Netflix Stock Reaches New Heights as Spending Ramps Up

Netflix (NFLX 1.51%) just delivered another stellar quarter, and the stock is up double digits on its fourth quarter 2017 results.

In this episode of Industry Focus: Consumer Goods, Vincent Shen is joined by Fool.com contributor Danny Vena as they dive into the latest developments at the streaming company. Find out about the company's key metrics, promises of higher spending on content and advertising, and some of the risks and challenges for this stock market darling.

The team also sheds light on Amazon's (AMZN 0.03%) new store opening and what it might mean for the company going forward.

A full transcript follows the video.

This video was recorded on Jan. 23, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, January 23rd, and I'm your host, Vincent Shen.

Earnings season is in full swing, and in this episode, we'll be looking at the latest quarterly results from leading streaming video service, Netflix. To help me break down the big announcements and news from the company, I've enlisted the help of Fool.com contributor, Danny Vena, who's joining us via Skype from San Diego, California.

Hey, Danny! It's been a few months since you joined us here on the consumer and retail show, great to have you back!

Danny Vena: Thank you very much! I'm glad to be back!

Shen: I know you've been covering Netflix for a while now, so I'm excited to get your thoughts on their latest release. But before we do that, I wanted to pick your brain really quick on Amazon. The company has been making a ton of headlines this past week. First, they announced that the location of their future HQ2, their headquarters, has been narrowed down to 20 locations, three of which are close to Fool HQ here in Old Town, Alexandria. Those are Washington D.C., Montgomery county Maryland, and Northern Virginia. And when Asit Sharma and I first covered this news last year, we mentioned Denver and Raleigh, North Carolina as other likely candidates for the new headquarters, and those also did end up making the list as well, not to mention bigger cities like Chicago, Boston, New York, and Los Angeles.

The actual news I wanted to hear more about from you, Danny, has to do with Amazon's latest experiment in brick-and-mortar retail. Their Amazon Go store has finally opened to the public as of yesterday at the company's Seattle headquarters. Can you tell us a little bit about this "store of the future" concept and what they're trying to do here?

Vena: Absolutely, Vince. Last year, Amazon announced they were going to open something of an automated store. What they were looking at doing was, they were going to use a combination of artificial intelligence, a combination of sensors, and they were going to use these to blanket a store so that that store could be completely cashier-less. They had some troubles with it initially after they first rolled it out. They were planning on opening it to the public in the spring of last year. They ran into problems when they had more than 20 customers in the store. The system would malfunction or crash. Which is probably not what they were looking to do. So then, they put off the big grand opening. They finally announced over the weekend that they were opening the store in Seattle to the general public after testing it for the last year on employees. So that store is open as of yesterday.

Shen: About a one-year delay. I don't think the people who had an opportunity to actually shop at the store are too disappointed. It's pretty small. It's only about 1,800 square feet. It's stocked with things that you would expect: snacks, some prepared food, beer and wine -- typical inventory for a convenience store like this. Keep in mind, there's no cashiers, no registers, no shopping baskets, no shopping carts. What you have is a whole host of cameras and sensors positioned throughout the store to track shopping activity, in addition to the check-in kiosks at the front of the store. When you come in, you log in with your Amazon account. Then, as you place items into your own bag or backpack, however it is, you're going to carry your stuff out of the store, they will be tracking that with your Amazon account. There are still employees at the store, but their roles have changed. They're restocking shelves, they're helping customers, checking IDs for alcohol purchases, for example, and also preparing food for sale in the kitchen next door. 

The early reviews and response that I've seen to this Amazon Go shopping experience are pretty positive. Customers seem to be talking about how strange it feels to just walk out of the store without having to wait in line or take out their wallet. I think that could definitely be considered a step-change in convenience -- that if you have the right product selection, you have competitive pricing, I definitely think that a store like this can build a loyal customer base for the company. 

Last point for you, Danny, how does Amazon Go fit into the company's strategy going forward? Management has definitely never been shy about experimenting, testing new ideas. Is this about the sensors and cameras, the technology behind that? Or is this about establishing a larger physical retail presence? They have some of their bookstores, they're pushing out to almost 20 stores in 2018. Or do you think this is something else entirely?

Vena: Vince, Amazon has been delving further into the world of artificial intelligence. It's well known that they're among some of the initial first movers in the AI space. They were the first to release their Echo family of smart speakers. They've been using it to track inventory, forecasting those types of things, for some time now. I think essentially, where you're going to see -- this is a big experiment for them. They have not announced any plans at this point to expand beyond that initial test store. That said, with the bookstores that they've opened up, with the acquisition of Whole Foods last year, you add this into the mix, and I think eventually, what we're going to see is, they may roll that test out into some of their Whole Food stores, and I think that could be a game-changer for them.

Shen: Yeah. Though management has been pretty mum about the next steps for this -- they refuse to comment on expansion and things like that -- you do see a lot of opportunities, like you mentioned, with Whole Foods and some of the other business segments that they jumped into, other projects and experiments they've jumped into, to roll out this technology and just learn more and more about the consumer habits in store and how that can apply to the various parts of the business.

Moving onto our main topic now. Netflix unveiled its fourth quarter and full-year 2017 report after market close yesterday, that was January 22nd. Before we dive into the actual results, Danny, I think it would be helpful for listeners to get some context and insight into what you usually focus on when you're deciphering Netflix earnings. So before we go to the actual report and those results, what were you watching and hoping to see?

Vena: Every company is a little bit different, and Netflix has essentially created their own market. Their streaming didn't exist before a decade ago. They pioneered the concept. And they also pioneered the concept of the low-price subscriber model, month after month of video entertainment, initially with the DVDs.

Shen: Absolutely.

Vena: So because of that, and because they're such a high-growth company, watching some of the normal metrics really doesn't give you the information you need to have. Netflix wants you to watch their profit margins and their subscriber growth. Personally, I still keep an eye on the revenue, because that gives us a little insight not into the subscriber growth but also the ASP, the average subscription price, that customers are paying. That's another lever that Netflix can pull. Back in October, they rolled out a price change in their U.S. market and across some of their major European markets. So watching the average selling prices, watching the number of subscribers both internationally and domestically, and watching the revenues, that's the attack that I take.

Shen: Awesome. It's good to have that context. The way that I look at Netflix and some of -these reports, similar to what you mentioned, you have these high-growth stock market favorites, you have to keep in mind the broader context of where the business currently stands, and what expectations it will have to live up to based on its valuation.

In the case of Netflix, we have a company that's trading at over 9x its 2017 sales, and right around 200x its earnings from that same period. That's a pretty hefty premium for investors to have to stomach. As you can imagine, expectations for the company are always high. But that's not really stopping the rally the stock has enjoyed the past five-plus years. And after yesterday's report, actually, Netflix shares, right before we came into the studio, they're up another 10% today already. 

Without further ado, Danny, can you walk us through some of the bigger numbers and highlights? Some of the metrics, for example, that you mentioned that you're tracking and how the company actually fared for the fourth quarter and full-year 2017?

Vena: I think part of the reason that the stock is seeing such a big move today is because the subscriber growth not only beat analysts' expectations across the board, but it also beat Netflix's rather ambitious forecasts. Netflix was modeling for just over 6 million total subscribers, and they ended up, instead of with 6.3 million, they ended up with 8.3 million, so 2 million more than what they were looking for. And that growth was not only limited to the international subscribers, which was expected, they expected to see high growth there. But Netflix also added 2 million more subscribers in the domestic market. They were only expecting just over 1.25 million. And one of the things that does is silence the critics that say Netflix is becoming saturated in its domestic market -- 2 million more subscribers in a quarter is pretty substantial.

Shen: Yeah. I think the total count now for that domestic business is around 55 million, and the long-term projections from management, they've said that they see an opportunity around 60 to 90 million for the domestic market. So they're starting to approach that lower bound. But despite that penetration here in the U.S. market, still really impressive growth across the board in terms of that subscriber count. How about some of the other things that you were really focused on?

Vena: I was also looking at the revenue. A couple of things that stand out: Netflix met analysts' consensus estimates for revenue and earnings per share, so there were no big surprises there. They did beat a little bit on the top line of revenue. But one of the things that stood out to me was the fact that the ASP, the average subscriber price, was up 9% year over year as some of the price increases they put into effect in October started to take hold.

Shen: OK. So even with Netflix approaching about 120 million subscribers worldwide now, they're still recording very consistent double-digit growth, and there's very little doubt that the company is still firing on all cylinders in terms of its international expansion, their content pipeline -- which we'll be talking about shortly -- and also some of the prestige of the original content that it is producing. Next up, we'll take a closer look at some of these efforts across the company and dive a little bit deeper into the core metrics and numbers at Netflix.

Danny, diving deeper into the quarter in 2017, I want to hear more of your thoughts on some of the content in terms of their spending, and also the increased marketing that management spoke about during the call and press release. Both of those are investments that will be going up in 2018. What's going on there?

Vena: Vince, Netflix has never been bashful about spending money on quality content. That's the key differentiator for them. They are willing to spend the money. They said they're going to hire the talent, they're going to hire the people that can produce the best content, give them what they need to get it done, and just let them go without interfering. One of the things I saw was, Netflix management said they're going to spend an estimated $8 billion on content in 2018, which is higher than 2017. The other interesting thing they said was, they're not stopping there. That number is going higher in 2019 and 2020. 

Now, Netflix has said that this content strategy is working based on revenue growth, based on subscriber growth, based on all of the testing that they do in their markets, so they're going to continue to spend heavily. But one of the other things they announced yesterday -- and this is the first time I've heard about this -- is they're planning on increasing their marketing spend from about $1.25 billion to about $2 billion in marketing. That's about a 56% increase in the advertising that they're using to attract new subscribers.

Shen: Yeah. And on the earnings call, Ted Sarandos, who is Chief Content Officer at the company, he had a quote that I think really encapsulates how Netflix can spend so aggressively on content. He said, "A good story told well is a global product." And that was in reference to some of their newer stuff. They had the movie Bright, they also had Stranger Things season two, which was a big hit. The great content that Netflix churns out, the films and TV series that get a lot of rave reviews, they've got a ton of award nominations and wins recently, the company has already invested and developed a means of distribution to its over 100 million subscribers, so that quality content can reach an audience without borders there. 

And in terms of the international audience, I think that was another major area of progress. The international expansion is about two years old now. The company is still establishing its audience in some newer markets. What did the company have to say about its international segment?

Vena: Vince, they're pretty excited about the fact that the international subscriber base is growing as quickly as it is. I focused in on one key comment. When an analyst on the conference call asked them, how was the international growth going, could they call out any key markets, how are things doing in Asia, and management initially said, "We're not going to call out specific geographies." However, they said, "Initially, what we're seeing is that growth across the world looks like it did in Latin America a couple of years in." And that was pretty key for me, because, I covered this information probably late last year, looking at how some of their earlier international markets were going. And Latin America was one of those.

And looking at some statistics here: Netflix first entered the market of Brazil in 2011. Four years later, they had achieved a 44% penetration in that market. And surveys done last year by RBC Capital showed that 77% of Brazilians watch Netflix, up from 71% the year earlier. That's huge, 77%. And of those people that watch Netflix, 90% of the subscribers were either extremely satisfied or very satisfied with the service. Now, they've done some similar surveys in the UK and France and Germany, and they're seeing essentially the same thing across the board. The penetration levels are there. Particularly looking at where we are in the United States, the U.S. market has over 50% penetration, although they haven't said exactly how much. But if they can achieve those kinds of penetration levels in their international markets over time, this Netflix train is not going to stop.

Shen: Sure. What that tells me too is they have these various markets where they've tested, and they've seen really strong progress, and they can take that model they develop and apply it to areas where they don't have as high penetration. And it all ties into their content strategy. They're producing more and more originals across the world, all different languages, to cater to all these different audiences and markets. And at the same time, those can have the global appeal as well, you'll have hits that will work internationally and in the U.S. market, and that's all coming together for the company.

The last thing I want to talk about is some of the risks and challenges for this company. Before we do that, I want to round back and talk a little bit about the bottom line for the company. They had some updates on their contribution margin and the profitability there. Can you give us a quick overview on how that's looking, how that's piecing together for the company?

Vena: Sure. Contribution margin is a non-GAAP measure, it's something that Netflix came up with because they believe it will provide investors with a clearer picture of where the company is going, where the growth is. Their contribution margin is the combination of revenues less the cost of revenues and the marketing expenses. And they reveal what that number is every quarter going back for quite some time. In this most recent quarter, the contribution margin in its domestic market was 34%. Looking internationally, the contribution margin was only 8%. So essentially, over time, once Netflix gets done building out their library of content in a particular geography, that contribution margin is going to increase. Essentially, they're going to be able to make 4x or 5x the amount of money in each international region than they're making currently, which is really going to drive those profits.

Shen: Yeah. And there was a big swing for that international contribution margin. You mentioned it was at 8%, but that was a swing from negative levels around that same percentage, so a complete reversal for this latest quarter, too.

Vena: And that's something that Netflix telegraphed. About a year ago, they were saying that the contribution margin internationally was going to improve substantially, but they were still expecting it to be negative. But as they got into the year, and as they got so many more international subscribers than what they were forecasting, the international contribution margin actually went positive this year, sooner than what Netflix management had anticipated.

Shen: Alright. Rounding out, now, this discussion of the results, I do want to address some of the risks and challenges that the company might encounter. Management said free cash flow will be negative to the tune of $3 to $4 billion in 2018. Their debt actually just about doubled to $7 billion over the course of 2017. Does any of that ring any alarm bells for you? Or do you think, with the growth the company is seeing, it warrants that kind of spending or a little more risk taking?

Vena: I think we should say, first, that there are no guarantees. There's no such thing as a free ride. What Netflix is doing is counting on subscriber growth and revenue growing faster than when the bills for these originals are going to come due. And so far, they have done that outstandingly. That said, if at any point, Netflix fails to deliver the subscriber growth that they have been delivering, those high numbers, they could run into trouble.

For me personally, I have been following this company since 2007, it's my largest holding by far. In the interest of full disclosure, after today's move, it's back up to 20% of my portfolio. I don't recommend anybody else doing that, but I had a small initial investment in the company 10 years ago and it's grown to that. I don't see a problem. It doesn't ring any alarm bells for me, because they have executed so well, taking this domestic model and translating it to an international model and taking it around the world. I think Netflix is right on the ball with what they're doing. The other thing that's important to mention, and they mentioned this on the call yesterday, is that when they pay for an original, they're paying for it one to three years before that ever airs.

Shen: Yes, I remember management mentioned that a few times as well.

Vena: So they're paying for stuff now that we're not going to see for a couple of years. At any point, if they see subscriber growth slowing, they're going to be able to dial back that spend on original content going forward, and all they have to do is meet their current obligations. So I don't think that's an issue. It's something that bears watching, but they've been able to navigate that successfully so far, so I don't think it's going to be a problem.

Shen: OK. And last thing that I wanted to touch on before we close out here, on the competition front, I want to spend a few minutes just talking about the competitive landscape here. You think about the direct ones like Hulu, Amazon, HBO, there's a bunch of new services incoming in 2018 and beyond. Do you think that might be a headwind for Netflix?

Vena: I think what's happening, and you see this more and more, particularly with millennials, one of the things you're seeing is, they're not signing up for cable packages, they're not watching that much linear TV. Everybody is watching Netflix, you have a lot of people watching Amazon Prime, you have a lot of people watching, as you said, HBO Go, Showtime, CBS All Access, and they're combining services. There was a study not too long ago, and I don't have it in front of me, but I believe it was something like 36% of customers that have video streaming services subscribe to more than one. So I don't think it's going to be a zero-sum game. I think the encroaching competition bears watching, particularly when we're talking about their chief competitors, Amazon Prime and Hulu. But that said, I think the big loser in this trend is going to be linear TV and the cable companies via cord-cutting, people giving up their cable packages. So I think this is basically good for Netflix and the entire streaming industry.

Shen: Yeah. After being the pioneer, as you mentioned earlier, of all these services, jumping in, seeing the growth here, and I think that's really widening the base and the target market for Netflix, among its competitors. And I think that stat about people subscribing to multiple services is very important to keep in mind. It's not a zero-sum game. And with content being the lifeblood of this company, they're obviously investing heavily into that, and staying focused on the quality of that pipeline. The word of mouth, the marketing spending that they're doing, that will all help with their growth and staying one of the leading services, the leading service, in this industry. Otherwise, thank you so much, Danny, for sharing your thoughts on Netflix and Amazon. It was great to have you back!

Vena: I appreciate it, Vince. Have a good rest of your day!

Shen: Thanks, Fools, for tuning in. Austin Morgan is the producer for Industry Focus. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!