knicks and the Rangers. Bell Canada and Rogers jointly owned the Toronto Maple Leafs, Raptors, Toronto FC, and so on. We hear all the time about how major-league sports franchises seem to do nothing but go up in value. Does a company having a stake in a team help make it a more attractive investment? And, as a shareholder, how much value does a company lending its name to a major arena really generate? Are people really opening checking accounts at TD because the Boston Bruins and Celtics play there? I'm a longtime listener, I love your work. Thanks for everything."

Thank you for listening, and thank you for a great question. Really, two questions there. Let's take the first one. A company having a stake in a sports team, does that make it a more attractive investment? I don't know, MSG is one of those things that's just not a particularly well-run company, and certainly the stock performance over the last five years has trailed the market, so David, I'm sort of tempted to say it depends.

Kretzmann: Yeah, it's never something I thought about, investing in a company and thinking it's more or less attractive because they have a stake in a sports team. It's never actually crossed my mind. Maybe I should pay more attention to it? But in general, I don't think it's a huge differentiator with a company. I don't think it's very common for a public company to own a stake in a sports team.

Mueller: Not very common at all. MSG has owned Rangers, one site said from 1926 on to the present. But I didn't even know that until I looked it up.

Hill: But what about the second question, which is a company slapping its name on an arena. The way it's phrased is, "How much value does a company lending its name," let's be clear -- they are not lending their name; they're paying for that right.

Kretzmann: Yeah, it's part of their marketing.

Hill: Yeah, it's part of their marketing. To answer the question, I don't think people are opening checking account with TD just because the Bruins and the Celtics play there. But maybe it works, because in addition to slapping their name on their arena, they presumably also get tickets, they get a luxury box or suite or something like that.

Mueller: The executives might. I think it's the Carla's Diner's Little League sponsorship writ large. [laughs] Very large in some of these arenas. But you get free mention of your company name. It's always the Verizon Center here in D.C. for basketball and hockey, or the SunTrust Park in Cobb County.

Hill: Yeah, in Cobb County where the Atlanta Braves play. Although, as a Washington Nationals die-hard fan, our producer, Dan Boyd, referred to them, the Cobb County Braves.

Mueller: [laughs] Right. So you get mentioned that way, you get on-site promotion, and it's a way to say, "Hey, we're in your community, we're paying attention to you guys." But other than that, and advertising and name recognition, I don't think it's much.

Kretzmann: Yeah, it's really just a form of brand advertising. With that kind of advertising, like with the Verizon Center in D.C., which will be renamed sometime next year, Verizon is stepping away from that deal, but there's really no way for Verizon to measure the return on investment there. How many people signed up as a result of seeing Verizon on the side of the building? Compared to something like marketing on Facebook or Google, where you can measure the clicks and the engagement. Slapping your name on an arena, that's really just a form of brand advertising. In my own case, it's hard for me to think of a time where that was really effective for me as a consumer. Growing up, the Sacramento Kings, my beloved Kings, they played in Arco Arena, but we still bought gas from Chevron. It didn't really mean anything. They renamed it to Power Balance Pavilion, Sleep Train Arena. Now it's the Golden 1 Center at their new arena.

Mueller: Boy, that's a lot of corporate names.

Kretzmann: It went through a lot of names, yeah, they burn through it. But it's just a form of brand advertising. I question whether it's really the best place for a company to allocate their marketing dollars. Hence, that's why you generally see these big name brands that have millions to throw at this.

Hill: That's the thing. I think you want to look at, separate from the money that is being paid -- because I think it's a legitimate question, If you're looking at an investment and saying, "OK, how are they spending their money?" If Company X is doing a good job with their business, you tend to overlook something like that. On the flip side, this email question reminds me of an article that our colleagues Tim Hanson and Brian Richards wrote in 2006, because in 2006, the NBA Finals featured the Dallas Mavericks against the Miami Heat. And at the time, the Dallas Mavericks played in the American Airlines Center, and the Miami Heat played in the American Airlines Arena.

Kretzmann: Hedging their bets, well done.

Hill: And as they pointed out in that article, American Airlines was staggeringly unprofitable, and spending somewhere in the neighborhood of $8 [million] to $10 million a year. That's a situation where if you are an American Airlines employee or shareholder, you're like, "Hey, folks, what are we doing here? Why are we spending this money when we could probably find a better use for $8 [million] to $10 million?"

Mueller: A company should really be able to measure its return on investment. David, your point about being able to measure clicks, or clickthroughs on direct-send emails, that's easy to measure, and get to your measure on investment. But how much really can you get, measure your radio spend or television spend, or your arena spend?

Kretzmann: Yeah, those are all their own bucket of brand advertising.

Mueller: I think it's just a way of keeping the name in consumer's minds. Coca-Cola has a huge advertising budget. Everyone in the world knows Coca-Cola because of that budget. How long would it take for that to disappear if they stopped advertising? Maybe that's what they're worried about.

Hill: I remember proposing, I think on this podcast a couple of years ago, I just think it would be interesting if Coca-Cola or Pepsi decided, "For one month, we're not spending a dime. We're just going to pocket the money. We're just going to put it aside."

Kretzmann: Would the world stop spinning?

Hill: The world would not stop spinning, and people would still be buying and consuming those two beverages.

Mueller: I'll switch to Shasta.

Hill: [laughs] All right. Jim Mueller, David Kretzmann, thanks for being here, guys!

Kretzmann: Thanks, Chris!

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening. We'll see you tomorrow!

Chris Hill owns shares of Amazon, Coca-Cola, and Walt Disney. David Kretzmann owns shares of Amazon, Discovery Communications, Facebook, Lions Gate Entertainment Class A, Lions Gate Entertainment Class B, Netflix, Priceline Group, Twitter, and Walt Disney. Jim Mueller, CFA owns shares of Amazon, Coca-Cola, Netflix, and Priceline Group. The Motley Fool owns shares of and recommends Amazon, Discovery Communications, Facebook, Lions Gate Entertainment Class A, Lions Gate Entertainment Class B, Netflix, PepsiCo, Priceline Group, Twitter, Verizon Communications, and Walt Disney. The Motley Fool recommends Chevron, Rogers Communications, and Time Warner. The Motley Fool has a disclosure policy.

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