Netflix’s platform is undoubtedly phenomenal. Growing to around 210 million subscribers, Netflix has gone from selling DVDs through the mail to being the world’s queen of streaming content. Of course, it took a manager with great vision, brilliant content creators and a lot of cash to get to these results. The company, which has grown at a dizzying pace over the last ten years, recorded a negative free cash flow of about $9 billion, a lot. It is expected, however, to make this up quickly over the next five years. The market certainly thinks it was worth it, as Netflix now has a market cap of around $285 billion. That’s $1360 per subscriber. That’s about 10x revenue.
The company is expected to post a net profit of $4.7 billion this year, so a P/E ratio of 60x. Seemingly high were it not for the stratospheric operating leverage of the business. Assuming, in fact, that the company doubles its subscribers to 420 million in the near future and keeps its ARPU (average revenue per user) unchanged at 12 USD, the company would be worth about 10x its profits. A real gift if growth continues. The point is that operating leverage also works in reverse. If the company started to lose subscribers, it would quickly go into loss (it is enough to lose 10% of the base to go into loss). This would mean: a) recapitalising to spend even more on content, but reducing margins; or b) cutting content costs, which in turn would lead to further loss of subscribers and so on. It is therefore essential to understand the competitive environment and the margins for growth. On the positive side we have that: 1) the streaming formula is successful and adopted by more and more consumers; 2) in emerging countries it is still under-penetrated; 3) the space to reduce time on TV and increase streaming is still substantial (35% of streaming time and 65% TV in the US). On the negative side, however, there is no shortage of elements: 1) companies offering streaming content have grown exponentially and there are now almost a billion global subscribers, with limited room to grow unless consumers want to adopt and retain multiple providers; 2) Netflix is positioned at the high end of the cost spectrum and at its price you can now subscribe to, for example, Disney+, AppleTV and PrimeTV together; 3) Emerging countries that are still penetrable areas often need ad hoc content that limits economies of scale, as well as better internet connections; 4) National and regional broadcasters are setting up competitive streaming services that are better suited to local cultures; 5) the explosion of streaming has given rise to an inflation of the price of content that tends to put pressure on profits and cash-flows; 6) Netflix’s advantage is based on a limited number of successful programmes that might at some point lose their appeal and not be adequately replaced; 7) while it is good to offer better and better services, it is very bad to decrease the quality of services (content) and therefore costs will always tend to increase and will have to be compensated by new subscribers to avoid stagnation (the bicycle that loses speed eventually falls over…). .).
We have no particular view on the continuation of the competitive struggle for streaming dominance, given the number, size and pocket depth of the players in play. Yet we imagine that whoever buys Netflix here would have to hope to see the stock double given the risks involved, and for this to happen (speculation aside) we would have to see subscribers triple and subscription prices remain unchanged or grow (with the ultimate goal being ex-growth companies at 12x earnings). This means 630 mln subscribers in Western countries or double that (1.2 bln subscribers) with a 30/70% mix between Western and emerging countries. This would compensate for the negative case of Netflix becoming ex-growth at 300 mln subscribers with an ARPU of 10 usd per person. In that case, to reach an ex-growth valuation of 12x earnings, the company would have to lose more than 50%. However, here the market would probably exaggerate, pushing the stock even lower and the company, as mentioned above, in its eagerness to recover, would probably spend too much and in a hurry on new content, reducing profits and cash flow a lot.
Being a growth company this is not part of our menu. The above is just to illustrate how a solid company with a winning product can represent an investment with a risk profile (volatility) quite different from what is perceived or perceivable.
The black swan song
The swan is said to emit songs of particular beauty as it approaches death. This originated in Greek literature, from Aeschylus to Aesop, and was later taken up by great writers. In reality, when the poor swan is about to die, it emits, like everyone else, sounds that are anything but musical. We have read editorials claiming that the current imbalance between oil supply and demand will lead to a return of investment in the oil sector. We disagree. Supply will soon be increased, but the scar will remain and will only further accelerate the energy transition, making it more attractive in the immediate term to invest in renewable energy; particularly today where we have some companies trading at more sensible valuations than a year ago. Today, more than 70% of oil is used for transport and the rest largely for chemicals. In five years’ time, no more internal combustion cars will be sold and in ten years’ time, almost all the cars in circulation in Western countries will have disappeared. Supply restriction policies are not feasible because Russia and the Middle East have failed to convert their economies and are in desperate need of selling oil. Oil will return to trading at much lower values than at present. Below 35 USD per barrel Russian oil is not profitable. Fortunately, they have plenty of gas that will be with us for the next twenty years. And Russia could, under enlightened political leadership, use its vast natural resources to produce agricultural commodities, wood and renewable energy to flow in the form of hydrogen in pipelines to Europe. And sooner or later this will happen. Russia will probably still go through difficult phases linked to the fall in oil prices, which will be added to the many sanctions that are already putting pressure on its economy. As yet there is no hope of the political change necessary for a revival. The country remains uninvestable. However, it is not difficult to imagine a prosperous future for this great nation. The ingredients are there. While it is true that the value approach tends to anticipate events, we are not yet at that stage here, and we do not think we will be for years. However, it remains an area we are watching from afar.
Take an Indonesian bank. Get a known one. Come on, exaggerate. Take the most financially sound and well-capitalized one. It’s BCA, Bank Central Asia. Assets approximately 80 billion US dollars. Capitalization $66 billion. Twice the size of UniCredit. It boasts a CAR, which stands for capital adequacy ratio, a metric that defines balance sheet strength, not far from our Capital Tier 1, of 26%. ROE of 16%. Valuations reflect this champion status. The stock trades at almost 4x tangible equity and 27x next year’s earnings. Stuff not even seen in Europe in 2006.
Let’s stay in Indonesia. Now it’s hot, it’s nice. Let’s take another bank. Bank Pan Indonesia. Assets about 16 bln USD, 20% of BCA’s. Capitalization 1.3 bln USD, 2% of BCA’s. It boasts a CAR of 27%, higher than BCA, but an ROE of “only” 8%. The stock trades at 0.4X tangible book value and 6x next year’s earnings. How so? Is the bank rotten? Far from it. The company is extremely solid and has a very strict lending policy. The cost of funding for smaller banks in Indonesia is higher than the big banks, a legacy of the financial crisis of ’97 that saw small banks wiped out. Things have changed, but the market and the retail sector are still tied to the past, but sooner or later they will be reconciled with a different reality. The bank has two big shareholders. One is the Gunawan family, one of the most powerful families in Indonesia, and the other is ANZ, Australia’s second largest bank. Between the two of them they control 86% of the bank. So we would say that the bank is pretty solid, supported and undervalued.
Let us now take Panin Financial, the company through which the Gunawan family indirectly controls Bank Panin. Not only is it a holding company, it also runs a major insurance company, Panin Life, which generates around USD 30 million in net profits per year. In a growing country, we could give it a conservative valuation of USD 300m (10x earnings) before the value of its stake in the (super undervalued) Bank Panin (USD 637m). Giving the latter a generous holding discount of 30% would still give us USD 446m. Combined with the value of the insurance company, this would give a super conservative valuation of USD 746m. However, the company trades at USD 419m (0.23x tangible equity…).
Let us now take Panininvest, the company through which the Gunawan family directly controls Panin Financial. This has activities in tourism that, in a normal context, generate about 10 million USD per year. If we value these businesses at 5x their profits in the current juncture, we come out with 50 million. If we add the value of 67% of Panin Financial we arrive at 335 million USD. The company is worth 200 million USD on the stock exchange (0.15x tangible equity). You don’t have to take amphetamines or assume great future growth to eventually see it at valuations 4 times greater. It just takes patience and common sense.
I would say there is no need to add anything else. This is just one example of the value that can be found in Indonesian small caps, companies that, unlike sclerotic Europe, will grow a lot in the coming years, but remain forgotten. For now …
A week with solid US bank results, driven by investment banking and consumer lending which grew well, reflecting a positive mood. The market reacted well and seems ready for a series of technical breaks that will probably induce the most sceptical to return to equity. The reporting season essentially begins next week. Among the leading companies reporting and in our portfolios are Stora Enso (forestry and wood derivatives), Yara (agro-chemicals), Biogen (Alzheimer’s), Orange Belgium (telecom), Barclays (banking), KB Financial (banking), Posco (steel and cathode material), Siam Commercial Bank (banking), AT&T (telecom), Intel (microchips), Hyundai Engineering &Constructions (construction), Hana (banking). It’s starting to get interesting…