- Streaming is worse than pay TV for most media businesses, but will be better for the winners.
- Netflix is the most obvious winner in streaming, its plummet this year presents a straightforward opportunity for investors to buy a market leader.
- The advertising optionality is also underappreciated by investors.
Netflix (NASDAQ:NFLX) is my favorite stock for 2023 (and beyond) due to the combination of investor-misunderstanding of the streaming business and the company’s solid hand as the clear market leader in the space. Other streaming companies could end up with much higher returns, but I favor Netflix because it has the least execution risk compared to its peers.
Streaming is Misunderstood by Investors
To understand the streaming business, investors must first understand the Pay TV business.
The first question is what are consumers of pay TV seeking? The answer relevant to streaming is entertainment. Consumers watch TV for all sorts of other reasons, such as getting the news, learning about different cultures, or even to study. But since the focus here is on entertainment companies, I’ll focus on the entertainment part of consumer demand.
There are a dozen non-streaming Pay TV providers in the US. They provide their services to around 60 million subscribers. These providers carry hundreds of channels operated by dozens of companies for consumers to get the entertainment they demand.
So already we can see, given the large numbers of producers, returns in aggregate for pay tv in the long run shouldn’t be expected to be above the cost of capital. Indeed, that is true for the majority of these channels. But because content is a differentiated product, there are the big four who managed to build a strong business in a difficult market. But they don’t control enough of the market to be called an oligopoly (a market structure that would lead to long-run above normal returns on equity).
The demand for Pay TV providers has been declining for a number of years, prompting The Walt Disney Co. (DIS) CEO Bob Iger to say that traditional TV is “marching to a distinct precipice, and it’s going to be pushed off.”
A lot of the selling in media stock this year has been as a result of their reliance on cable revenues. That would be the right approach if the change in consumer-taste was away from TV entertainment, a shift towards outdoor activities for example. But the change in taste isn’t in the demand for TV entertainment, it’s in how to access said form of entertainment, which is a big difference.
The introduction of streaming gave consumers two advantages: 1) A cheaper product. 2) Complete control over what to watch. The first advantage is probably bad for streaming companies in the long run, although the streaming subscription fee is close to the affiliate fees. The second factor also meant that consumers value selection and discovery. Cable viewers could only watch what was on. But if they have a choice in what they watch like they do in streaming, they want to have a lot of options from which to select. This created a barrier to entry for the streaming business that cable didn’t have. The cost of building up a content library for streaming is a headwind in the near-term, but it will be what limits new competitors from entering the market, increasing returns in the long run.
The market share for the companies owning the big four networks in pay TV in 2021 was around 46% (calculated using the table here). Thanks to the high content costs required, the market share of the top four streaming companies in the long run will likely be much higher. There were 153 channels listed in the table from Nielsen (operated by more than a dozen companies), I don’t think there will be 153 streaming services.
Out of those 153 channels (or dozen cable companies), six are trying to make a switch to streaming with Netflix the seventh player. In addition to Disney, there is Warner Bros. Discovery Inc. (WBD), Comcast Corporation (CMCSA), Paramount Global (PARA), Lions Gate Entertainment cooperation (LGF.A), and AMC Networks Inc. (AMCX). Netflix CEO Reed Hastings summed up the future of competition in the space best in his recent DealBook appearance:
If you look at the consolidation, there’s been Fox and Disney, CBS and Viacom, Discovery and Warner Bros. there’s likely more of that.
The increased consolidation will mean that the share of the top four streaming companies is likely to be much higher than the 46% in pay TV. Former CEO of WarnerMedia Jason Kilar agrees:
There will be multiple business casualties in the paid streaming wars and a few business victors. Digital markets for industries that have high fixed costs and relatively low variable costs have tended toward a few, unusually large winners, and I believe such will be the case in entertainment. In this scenario, no more than three global entertainment companies are likely to attain the streaming-service scale required—300 million global subscriptions at an average of $15 per month—to generate attractive cash flows.
He went on to add that those three companies would have more than $10 billion in cash flows from streaming subscription, much higher than what entertainment companies historically generated.
The combination of the continued demand for entertainment and the higher barriers to entry to streaming mean it will end up being a better business than pay TV for the winners.
Why Netflix Stands Out from the Rest
Going back to the Kilar quote, Netflix is the easiest bet because it’s the unlikeliest casualty of the streaming wars. Netflix’s place as one of the top three leaders is almost certain.
In terms of upside potential, Paramount is probably the best bet. At an enterprise value of $28 billion, the company could sell its studio business at a lucrative price compared to what investors are buying for and then continue to manage the legacy business which is still generating a lot of cash ($4 billion in adjusted OIBDA so far this year). Just to illustrate the value of Paramount’s studio business, Disney has an option to Buy Hulu’s stake from Comcast for at least $27.5 billion by 2024. Hulu has around 43 million subscribers, around the same as Paramount+. Hulu’s ARPU however is roughly 50% higher than Paramount+. Based on these numbers, you can argue that Paramount studios could sell for two-thirds of Hulu’s valuation, that is an enterprise value of $18 billion. Hulu obviously has the Live service, but Paramount has the studio and theatrical business, so the valuation seems reasonable. Note that Hulu could end up selling for more than $27.5 billion as well. This leaves the legacy business with an enterprise value of $10 billion, even at three quarters of OIBDA instead of a full year to account for the decline in the legacy business, share buybacks could secure 100% of the remaining shares inside three years.
The downside scenario is that a recession in 2023 would put huge pressure on the TV business’s profitability, at a time when the company still needs to invest in streaming. This would push the stock lower and potentially offer interested buyers an opportunity to acquire Paramount’s studio business at distressed levels. That’s the only reason why Paramount isn’t my top pick for 2023.
For Netflix on the other hand, it trades at 28x P/E compared to the market’s 20x. This is a reasonable level if you believe the company will be the leader in an oligopoly. It is clear however that multiple expansion in the stock is unlikely, so the majority of the returns will have to come from growth in earnings. If you believe Kilar’s projection of $10 billion in cash flows, then Netflix could almost double, given its TTM operating income is $5.7 billion. It is true that the $10 billion won’t come all in 2023, but markets are forward-looking, and you can see strong outperformance in NFLX if they show investors next year they are on track. And unlike Paramount, a recession could be a net positive for Netflix as an acceleration in chord cutting can push more customers its way. Netflix’s risk is that a global recession will put a lot of pressure on its international subscribers, while many of its peers don’t have that international presence and so won’t suffer as much. There is an argument that this was the case in 2022 for Netflix and they are still on track to gain subscribers.
Also note that Kilar was looking only at subscription revenue, but Netflix can become a big player in advertising.
Advertising Will Be Netflix’s Secret Weapon
A more obvious bet than buying Netflix or Paramount in 2023 is to short the smaller social media names. The risk to that is a soft landing, which would see those stocks absolutely rip higher, and that’s why I wouldn’t short any of them. But the discussion why smaller social media names are a short is very relevant for the case to buy Netflix.
Digital advertising has long been a duopoly between Google and Facebook. The reason for that was advertisers needed a way to reach consumers who were rapidly moving online, and Google and Facebook had the largest userbase and gave advertisers creative tools to reach those consumers. Google’s search business has a barrier to entry, but Facebook’s had virtually none and the company had to fend off new entrants every couple of years or so throughout its existence. This dominance by the duo however is coming under attack and likely ended in 2022. First there was Amazon, which managed to build a $30 billion ad business by smartly using its properties in commerce, media, and gaming. Then Apple dropped its ATT bombshell. I argued in a previous article that Apple could become the world’s biggest ad seller. Some on Wall St. estimate that Apple could hit $20 billion in ad sales by 2026. The third attack is coming from Connected TV.
The Trade Desk (TTD) CEO Jeff Green discussed this development in his company’s most recent earnings call:
we’re living a secular tailwind that I don’t know that we’ve ever seen before, and I don’t know that we’ll ever see again and that is going to continue into 2023, largely because of the amount of inventory that is coming online. But also as you look across the open Internet, and whether that’s inside of display or native or audio or any other channel because CTV is leading the way in forging the future of identity, CTV is not just leading in our business and not just the most interesting thing happening in programmatic, but it’s the most interesting thing happening in ad-funded media.
And so as a result, CTV is the first – is quickly becoming the place where people spend their very first dollar and was not surprised at all to see our partner, Disney+ report 12 million new subscribers. And of course, Netflix added a couple of million themselves on just the promise of an ad-funded option coming soon. So there’s more inventory coming online, programmatic we’ll just continue to drive CTV. And I do believe that very soon, CTV will be the most data-driven channel.
No longer do advertisers have to go to either Google or Facebook, they can now go to Apple, Amazon, and soon enough streaming companies like Netflix. But even at the small scale of the US linear TV ad market, the $60 billion spent by advertisers are likely to transfer to Connected TV (streaming) over time. And if you believe streaming will be an oligopoly, then that $60 billion will go mainly to three streaming leaders. This is potentially $20 billion of high-margin revenue going to Netflix. And that’s without including international markets, and assuming connected TV won’t take share from other digital ad properties like social media, as Green seems to be suggesting in the quote. At 20% margin, that would be another $4 billion in operating income. Netflix could triple its current operating income from growth in streaming subscription and advertising. And that’s, again, without having to take share from the broader digital ad market.
Here’s Reed Hastings on the opportunity, from the same DealBook appearance:
The big thing that I missed is, I was on the Facebook board, so I kinda bought into for a decade to the belief that systems with a lot of data were going to be able to do higher CPMs than anybody else. So Google and Facebook were gonna mop up the world, and they have a lot in non-TV advertising. What I failed to understand is that there’s a lot of TV advertising that now couldn’t find the viewers, because the 18-49 segment had moved online, they were not watching linear TV. And so the advertisers are desperate for connected TV or internet TV solutions, so that’s the real thing that I missed. We didn’t have to steal away the advertising revenue, in fact it was pouring into connected TV if the inventory is there.
In Common Stocks and Uncommon Profits, Phillip Fisher argued that investors will do well by looking for companies with strong management teams and strong growth potential, then buying them at a time of corporate trouble. In a lot of ways Netflix this year presents a classic Fisher buy; it has a fantastic management team, the article discussed the growth potential for the company’s streaming and advertising markets as well as why their advantages are likely durable, and there is no doubt 2022 was a difficult year for the company following the first subscriber loss in more than 10 years and a 46% decline in the stock. As a result, Netflix seems to me like a great buy now and it’s my best idea for 2023 (and beyond).
Editor’s Note: This article was submitted as part of Seeking Alpha’s Top 2023 Pick competition, which runs through December 25. This competition is open to all users and contributors; click here to find out more and submit your article today!
Disclosure: I/we have a beneficial long position in the shares of NFLX, WBD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.