Introduction
In early 2022, the Enhanced Yield Fund made an investment in the senior bonds of global streaming giant and pioneer NETFLIX.
At the time, markets were questioning the viability of the Netflix model – worried about its ability to attract meaningful subscriber growth after huge growth during the COVID-19 pandemic. Additionally, new and well-funded competitors had emerged from the likes of Amazon, Paramount and Disney. Investors were also worried about Netflix’s ability to access quality content going forward, as some external content creators had started to build their own platforms.
As always, in trying to understand the business, our strategy was to go back to first principles, i.e. at its core, what were the basic fundamentals of this business?
Netflix was founded by its current Chairman and until recently, CEO Reed Hastings – who has also sat on the board of Facebook and Microsoft. Hastings effectively pioneered the VSOD or “Video Streaming On Demand” industry. While a visionary and accomplished industry veteran, he also has a track record of acknowledging his own shortcomings when it comes to experience – happy to bring in experts to advise him. This is not always the case for an operator of his calibre.
While it is often mistaken as just a content library, at a base level Netflix is in fact a technology company – whose user experience needs to be better than its competitors – and it is!
Netflix has built an enviable platform for watching content, that tailors itself to each individual subscriber, feeding off viewing histories, and drilling down into such granular elements as recurring genre’s being viewed, recurring actors that the subscriber has watched, etc. This is currently un-paralleled. Most importantly it is fun and easy to use.
The platform is useless however if you don’t also have a market leading content library. Not only is the library the best in the industry, but Netflix’s track record for consistently creating new content is un-matched. It has a history of regularly creating content that ranks among its most watched shows.
The Opportunity
In early 2022, Netflix’s equity was hit hard and the yield premium that investors demanded for investing in its bonds also increased materially. This was driven by the above concerns around subscriber growth, content and competition.
At the end of the day, we felt the market was missing the point. Netflix fell into our coveted “best of breed” category – in an industry that it pioneered. Additionally, apart from the quality of its content library, its huge size also provides it with considerable scale benefits – and outside of its own content, it has become one of the biggest (if not the biggest) clients of the major content creation companies – generating revenues for these businesses that they are unlikely to give up – regardless of their own aspirations.
From a business management perspective, Netflix’s balance sheet is well managed – with a sensible mix of debt and equity, and it has the right people at the helm of the key divisions within the company, and a good handle on what is required to stay on top.
This was demonstrated late in 2022 when it built its new advertising based offering – an offering that the market was sceptical about. Not only did Netflix build it in a very short period of time, but subscriber numbers have far exceeded market expectations. Again – evidence that Netflix knows who their audience is, what they want to watch, and what they are willing to pay.
Our Investment
We originally bought the bonds at over 2% above the cash rate – a very attractive yield in both absolute terms and also relative to where Netflix bonds had traded historically.
With the execution of the new ad-based platform, its market leading technological capabilities, its ongoing ability to create new and interesting content, and the subsequent maintenance of the broader subscriber base, the bonds rallied strongly in early 2023. So much so that we have now closed out the Fund’s position, having generated a ~7% return over the past 12 months. Not a bad result considering the average 90 day bank bill return of ~2.50% over the same period.
This investment is emblematic of the sort of investments we look for at PM Capital. A market leading business, with strong management, whose performance is being questioned by the market for what we believe to be the wrong reasons. When you let the fundamentals of a business drive your decision-making process, and not market hype, our experience is that most of the time the rest will take care of itself. Suffice to say, we will watch Netflix with interest in the years ahead.
For more on the Enhanced Yield Fund, go to https://www.pmcapital.com.au/enhanced-yield-fund.
