Arif Karim (03:04):
As Netflix grew subscribers, they had more revenue come in. They would take that revenue and reinvest it in both content to… And really, content is the product. In any media service, content is the product. They reinvested in content and they would invest a portion in marketing to go out and add new subscribers. It became this flywheel effect: the more content you had, the better content you had, the more appealing your service was and you market to new subscribers your content and you would add them and then they’d bring you more revenue and hence you have more money to reinvest in content and marketing.

Arif Karim (03:41):
One thing that was really interesting was that there’s another piece of this flywheel effect, which is that when you bring an incremental subscriber, you have incremental dollars to spend on more content. The incremental dollar of content spending benefits all subscribers. Every incremental subscriber benefits all subscribers and that’s the classic network effect phenomenon.

Arif Karim (04:01):
It’s such an inherent part of Netflix’s core. At the time Netflix and for many years, since they made that transition from DVD to streaming, they basically reinvested as much of their dollars coming out of the PNL into content and marketing as they could and in fact to accelerate the build of that scale because nobody else was doing this. They had the market all to themselves: Internet, global, video delivery market. They had this to themselves.

Arif Karim (04:27):
They accelerated to build of that scale by borrowing money at very low rates. Capital was cheap and the market was willing to lend to them at very low-interest rates. I think the management was very savvy and smart and taking advantage of the fact that there’s all this capital available to accelerate growth of that scale, both of subscribers and content. The bigger those two get, the more scale Netflix has, the better service they can offer, the wider the distance between it and any legacy media provider would be when the legacy media providers decided they would get into this business, which surprisingly took them a long time. It sounded like Jeff Bezos at Amazon talk about how Amazon had, I think it was a seven-year lead on cloud computing before anybody else started doing it.

Arif Karim (05:16):
He was just like, “We were quiet about it because we didn’t want to alert our competitors to it. We were surprised that they didn’t come in and start doing the same thing but we were quietly building this great business.” The thing is, these kinds of businesses when it’s a new business model, you need time to work out the kinks in that business model whether it’s how do you acquire subscribers cost-effectively, how do you retain them efficiently, how do you deliver service in a way that’s… Usually, new services are kind of crappy in terms of quality. We all know this from Netflix. When Netflix streaming first launched when it was free, it was B movies and it was not that good, which is why it was free.

Arif Karim (05:55):
But when Netflix made the change to basically start charging for streaming, they believed in the future services being this amazing service that could be very convenient and cheaper than at the time, the current way the video content service was being delivered via wires. But it took a while for the service to get better so that when you press play, it plays. There was a lag.

Arif Karim (06:19):
Similarly, with Amazon and their AWS Cloud Services, it started out low. It served startups that were looking but didn’t have the money to buy their own data centers, they would use Amazon service. In that, you learn and you develop technical capabilities to improve the service to a point where it’s the classic [inaudible 00:06:37] and disruption work, your service becomes a superior service delivered at a lower price. All of a sudden, you’re eating the lunch of the incumbents who are highly profitable but under-investing in both the service, the technology, and maybe even the content because today if you look at Netflix, they rival HBO, which historically has been kind of a top tier content guy in the business but they rival HBO in terms of content quality.

Arif Karim (07:03):
And yet, they have this huge amount of content as well that spans the gamut of I might be a guy who loves high-quality content that’s award-winning, but you might be the guy that loves Adam Sandler and that’s what you care about. So they span the gamut of that. I love things about black holes. You might like standup comedy or you might like animation.

Arif Karim (07:24):
Over time they’ve expanded the types of subscribers they can address by expanding and scaling their content. So all that together comes together to create the moat Netflix has today. The way I describe it usually is that the number one thing and what I think about the moat of Netflix, which most people don’t think about, but increasingly there’s more talk about it, which is that culture is a huge moat source that has not been talked about before and probably because it’s hard.

Arif Karim (07:47):
Do you know who talked about culture as a moat source? It’s VCs, venture capitalists do. Because they understand it’s the people building a business that’s all that relates to success, whereas historically value investors have thought about tangible assets as being the value of the business. The value of the business is not the tangible assets, it’s how productive those assets are. Whether they’re tangible and today more and more, so intangible. That all comes down to people that are managing the assets of the business and managing the productivity of the group of people working together every day to produce something.

Arif Karim (08:19):
It’s that managing of assets and people will do something that customers really value. But as I delved into this space, a couple of things happened actually. One was, being a value investor, the thing that looked most interesting to me was Time Warner because they owned HBO. HBO is a global brand. Everybody knows HBO. When you compare the multiple of Netflix to a Time Warner, there’s a huge disparity. Here you had Time Warner, they had this massive content catalog because they’ve been around for a long, long time. They generated new content constantly.

Arif Karim (08:54):
Then you got HBO, which was a premier network they had built out. It had large distribution in the US, something around 40 million subscribers in the US. Its content was being distributed internationally as well via licensing. So, they were making sort of a per-subscriber fee so much as on the order of US subscribers, which was $10-$15 a month, they were making more like $1 or $2 a month or we call it sort of loosey subscribers internationally.

Arif Karim (09:23):
At the time, they talked about something like 120 million global subscribers. But really, it was licensing deals with international pay TV providers, licensing their content. They didn’t have any sort of direct relationship with the subscribers. As luck would have it, Time Warner launched what was called HBO Now, I think at the time, which was their streaming service. This was in April 2015. We were all lathered up about this. It’s like, here’s this opportunity. It was a hidden gem that Time Warner really wasn’t getting any credit for and I remember saying at the time that this is going to be great.

Arif Karim (09:57):
The only thing HBO needs to do, that Time Warner needs to do is they need to go out and hire the deficiency they had, was being able to reach customers, directed customer over the internet type of skill set, I guess you’d call it that I understood to be hard. I understood them not to have that necessarily. That was something you had to build out. I remember making this comment, they just go hire the head of Netflix’s customer acquisition for whatever price it costs. They should just go out and hire him and they just spend a bunch of money to go get subscribers, you get to scale.

Arif Karim (10:29):
Over the next year or so, it was very disappointing. When they did this, Time Warner concurrently, soon thereafter, I could get an investor date of late in 2015 or mid-2015 and they talked about how they were going to invest money behind this effort and they were going to… They cut their guidance for earnings. I was like great, the stock was down. I was happy about it because they were doing the right thing. They were investing in the streaming business that can be very lucrative and global. Cut forward a couple of months, a couple of quarters, and all of a sudden Time Warner was talking about, “Our earnings came in better than expected. Our costs were lower.”

Arif Karim (11:06):
I was kind of scratching my head and thinking that shouldn’t be. Actually, whatever savings you have, you should definitely reinvest into HBO and they were talking about how they’re rewarding their shareholders now and returning capital, continuing to return capital to shareholders. And to me, it was just like, HBO had not grown that much. They’d grown, I want to say, out of memory maybe 500,000-800,000 subscribers over the year, which was nothing different than Netflix, which was growing, I don’t know, something like 10 million or something like that at the time.

Arif Karim (11:31):
Let me see if I can find the numbers actually. But you basically had… Here. Okay, so from 2015 when HBO NOW launched to 2017, you have them adding 800,000 subscribers in 2015, 1.2 million new subscribers in 2016, and 3 million, 2017. And so the total of that is 5 million subscribers. On the other hand, Netflix added 17 million subscribers in ’15, 19 million in ’16, and then 24 million in ’17. They added, what is that? 27, 36, and 24, it’s about 60 million, basically.

Arif Karim (12:10):
So 60 million compared to 5 million. It’s just ridiculous, the disparity. Thankfully, we didn’t wait till 2017 to discover this. This is kind of history. But we saw early on that Time Warner wasn’t putting the type of resources we believed they needed to, to really get HBO Now going. And we felt like there was a window now for this where you have to get to scale to compete with Netflix.

Trey Lockerbie (12:35):
Do you think that there was a difference in philosophy there? Because obviously, HBO is known for putting in just deca millions of dollars into the content itself. I mean Game of Thrones comes to mind. These are unbelievable expenses. And are they just relying on the quality of the content to drive subscribership as opposed to maybe a different philosophy that Netflix had? Or is there any difference in approach there that you see?

Arif Karim (12:59):
That’s a great question. That’s where I was heading is that what you could see was that there was definitely a difference in management, philosophy, and culture. To your point, you said HBO is putting a deca million into Game of Thrones and they’re known for high-quality content. And I think it was maybe in the 2015 timeframe, plus or minus a year, where Netflix’s Chief Content Officer Ted Sarandos had made this comment in an interview where he said that Netflix’s goal was to become HBO faster than HBO could become Netflix. That was a really interesting comment because our bet was that HBO would become Netflix faster than Netflix would become HBO.

Arif Karim (13:38):
That’s what we’re betting on when we owned Time Warner. It was entirely driven by sort of this very nominal view of the difference in valuation, Netflix is so expensive and Time Warner was trading at, I want to say maybe 15 times, around there or something like that. Around plus or minus a couple of points. But what we saw when we got involved and they- we were paying attention closely to media space, was that the management at Time Warner was still stuck to this idea of what shareholders want is they want current capital returns, they want return on capital.

Arif Karim (14:12):
This was the big beam from the call of 2010-2016 or ’17, where large companies and then I think this was activism in the early 2010s, that drove them to be very much oriented towards returning capital to shareholders, under-investing in their own businesses. But on the other hand, you saw startup cultures like Netflixes where it wasn’t a startup anymore, but it still had that culture of innovation and looking to add value for the customer and just a more dynamic agile culture behind focusing on the customer experience and delivering to the customer what would be valuable and enjoyable for them and then incrementally working to improve that over time.

Arif Karim (14:51):
You’re kind of building this. The moat ends up being, at the end of the day, delighting the customer. This is a term that I think Apple would be introduced or people have learned this from Apple, that delighting the customer is a very lucrative business model. If that is your focus, it’s very lucrative. On the other hand, traditional media companies like Time Warner, and we saw this with other media companies as well, were beholden to this legacy business model that was tied to cash flows coming out of a cable TV business.

Arif Karim (15:19):
Now, at the time, if you looked at cable TV, you had 200 channels you could watch. You paid $80-100 a month for access to that video. And the average American, I think the statistics I’d seen were like watches four to five hours of television a day. But what we saw with Netflix was that their customer engagement, if you look at their subscribers, their subscribers were spending two hours a day watching Netflix. They were highly engaged and yet, they’re only paying like $12 a month.

Arif Karim (15:46):
So for $12 a month, you’re getting two hours of high-quality engagement as a customer, when you also… Most customers also had cable television, they were paying $80-100 a month for and we’re watching maybe an incremental two to three hours on that. The value proposition was vastly different. Coupled with that was this idea that people wanted access to video content, quality, professional video content, anytime, anywhere. You want it on your iPad, on your iPhone, the legacy media companies were all about limiting access to content. So you came to watch on a certain channel, this show that you’re watching once a week so that you’d be able to binge as you’d like.

Arif Karim (16:24):
You have to watch it when they put it forward on cable television so have to be there at a certain time to watch, as opposed to watch whenever you’re free, whenever you want. You have to watch on your cable TV box, you need your cable television box to access content as opposed to watching it anywhere. Now, some of the media providers like CBS, I think was one. Memory is getting a little blurred but there were some that had apps on your tablet that they have just started to implement and you have this surf TV anywhere kind of a thing where you can watch it anywhere. By the end of the day, the experience was [inaudible 00:16:56].

Arif Karim (16:56):
It was there was a lot of friction in it. It was all about control, controlling the content because there were so afraid of people stealing content or sharing it with friends and Netflix really was not. These are all part of your question about what does it say about management and really inherently, culture of the company. It was all about the viewpoint of… For the media companies, it was very much about profit maximization. I want to control my content because then I want to control the economics around that and I want to accrue more cash flow from my customers for myself.

Arif Karim (17:29):
Netflix’s model is more like, “We want to deliver a great experience to the customer. So we’ll start with that. And then we’ll worry about the other parts later.” And in the process, there’s a bunch of learnings that they had. And then I’ll just throw out one that to me, was fascinating, which is this idea of controlling your content. So going back to Napster back in the early 2000s when the music industry basically sued consumers for downloading music for free using Napster, it was about the media industry sort of learned from that, that they needed ways to control their content so that it couldn’t be stolen by customers. And that’s well and good, of course, you don’t want that.

Arif Karim (18:08):
But on the other hand, with Netflix, their model is more geared around winning new customers. We want people to watch, we want people to have access to our content, we want them to then want it and then eventually they’ll pay for it, was kind of the belief. And so I like to think that when you share your Netflix password with friends and family, what it really ended up being was a viral marketing strategy, really, for Netflix. It had been in the news for a little bit. And certainly on investor calls, would ask about when would Netflix clamp down on password share? When are you going to access these lost revenue sources by clamping down?

Arif Karim (18:45):
Netflix has always been kind of danced around that topic, not really sort of like… They’ve never given like a direct answer to it and how they would address it or when they would address it. And from our perspective, that was just a company realizing it’s been not necessarily wanting to publicly state it is that when I share my password with my dad or my sister or my friend, those people are watching Netflix content. For Netflix, there’s no incremental cost to them watching it. But of course, it could be incremental revenue if they’re losing.

Arif Karim (19:10):
However, when you look at Netflix’s plans, their Standard Plan allows you to have two simultaneous content streams. And so if there’s a third person that tries to access it, you’ll get a notification or they won’t be able to get access to it. What’ll happen then is maybe you’ll upgrade to their high tier where you have for media streams. So instead of controlling monetization by the number of users, Netflix was controlling monetization via the number of streams. And from a customer perspective, if your content provider comes to you and says, “You are stealing content from us by sharing your password. That’s wrong. You’re being a criminal.” It’s a very different experience than saying, “You’ve used up all your quota of stream, would you like to upgrade to add more?”

Arif Karim (19:57):
And that way, it’s like very easy to sort of be like, “I’ll just upgrade,” or, “I’ll split it with my friend or whatever.” So anyway, I want to come back to that kind of that flywheel effect.

Trey Lockerbie (20:07):
You’re touching on the moat a lot, which is something I really am curious about. Because admittedly, I’m a customer of Netflix. I watch it probably right before bed almost every night with my wife and I find it to be a resource for very bite-size type content.

Trey Lockerbie (20:24):
I have so many questions around this. Well, the first one was, if you know anything about the strategy with comedy, because Netflix leaned in really hard early on with live comedy specials and it kind of makes sense economically, in my mind, where it’s probably cheap to produce, relatively speaking, you get a lot of value for little and there’s a lot of it out there that you could produce pretty quickly. But it’s certainly become… I guess what I’m comparing that to is like, that’s where I would think to go first, rather than an Amazon.

Trey Lockerbie (20:54):
I have other purposes for why we go to Amazon, which I want to get into as well. But I’m curious if you know anything about that strategy or what’s kind of come out of that or how you kind of see the use occasion of Netflix versus some of the other platforms.

Arif Karim (21:06):
Comedy is a good one to touch on. One of the nice things about Netflix’s model is that they’ve focused on building scale, on subscribers. Today, they are the largest scale content provider globally with over 200 million subscribers. Of course for Netflix, a subscriber is a subscription, which means that there are probably an average we’re guessing here, but an average of two to three viewers have that contact per a subscription. When you have that level of scale and you can go back to when they had 60 million, 80 million, 100 million, you’ve got a diverse set of tastes amongst that subscription base.

Arif Karim (21:42):
And so, early on Netflix is able to get data. Because it’s a two-way connection over the internet, they’re able to collect data on what people are watching, how long they watch and then create these profiles of sort of subgroups of consumers that they are addressing. Obviously, things like comedy became a big genre that led to success for Netflix and continuing to drive that flywheel of new subscribers joining and engaging really. Which also the higher the engagement, you can see Netflix then chases that with incrementally higher pricing.

Arif Karim (22:14):
So yeah, comedy is one area that they’ve invested in. And although the production costs might be low, what they pay the talent has been increasing over time. There are other types of content. Netflix interestingly, going back to that comment about becoming HBO before HBO became Netflix, most recently, in the last couple of years, Netflix has been rivaling HBO on the number of Emmys they’re contending for. Which speaks to the quality.

Arif Karim (22:38):
But at the same time, some of the most popular content that Netflix has is Adam Sandler movies, which are not really high quality, but people enjoy them. I do. Some of the most popular content on Netflix. And so, to your point, they’ve built out these different genres. And most recently, animation has become kind of a big area of focus for Netflix as well. And then now feature content films are another thing.

Arif Karim (23:00):
I think in their most recent call or a call before, they talked about how they basically wanted to come out with basically a new feature film every week, so that every Friday, Saturday, you have a film to watch which is when most people watch movies, which again, is going to have the HBO model, HBO… I think they said once that 60% of subscribers only watched movies and they had first dibs on that window post the actual release on movies across several studios. You asked an interesting question about how do you think about the ways that Netflix addresses content for their audience versus some of the other services?

Trey Lockerbie (23:36):
A good example of this is, every Friday, our family developed this tradition of family movie night and we have a three-year-old son. And so my three-year-old son, we’re kind of just introducing him to all the classic Disney-type movies. To be honest, I’ve never really gone on Disney+ and it’s probably all there. But what’s been easier for us is just going on Amazon, I can type in Frozen, rent for 3.99 and within literally half a second, that movie is playing. It’s so easy and sticky in that way. But a platform like Netflix is lacking in a lot of those classical movies that you can’t access as easily.

Trey Lockerbie (24:13):
So I’m kind of curious about that distinction and if that’s intentional or if Netflix aspires to eventually own the rights to a bunch of content like that or if it’s just the motor around the rights and they’re pretty… I know Amazon bought MGM Grand, for example, specifically for rights. Is everyone just kind of carving out their own piece of the pie that’ll be pretty defensible over time in your mind?

Arif Karim (24:37):
Our belief has been that while Netflix has built this market and is the leader in the market, that at the end of the day, content is the product. Get this distribution service and you can create a great experience in that service. But if you don’t have the right content, then the service is kind of not really useful because the product is the content and Netflix understood this early on, I think when they tried to renew their first set of licensing deals. One was with Starz. When they first got that deal, they paid something very low because they had 20 million subscribers and Starz didn’t really believe this was going to be a sustainable model, I don’t think.

Arif Karim (25:17):
But then when it came time to renew, three years later, that deal didn’t happen and the rumor was that Starz want to 10X they used to relicense. And that’s kind of around the time that Netflix started its own initiative to produce its own content, original content. Kind of getting to this point, which is that they saw that over time, as media companies, they were licensing from understood that Netflix was actually winning customer attention away from them via more lucrative channels or just cable television, that they would start to limit content to Netflix, licensing to Netflix or charge exorbitant prices and Netflix would be beholden to them.

Arif Karim (25:55):
So fast forward to today. And you basically have pretty much every media company, legacy media company has its own service now available. And this was a moment that we were actually anticipating. But the key is to understand what those moat sources are for the different media companies. So to your point, if you have a three-year-old kid, and you want them to watch all the classic, basically Disney movies, the way to go about it is either renting on Amazon or subscribing to Disney+. When you think about the market, no company will have a monopoly on the best content in the world.

Arif Karim (26:29):
That market for video content around the world is trillions. It’s a huge, huge market. What you have is a transformation and how that content is being delivered, how it’s being produced, what it cost and in that, we believe you can have a handful of global winners, but it’s going to be global scale. It’s going to be this duality of very large global scale players and this long tail of smaller very niche content providers. You or I will probably subscribe to two, three, four different subscriptions to get the entire bundle of content that we want. Amazon has an interesting model in that early on, they’ve always been about selection.

Arif Karim (27:11):
Selection is the big thing with them. And so it’s interesting that when you go on Amazon, so not only do they provide sort of free video to Prime subscribers, akin to like Netflix, where you’re paying a subscription fee, you’re getting some set of content for free as a result, but they also have kept it open so that you can actually rent content that’s not actually provided on their Prime platform. But also, you can subscribe to streaming services, like in the past, I’d subscribe to Showtime via Amazon.

Arif Karim (27:38):
And so they kind of just want to be the marketplace for everything, not just their own. Just like in retail, there’s things you buy from Amazon retail directly but then there’s all these third-party retailers that also sell via Amazon. So for Amazon, they’ve got a pretty unique model in that perspective.

Arif Karim (27:53):
It’s all about offering you the broadest selection of everything, whether it’s content or goods, whereas I think the most interesting launch in the last couple of years has been Disney, obviously. And it’s one that we’ve been kind of waiting for, like when is Disney going to do this? Because when we thought about the legacy incumbents that would be potential competitors to Netflix, what became clear a couple years ago to us was that Netflix had gotten to such a scale, where it’s because it’s globally-focused like global scale market is a big market.

Arif Karim (28:21):
And when you have the amount of revenue Netflix is bringing in and you couple that with the rate of growth in revenue by bringing in new subscribers and also incrementally raising prices, what you have is a player that can basically buy any tent-pole content they want as long as it’s available to buy. And the thing to realize is that we think about Disney content or MGM content or Time Warner content, they’re kind of a middleman, they’re a curator. Who really makes the content are the creators, the directors, the screenwriters, actors, and Netflix has just as good a chance of winning that talent produce for it as Disney does or Time Warner does, because it has a scale. But there’s a lot of other incumbent and media providers and legacy media providers that just wouldn’t have the scale because they’re all regionally focused.

Arif Karim (29:10):
Most media was regionally focused in the past, whereas with the proliferation of the internet, especially wireless, you’ve taken what used to be a regional scale of business and made it a global scale business. And so if you can’t make that leap to global scale, you’re not going to able to compete. You won’t be able to pay the price. So we’re going to see big dollar prices, right? Like, oh, you pay… We already see movies costing a couple of $200-300 million to make to pay these high prices. But the thing is, the more subscribers you have, the lower the per-subscriber cost ends up being.

Arif Karim (29:41):
And so the scale economics accrue to the largest players as a result for that best content. And that’s what really pulls in new subscribers into your service. I hope I’ve answered your question.

Trey Lockerbie (29:53):
Yeah.

Arif Karim (29:53):
How I think about these different services.

Trey Lockerbie (29:55):
What is the best metric in your mind? Let’s start with financials first and then talk a little bit more about business metrics. For a fast-growing company like Netflix, you mentioned earlier, okay, it was a PE of X. But is that even a consideration with something like Netflix? Obviously, the earnings as you were saying, you’re expecting them to reinvest those as they scale. You want them to. So should we even pay attention to PE’s? Or to something like the price to sales or any of the key ratios that you watch for high, fast-growing companies like Netflix?

Arif Karim (30:25):
Our way of figuring out the value of any business ultimately relies on what we expect future cash flows to look like. And all businesses have various periods where they invest cash flow for growth. In the case of Netflix, and lots of technology companies, they invest via the profit and loss data, the P&L, where it’s investing in marketing or content, things like that. Whereas a company like Walmart or Home Depot, kind of went through similar growth periods where they invested in stores. You don’t expense a store, you actually depreciate it over some period of 20 or 30 years or whatever it is.

Arif Karim (30:58):
And so you get this dichotomy in terms of how value is measured from an accounting perspective because accounting is… A lot of accounting rules are basically oriented towards a kind of legacy economy, which is the tangible world economy, not necessarily the intangible world economy. Michael Mauboussin, who’s a great thinker in finance and financial modeling talks about this in at least one paper, but I think it’s more than one paper if memory serves.

Arif Karim (31:23):
For us, ultimately the value of any business ends up being around the future cash flows that you expect. And so we’ve always had an expectation of like, Netflix will scale, when it gets to a certain scale, it’ll start to then become… So it’s always been profitable. In the market has been this view, that Netflix is unprofitable, but it’s actually not. It’s been profitable. It’s just that it’s been cash flow, negative, what they’ve done is they had recognized that they had a window of opportunity to become a global player and a leader in this space that would drive scale for them, which would then help them build that moat, competitive advantage versus others.

Arif Karim (31:56):
In order to accelerate that, they not only took their profits from their existing business at any given point in time, but they also borrowed money to over-invest in content. If you think about it, if you’re going from being a US business, which is what Netflix had been in 2011, ’12, ’13, basically, they had some international but basically US business to a global business, well, now you need to deliver content globally. The type of content that people all around the world would need. And it’s the whole chicken and egg problem.

Arif Karim (32:26):
You can’t win subscribers in Korea unless you actually have Korean content. So you’ve got to build a content base first to make an attractive service for Koreans. Now, of course, augment that with US Hollywood types content that has global appeal, but you will need some set of local content to win customers and then keep them over time. And so Netflix had to build this content catalog faster than its own profit and loss statement could generate cash.

Arif Karim (32:54):
So the whole idea that Netflix wasn’t profitable, is actually not quite right. It actually was probably because the content does have some depreciation cycle. It’s just that it was borrowing money, it was cashflow negative. Our thought was always that once they, in fact, this is exactly what I said internally back in 2016 when we flipped from Time Warner, we sold Time Warner and bought Netflix because they had obviously the right strategy, they were doing the right things.

Arif Karim (33:15):
My comment was that Netflix is over-investing in content right now, but if that over-investment drives 20-25% subscriber growth for the next three, four, or five years, this is going to be a huge business. And at some point, they’re going to get to the point where they can’t physically buy more content because it’s just not available. There’s a diminishing rate of return on content investment over time. Where that cutoff was, was unclear.

Arif Karim (33:42):
This is something that we all kind of play by year. [inaudible 00:33:44] Plays it by year and we play it by year to kind of see at what point is an incremental investment and content not generating new subscribers or new engagement. But at some point, it was going to be ridiculous. They were going to be able to spend so much money on content, that it was going to be hard for them to actually buy good content. At that point, you’re going to see the free cash flows fall to the bottom line.

Arif Karim (34:01):
And so you kind of have to play out the business model over a decade to see where that happens. And for us, we felt like that crossover was going to happen in that 2023-2025 timeframe when the company would go from being free cash flow negative to free cash flow positive and they grow tremendously from there. Our own thought was that they would be generating something on the order of 30, 35, maybe even up to 40% operating margins, unclear exactly where it was going to be. Right now, we believe it’s probably going to be more like mid-30s plus or minus one or two.

Arif Karim (34:31):
But that was always a thought. And then you basically discount that cash flow back and that’s how we arrive at our own value for the business price to sales or PE. On the PE side, one of the things we did is we also… We thought about well, what if you normalized pricing? Because it’s very obvious that customers were receiving a lot more value from the service and than they were paying. They were paying $12-13 a month, but most customers felt it was worth much more than that just based on… If you’re engaging two hours a day, 30 days a month with Netflix at $12 a month, you’re getting a great, great deal.

Arif Karim (35:03):
And then we also saw a history of price increases, usually about a buck a year for the service and churn would sort of spike a little bit in that quarter and they would settle down and the company would continue to grow massively. And of course, after that, so if you normalize for that, we sort of arrived at the back of the envelope value, PE multiple in the high teens to low 20s, which seemed very, very reasonable when you look at the growth and the moat and then the large global TAM that was available to them.

Trey Lockerbie (35:34):
What’s your input for estimating the cash flow positivity based on a certain amount of subscribers? Were you plotting out, okay, this adoption rate extrapolated? Because what’s so fascinating about what you said earlier is eventually, they’ve just fully expensed this content, and then it’s just pure profit. You had an idea of what that was at a certain subscribership. And then obviously, they went profitable or cash flow positive in 2020. So earlier than you expected. Did they just achieve the same subscriber count earlier or did they exceed your expectations on the operating side?

Arif Karim (36:06):
Forecasting is an art. No one knows the future. So we’re all sort of giving it our best guess. But it’s based on you try to anchor it on reality. So we saw that media companies, in general, had scaled media companies that high 20s type operating profits in the media businesses. It’s not even higher, potentially. This was going to be a global business, global scale. So it potentially could be higher than that even. And then we saw the momentum that Netflix’s business had and the way I thought about it was that this goes back to that conversation about HBO needing to hire the head of subscriber acquisition at Netflix, is that they have figured out a formula over a decade, their DVD business was all about acquiring subscribers online.

Arif Karim (36:49):
You have to do this cost-effectively, efficiently, you have to retain those subscribers to make the economics work. So Netflix had been at this game, honing how you do that online for a decade before they went to the streaming. And then there became sort of on steroids, it got juiced up even more, and it went global. It wasn’t the just US anymore, it was global. And so that’s a capability, they developed that pretty much every other incumbent didn’t have that capability.

Arif Karim (37:14):
New tech kind of companies had it like Amazon, but not Disney, not Time Warner, not CBS. There was some level of faith. They were printing roughly 2 million subscribers a month that they were adding, and this is lumpy because we’ve seen over time every time that Netflix misses their subscriber number or the stock is always volatile, it’s always down 10-15%, the market getting nervous or just short term investors, buying, selling, shorting or whatever it is, but what we saw is that if you look at it from a 12-month perspective, a rolling 12-month perspective, it had been pretty consistent about adding something on the order of 2 million subscribers per month, plus or minus.

Arif Karim (37:51):
The sources of the subscribers were different. Sometimes it was a little bit more heavily weighted to the US, sometimes it would be Europe, sometimes Asia, but you saw this sort of consistent overall addition of subscribers. So we sort of just played that out and said, okay, so if they could continue and in the US, they had something like 50% market share of households.

Arif Karim (38:08):
We looked at the US as being an immature market. We weren’t expecting much subscriber growth there because once you get past 50, half of all the households. And then, of course, you’ve got, I don’t only be 10 or 20%, other sort of people that are sharing passwords with the subscribers, so you might realistically have 60-70% market share in the US. There, we felt like the big growth would come from pricing, just raising pricing $1 a month for several years until they got to a spot where like customers resisted it. It doesn’t feel like to us, we’ve reached that yet.

Trey Lockerbie (38:41):
Have you done any surveys about that? I’m curious, have you estimated how price-sensitive the customers are? How elastic the price might be for Netflix?

Arif Karim (38:49):
We haven’t done surveys, but we’ve seen other people’s surveys. Yes, there’s a service called Bespoke, we’re not direct subscribers, but they’ll put up things on LinkedIn, where they’ll put up charts of what customers think of price increases or how they view Netflix. But for us, surveys are interesting but the data is what really matters. When it comes down to it.

Arif Karim (39:10):
Like I said, in the past, you’ve seen a little bit of a spike in churn, the quarter after pricing has happened and then just kind of goes back to normal. And so when you compare like a year later, Netflix has grown subscribers on the back of those higher prices.

Arif Karim (39:22):
And so effectively, that tells us that Netflix subscribers by and large, think it’s worth more than whatever they’re paying for it even after price increases. And one way to think about it is that if you’re watching two hours a day of Netflix for 30 days a month, that’s 60 hours of Netflix a month and at whatever, $12 a month, $13 a month, $15 a month even, it’s less than the cost of a cup of coffee every day.

Trey Lockerbie (39:46):
But the caveat to that in my opinion and it’s ironic because all these companies disrupted cable, but you start to hit a threshold I think where in aggregate the cost you’re spending on content is what you start considering. Where at a certain point, you’re like, “Well, I’ve got Netflix, I’ve got HBO, I’ve got X, Y and Z. And all of a sudden, I’m spending $120 bucks a month on content and I used to spend 80 on cable.”

Trey Lockerbie (40:09):
I’m wondering if that’s a thing of the past or if customers will be sensitive in that regard, like in aggregate, and then start cutting from there.

Arif Karim (40:17):
It’s a great question. It’s an open question that we’re waiting on. Our viewpoint is once Netflix became the HBO, of television, its next goal was to become television of television. So basically, you just go to Netflix to watch all your content. On the other hand, people have various tastes and every household has a few different household members that might have different types of content preferences. Going back to your question about comedy, the different genres that Netflix has added over time, that’s all investment in content, that’s all investment in trying to engage as much of your attention across your household as possible because eventually, Netflix wants to be the $25 streaming service in a 30-hour streaming service, you pay $1 a day for all of your TV needs from them.

Arif Karim (40:59):
While many people have this sort of nostalgia for Disney cartoons or Star Wars or Marvel, which are great, obviously making huge amounts of money that they make a movie on the theatrical releases and then and then the engagement that you get from customers. But eventually, you just come down to basically Netflix and Disney that cost you 40 bucks a month, let’s say, maybe 50. But look at the type of content that we’re getting, the quality of content between these two services. It’s pretty amazing, actually. Compared to the majority of the content that you get on cable television.

Arif Karim (41:32):
It’s a huge step up in quality. But at the end of the day, from our perspective, and I think this is true of Netflix’s perspective, they want to be your television service at $25-30 bucks a month. And the way we think about it is that Netflix and surveys have shown this, that most subscribers in streaming think of Netflix as a kind of a base platform service they start with, and then they’ll incrementally add other services depending on the content they want to watch.

Arif Karim (41:56):
When Billions is on Showtime, they’ll add Billions Showtime for a couple of months, watch Billions, and then they’re kind of done, they’ll stop subscribing to that. And then maybe when there’s a new Marvel movie, they’ll go to Disney and they’ll subscribe to that. If you have kids, then Disney is a lot stickier. But as an adult, you run out of content on Disney pretty quickly. And this is the other part of the flywheel. And Disney obviously has learned this and knows this and they’re investing in this.

Arif Karim (42:18):
But the part of the flywheel, to come back to that topic earlier, is that the more subscribers you have, the more revenue you have, the more dollars you have to invest in content, new content, which then engages your current subscribers and draws new subscribers which brings more revenue, which gives you more content dollars to spend on new content.

Arif Karim (42:35):
It’s a cycle. Disney has been a phenomenal success. I make the argument that I really admire Disney because they were late-ish to the game. I was surprised how long it took them to get to the direct stream business. Because along with HBO, Disney was the other one that has global brand recognition. They’ve got… As you mentioned, this IP, the catalog of content and brands and franchise they have is incredible, globally known.

Arif Karim (43:00):
I have to hand it to them, they did an incredible job. Disney always comes across as a company that talks about premium content that they have. There are various companies that talk about it, but Disney really does have premium content and you would expect traditionally that someone like Disney would be arrogant enough to say that, “Well, because we have a premium content, we’re going to come in at a premium price.” And yet they were not arrogant. They were very, very smart. I like to say they were so smart, they actually copied Netflix’s playbook step by step.

Arif Karim (43:28):
So what did Netflix do? They priced their service very low to make it a no-brainer for you to subscribe. They made it very easy for you to subscribe, very easy for your to cancel, no contracts, no, no issues about that. You can come back whenever you want, make it really easy. In the process of getting you the experience that they wanted to deliver, they built out their own CDN network, the content delivery network, so that whether you’re in Brazil or Germany, or the US, when you hit play for a certain piece of content, you get it pretty much instantaneously.

Arif Karim (44:02):
Whether it’s broadband where you have 100 megabits per second network speeds or on your phone when you’re out on the train, on the subway at 4G speeds, or at 3G speeds, it’s pretty seamless how quickly that content loads [inaudible 00:44:16]. In order to deliver that, there’s a huge amount of back-end network work that you have to do that Netflix did pretty early on.

Arif Karim (44:22):
What did Disney do? They acquired BAMTECH, which built this out for sports, and then leveraged BAMTECH’s CDN basically to be able to do the same thing. Netflix has built out this huge content catalog organically. They like I said, the people in the market, investors in the market have criticized Netflix for borrowing all this money to the tune of $11-12 billion in order to invest in content, build out this content. Disney went out and bought FOX to build up a scale of its content. So all in all, one more thing is that that low price, Disney went with this low price when they launched and it’s because they want to make it really easy for you, deliver tons of consumer surplus to you to subscribe and then stick around, wait for new content, instead of saying, “I’m paying $15 a month for this. And I haven’t watched anything new in a month, I’m just going to cancel.”

Arif Karim (45:08):
But if it’s 6.99, “Well, let’s give it another month. We’ll just kind of forget about that.” And so Disney picked up all these different tactics that Netflix had used to succeed in building out a scale to do it for itself. And now look at Disney, over 100 million subscribers in a couple of years. This is unimaginable. It’s incredible, right? So Disney was very smart, they were very humble, humble enough to copy Netflix, pretty much play by play, build out their service.

Arif Karim (45:34):
In time, we think that what’ll end up happening is you’ll have probably three, four, maybe five global services, depending on your economic situation and your interests. If you’re in the developed countries, maybe you’ll subscribe to three of them for like $40 or $50 a month in total.

Arif Karim (45:50):
If you’re in an emerging market, maybe one. Maybe you share a couple between friends or family where you share passwords, I think that’ll be part of it. But at the end of the day, if the business model revolves around continuous simultaneous streams being delivered, I think the business model works really well actually and actually expands the market for video content. Because there were once large swaths of the world that couldn’t afford to pay $20 a month or $50 a month for quality professional content. And now, if you’re sharing Disney and Netflix and maybe a third thing amongst or five, each sort of two, three simultaneous streams, you’re each basically ending up paying $5 a month maybe for all this amazing content. So the value proposition goes up, the market size expands and you have space for I think something like three global winners as a result.

Trey Lockerbie (46:40):
How should we think about the amount of debt that Netflix carries? Obviously, you’re not too worried about it with cash flow positivity now, they’ll be able to start winding that down. But obviously, all this content generation is expensive. How do you think about that?

Arif Karim (46:55):
Now that Netflix has transitioned to… The guidance that management has given they no longer opt to go to the market to raise debt, if they do, it’s going to be opportunistic. Pretty much what Netflix is saying is that they’ve gotten to the point in their scale, where it’s self-sustaining, in terms of the content investments they make. And as they continue growing, we think they’ve also guided to, they’re going to do something like 20% operating margins this year. That’s what they’ve guided to. And then they expect to keep growing that by about 300 basis points, so 3% additional operating margin points every year going for the foreseeable future.

Arif Karim (47:28):
And then for us, that means in five years, you add another 15 points of margin. That’s 35%. That’s kind of how we think about where the ultimate margin goes to and so the way that we think about incremental revenue is that when they bring on an extra subscriber, you buy content with that incremental content, that incremental revenue stream.

Arif Karim (47:49):
When they raise prices, that falls the bottom line. So there’s this network effect and also this economic effect. On the network effect, every additional subscriber enables Netflix to buy more content that benefits all the subscribers in the base. That’s the network effect. Incremental customer benefits everybody. The economic effect is incremental dollar revenue generated by a price increase falls directly to the bottom line. That’s roughly kind of how we model it and that’s roughly how it’s kind of played out.

Arif Karim (48:17):
And so that incremental dollar every month, over a subscriber base of 200 million-plus ends up being an incremental $200 million per month every time they raise pricing by a dollar. Our thought is that when you work out the numbers, you’re going to end up with free cash flow. We think that over the next decade, Netflix is going to double its subscriber base, right. So something in that 2028-2030 timeframe, you’ll have 400 million subscribers rather than 200 million.

Arif Karim (48:46):
In addition, we think that price will increase by roughly about $1 a year. That ends up being something on the order of 7% a year price increases [inaudible 00:48:54], and that ends up creating a revenue stream of about $90 billion in kind of timeframe at roughly a 35% operating margin. Again, these are all rough numbers. No one can predict exactly what the future will look like. But we think these are reasonable numbers from our perspective and that’ll generate something on the order of $18, $19, $20 billion in free cash flow. A lot of their debt comes due to way out in the future, a few years out. I think the total debt today is on the order of $14 billion if memory serves.

Arif Karim (49:26):
$14-15 billion. Being able to manage that sort of debt load is fairly easy from that perspective. In fact, we think that they could actually borrow more money over time and do more. What more could they do? How do they add value? This is one of the things that we think a lot about. When I think about ultimately and this goes back to my comment about which is really where the insight sort of formulated was watching how the traditional shareholder focused company like a Time Warner focused on shareholders’ profitability, shareholders care about profitability, the extent that they were actually offering consumers less than less value as a result.

Arif Karim (50:04):
On the other hand, you had Netflix, which focused on a consumer and tried to address their value and in the process create a budget for shareholders. Two very diametrically opposed viewpoints on how you approach strategy and building a business. And so I really liked that idea of the role of a company is to create value for their customers and in the process, also share that value with employee stakeholders. So its employees, its partners, in this case, it’s content creators and there’ve been different profiles of high profile, the content talent that has gone to Netflix because they were easy to work with, better economics, all sorts of cultural things that they got more freedom from Netflix.

Arif Karim (50:42):
It was like a win-win-win. It’s like you got more freedom, more money, a larger viewing audience to watch your content, 200 million subscribers. And anyone who makes content, that’s what they care about is how many people watch my content? How much money do I make, and how much creative freedom will I have to make that content? And Netflix offers the best of all those worlds, relative to legacy media. And so to see a company be able to do that is amazing. And I think that’s entirely ingrained in the culture of a company, entirely the reason why the company’s been so successful in disrupting this multi-hundreds of billion-dollar industry in a way that… It wasn’t really hard to imagine back when Time Warner CEO called Netflix, the Albanian army that was trying to take their little guns and attack this big giant media industry.

Arif Karim (51:28):
Going forward, there’s various ways that Netflix can add more value. And of course, that drives subscriber engagement, new subscriber additions, and the ability to increase pricing over time. And increase pricing in a way that customers are okay with. This is the key, pricing power is not that I can shove pricing down your throat and you have no choice. That’s one way to do it. And I think that’s how most Buffett-esque. I don’t think Buffett thinks this way actually, but I think Buffett-esque investors who’ve learned from him think of pricing powers, I can cram down pricing on you because I can because you need my thing so badly.

Arif Karim (51:57):
I think the better way to create a service product is one where the customer gets so much value that they kind of don’t mind if you charge them more, because you’re like, “I love this. I just love…” You look at Apple, this is the epitome of pricing power. You can buy a smartphone for 200 bucks, but you pay 1,000 for an iPhone. This is just mind-blowing. Ferrari is another one like that, where you can buy a Honda Civic for $20,000, but you’ll pay 250,000 for a Ferrari.

Arif Karim (52:19):
Again, these companies are creating so much value for their customers, however, you define that value, whatever that customer set is that customers are willing to hand over money to them, they’re begging them to take their money, basically, their products. So with Netflix, they just announced recently that they’re going to enter gaming, that they’re going to add gaming to their service, which we’ve done some work on the gaming industry. It’s very mainstream, very ubiquitous, there’s a big global market, exactly the market that would be consuming content. These are other ways that Netflix adds value and so potentially could surpass our forecasts over the next decade.

Trey Lockerbie (52:53):
I want to talk about those forecasts a little bit. I have one last sort of two-part question for you again, which is basically, now that we’re cashflow positive here on Netflix, how do you see that cashflow growth continuing, and then what’s your discount rate to get back to today? Another way to think about it is just what’s the intrinsic value for Netflix and how does the price kind of compare to that in today’s market?

Arif Karim (53:15):
Our sort of forecasted model, it goes to 2028, 2030 timeframe. Forecasts, Netflix, growing subscribers. The bulk of the broken subscribers will come from international markets. We really don’t care too much about US subscriber growth because we sort of had the viewpoint this is a mature market, it’s exceeded our expectations, actually, in that it has actually grown. But where we do think that us contributes is on price. So Netflix has much better pricing power here because we were willing to pay a lot more for video entertainment than say a customer in India or even Europe actually.

Arif Karim (53:50):
We do think that the US contributes to pricing over time, which falls directly to the bottom line, pretty much we see most of the subscriber growth coming from international markets where the penetration rate is sub 10% still, from our own viewpoint. If they’re successful in doing what we think they can do, which is grow revenue to like 90 billion on the backup, call it about 10% subscriber growth over the next decade is compound annual growth. That’s basically doubling the number of subscribers today to sort of eight to 10 years from now.

Arif Karim (54:17):
Pricing grows about 7% a year. Operating margin grow at a 35-36-37%. We see revenue of about 90 billion and a free cash flow of about 20 billion. And so when we discount that back, we do a WACC, weighted-average cost of the capital discount. We think Netflix has guided to roughly 15 billion in debt that they’ll have in their balance sheet. We think they can actually grow beyond that to something like two times EBITDA. We think of their equity capital as being kind of a standard 9% which the market has returned over time.

Arif Karim (54:48):
In the past, when we first invested in Netflix, we had a higher equity discount rate because we thought it was riskier, it was unknown how well the international markets could develop. The US was very developed, it was very mature. So that could get a 9% discount rate or standard average market discount rate. The international was they were investing in, that was much riskier business and that was just unknown. Like there was a lot of upsetting come from that.

Arif Karim (55:11):
But today we sort of see those international businesses being known. They demonstrated they can grow it quickly. And this is the other thing Netflix does really well is they’ve taken the business model of content production from being a very local one. So if you think about US media companies, they produced in the US, European media companies, they produced it and Europe. Netflix is the first that has a global production capability and they take that global production and they distributed it globally so that some of the biggest shows in Latin America are big shows in Europe.

Arif Karim (55:39):
I assume at some point, they’ll be big shows in India, because culturally, there’s a lot of similarities between Latin American and India. Indian shows have been distributed globally and one of the big shows here was Sacred Games that came out of India. And it was subtitled. There’s European shows that have been done really… Lupin is a French show that has done really well here. But it’s all in French. So we’re seeing this ability to basically source content globally, and distribute it effectively, globally, which no one else has done yet. This is the first thing Netflix has done.

Arif Karim (56:06):
And from that comes a lot of advantages, an economic advantage in content production, because the US is one of the highest cost content production regions, whereas India or other parts of Asia, parts of Europe, Latin America, these are lower content costs production places and yet the value they can generate from it is global. So we watch in the US, we’re a high-value market, Europe is a high-value market. So there are lots of economic plays in there that make precisely pointing to what content costs will be in the future kind of hard and also what the margin will be kind of hard.

Arif Karim (56:37):
But we think a kind of mid 30s margin is a reasonable estimate. So when you bring that back down to what we think the fair value of the company is, I think you’re going to be surprised. Given the $500, it’s like, 520-ish price that we’re at today, we actually think this is worth $870. There’s quite a bit of upside. Yeah. But that’s… If you believe those forecasts, if you believe those forecasts and depending on what your cost of capital assumptions are, it’ll be different. But for from our perspective, given our framework, 870 is kind of what we think it’s worth.

Trey Lockerbie (57:10):
Arif, this has been fantastic. I’ve really enjoyed talking with you about Netflix and I learned a lot. It’s a product I use all the time, so I had a particular interest in it. You’ve been right about the stock for a long time. It’ll be interesting to see where it goes from here. But thank you again, for taking the time to come on our show and we always love having you back. So I hope to do it again soon.

Arif Karim (57:28):
Oh, you’re very welcome. I love chatting with you and your colleagues. It’s always a great conversation. I’m glad you found it interesting. I hope your audience does too.

Trey Lockerbie (57:37):
All right, folks, that’s all we had for you this week. If you’re loving the show, feel free to follow us on your favorite podcast app so you get these episodes in your app every week automatically. Don’t forget to follow me on Twitter and say hello @TreyLockerbie. And lastly, if you learned a lot from this discussion and you want to figure out how to do your own intrinsic value calculations, you can simply google TIP Finance, and look at all the courses and tools we’ve already built for you there. So with that, we’ll see you again next time.

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Outro (58:19):
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