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Adam Levine-Weinberg  

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  • United Airlines' Path To Much Higher Profits [View article]
    OK, I think this is really where we differ on the airline industry. I think that airline margins today are close to where they will remain long term. I would say that airlines have not a decade, but a year (or maybe two) of margin growth left. After that, margins will start to contract.

    The airline industry will never earn 25% margins. It is way too easy to buy or lease an airplane and add flights. Delta and United may be fine with earning double digit margins with no growth, but LCCs and ULCCs are willing to sacrifice a bit of margin for higher growth. As capacity comes in, ticket prices will come down until margins are back at an equilibrium point where everybody starts cutting back on expansion plans.

    Did you see that United mechanics were picketing this week to demand that their pensions be restored? They stated that the airline got rid of the pension plan when it was in trouble almost 10 years ago, but promised to restore it when good times returned. To be honest, the only thing holding back labor unions is that the NLRB will hardly ever sanction a strike because the airlines are too big and so having even one out of commission would damage the economy.
    Nov 26, 2013. 11:10 AM | Likes Like |Link to Comment
  • Netflix: Asking Key Questions For 2014 [View article]
    Bohsie: you need to explain why any cable network would do this. Why would you give your content to another company so it can charge a 30%-50% markup for putting in on the internet? All of these cable companies already put their content on the internet. If demand for live streaming TV over the internet becomes significant, the top companies could just form a joint venture (or use Hulu, which already is a joint venture between 3 of the biggest players) and go direct to consumer.

    The reason why the networks sell to cable, satellite, and telecom companies is because those companies bring a large, guaranteed check, and provide a delivery mechanism. Netflix doesn't do either of those things. Why give a cut to a middleman if there's no technological or infrastructural barrier to selling directly to end users?

    Just look at the trouble that Intel had with setting up its over the top TV service. It reportedly had great technology, and no success in garnering content.
    Nov 22, 2013. 09:54 PM | 1 Like Like |Link to Comment
  • United Airlines' Path To Much Higher Profits [View article]
    Oh, I also wanted to add a bit of color on fleet replacement. I did notice your statement near the end of the article about how everybody's updating their fleets. This is a case in point in why I think United has the wrong strategy.

    Delta and United are both replacing domestic 757-200s with 737-900ERs right now. The 737 is a much more fuel-efficient plane than the 757, so swapping these out makes a lot of sense. United got started earlier, but I think it still has about 60 on order in the next few years, and then it will move to the MAX after that. Meanwhile, Delta just took the first of 100 737-900ERs in late September.

    Delta's domestic 757s were configured with 174-184 seats, and its new 737s have 180 seats, so the company is getting lower fuel consumption without giving up capacity. By contrast, United had 182 seats on its domestic 757s, but it's only putting 167 seats on the 737s it is taking.

    The difference is that Delta has a few rows of premium economy seating, whereas United has this vast E+ section. United is effectively ceding a permanent 6%-7% unit cost disadvantage in order to generate more ancillary revenue. The ancillary revenue is growing, but it's nowhere near enough to compensate for such a massive gap in unit cost.
    Nov 22, 2013. 03:13 PM | Likes Like |Link to Comment
  • United Airlines' Path To Much Higher Profits [View article]
    A few things: First, just to use the example of CSX, it has a 25% pretax margin. Delta is working (successfully) to get to the 8%-10% range. You should not expect the two to have similar multiples, because there's clearly a lot more risk in the lower margin business.

    Second, United and Delta have both set an explicit goal of growing at less than the rate of GDP. So I would expect the long-term growth rate for large legacy carriers to be even lower than for rails or other industrials. I think you could make an argument that they are all overvalued, but it's hard for me to be excited about many airline stocks today. (That said, there are several higher growth/lower valuation names that I think are very attractive.)

    Third, rails have a huge moat that doesn't exist for airlines. The most important capital asset for a railroad is the track it owns, which represents an extremely high barrier to entry. By contrast, airline assets are inherently movable. Obviously, it's a bit of an oversimplification, but new airplanes can move into your market on a moment's notice.

    Arguing that rails and airlines are basically the same is effectively arguing that Warren Buffett is a moron, since he thinks airlines make terrible investments yet he plunged billions of dollars into BNSF. I think Buffett overstates the case against airlines, but I'm certainly not going to buy an airline stock over a rail stock without some kind of discount.

    Adam
    Nov 22, 2013. 03:03 PM | 1 Like Like |Link to Comment
  • Danger Zone: Netflix [View article]
    Netflix had a pretax margin of 4.5% last quarter. But if you back out the international revenue and contribution loss, Netflix had a 13.4% pretax margin. That's not quite as high as the peak, but it's getting close, and has been rising pretty strongly in recent quarters. And non-paying customers represent less than 10% of the subscriber base.

    I think one of the big reasons why Netflix's stock price is so out of whack and so volatile is that the vast majority of arguments made for one side or the other are bogus. As an investor, it's pretty frustrating. But the market will sort things out eventually.
    Nov 22, 2013. 02:41 PM | 1 Like Like |Link to Comment
  • Danger Zone: Netflix [View article]
    Netflix has said that they are doing more marketing around DVD now in order to try to manage the decline. If I'm not mistaken, the "cost" of the free month is classified as a marketing expense. I would assume that this is what's going on.
    Nov 22, 2013. 02:31 PM | 2 Likes Like |Link to Comment
  • Danger Zone: Netflix [View article]
    David: First, I agree with the general thesis that Netflix is overvalued based on any reasonable growth assumptions. But it seems like your entire model is held up by the 15% pretax margin projection. I would say that most Netflix bulls think the company is becoming a "media" company with a potential for 30% margins or better. With more original and exclusive content, Netflix should have better pricing power in the future than it did two years ago. Furthermore, just by adding subscribers Netflix can leverage the content it has already purchased.

    Your fixed margin assumption (even if it's generous for the next year or two) is basically an assertion that operating leverage doesn't exist for Netflix's business. Presumably that's due to competition for viewers from other services and competition for content, which would continue driving prices up. Personally, I'm sympathetic to that argument. But right now, you have a rigorous DCF model attached to a "hand-wavy" argument that costs are going up but price increases will drive away customers. What do you think the content cost inflation rate will be? What do you think the effect would be over the next several years of raising the base price in the U.S. to $8.99 or $9.99? Those are the really key questions, in my opinion.

    Best,
    Adam
    Nov 22, 2013. 10:08 AM | 2 Likes Like |Link to Comment
  • United Airlines' Path To Much Higher Profits [View article]
    I think it's a little late to talk about the airlines having low valuations. I was promoting this line of thinking last year when Delta was a single digit stock. At $27, I think it's a good company but not one that I want to invest in.

    IMHO, investors are flocking to United because it seems cheap on a P/S basis compared to Delta. It's basically been riding the coattails of Delta and US Airways for a year now. People seem to assume that there's no fundamental reason why United should have lower margins than its competitors.

    The problem is that United has a MUCH worse cost structure than Delta or the new American. The biggest myth around this $2 billion plan is that these are "cost cuts". To be clear: they are cost cuts from a baseline under which costs would have risen by $2.5 billion or more in the next 4 years (holding fuel prices constant). When the program is complete, United will have higher unit costs than it does today (again, holding fuel prices constant).

    Now, it's great to hold cost growth below the rate of inflation, which is what this plan does. But Delta and American have similar plans which will result in similar or better relative cost performance over the next 4 years. Bottom line: in 2017, United will still have the highest cost structure in the industry. United already has the best revenue performance in the industry, so there's more risk than upside there on a relative basis.

    Unless you think that the airline industry as a whole is going to sustainably earn well above its cost of capital (i.e. there are very high barriers to entry/expansion), I think United is in big trouble.

    Adam
    Nov 22, 2013. 08:52 AM | 1 Like Like |Link to Comment
  • Netflix: Asking Key Questions For 2014 [View article]
    Bohsie: The big companies like Comcast, Time Warner, AT&T, etc. get the best pricing because they bring lots of subs to the table. Netflix can only do that if it brings ALL of its subscribers to the table. If it offers segmented service and only a few million people took the full "cable" package, Netflix would be a low-tier pay-TV company and would probably have to pay higher rates.

    BTW, just to be clear, this is totally a hypothetical. I don't think there's even a 1% chance that Netflix will ever do this. First, Reed Hastings has been very explicit about staying focused on the core offering (and that's really almost an ideology for him). Second, it doesn't make sense for the TV networks.

    What value does Netflix really bring to the table? It's basically a name with some software and delivery infrastructure that could be replicated for at most, a few billion dollars, and probably less. So if you're running a TV network, what's the advantage of selling your content to Netflix rather than selling direct to consumer, either alone or in partnership with other networks? Netflix is not really creating any value in the scenario we're discussing, so I don't see any way that this could become a major source of profit.
    Nov 20, 2013. 10:00 PM | Likes Like |Link to Comment
  • Netflix: Asking Key Questions For 2014 [View article]
    I think you are way off in your estimate of overhead. It's impossible to give an exact number, because cable operators don't break down costs to that level of detail between the video, internet and voice services that they operate on the same lines. However, for Comcast, content spending recently has been close to 45% of video revenue, and the operating income before D&A was over 40% of revenue for the whole cable segment (of which half the revenue is residential video).

    That suggests that the overhead, aside from capital investment (which would be necessary anyway to maintain the internet and voice services) is less than 15% of revenue. The biggest cost savings that Netflix could theoretically provide is just accepting a lower margin.

    On the other hand, Netflix would have to pay a LOT more if it is actually segmenting customers. Perhaps it could theoretically get ESPN for the market rate of $5.50 or so per sub, but only if it's buying for 33 million subs. And also taking ESPN2, ABC, the Disney Channel, A&E, and ABC Family, for another $6-$8 per sub. If it's just offering full service as a separate tier, it would either not be able to get the content at all, or would have to pay a premium.

    The other cost you have to keep in mind is internet bandwidth. I have a 6 Mbps connection, which is plenty fast for my needs. But if I was all of a sudden trying to stream 2 or 3 full HD feeds, I would need to spend another $20-$30/month on internet.

    Adam
    Nov 19, 2013. 01:05 PM | 1 Like Like |Link to Comment
  • Netflix: Asking Key Questions For 2014 [View article]
    Netflix relies on people having internet connections, most of which are from the same companies that provide pay-TV. The additional cost of operating a pay-TV system once you have the equipment in place and are operating a high-speed internet business is not that large.

    I think we're basically on the same page about what cable channels charge in retransmission fees (although ESPN is actually a little pricier based on the stats I've seen). But the cable and broadcast networks insist on bundling their channels, and for the most part, they insist on being included for every subscriber. When they don't, the cost is more like $8-$10 per sub (and then the cable company gets a markup on top of that): think HBO, Showtime, Starz, etc.

    Also, would this service include commercials? About half of the TV industry's revenue comes from commercials, so if you're cutting them out you should expect to pay about twice as much. A bunch of networks are up in arms about the "Hopper" which basically lets Dish customers skip commercials. I can't imagine them rushing into the arms of Netflix, which has taken a clear stand as anti-commercial.
    Nov 18, 2013. 08:01 PM | Likes Like |Link to Comment
  • Netflix: Asking Key Questions For 2014 [View article]
    What's stopping them is cost. Anything is available for the right price, but Netflix's business model cannot support current season TV. TV networks can make $1-$2/month off of every pay TV subscriber through retransmission fees (ad revenue is just gravy). That's a guaranteed revenue stream of over $1 billion a year. This money is basically a ransom from pay-TV companies, because they can't afford to lose a key channel like TNT, TBS, AMC, USA, or even the big 4 broadcast networks.

    If Netflix starts getting access to the top content from these networks, they would be giving up their leverage with cable companies. So Netflix would probably have to offer something like $500M-$1B annually to each network to get its shows the day after they air. That's just not going to happen.
    Nov 18, 2013. 04:50 PM | Likes Like |Link to Comment
  • Netflix: Asking Key Questions For 2014 [View article]
    The vast majority were streaming, as evidenced by the fact that after the split, over 90% of U.S. subscribers kept the streaming plan. In fact, the major reason why membership was growing so quickly was that Netflix had introduced the streaming only plan in 2010.

    I don't think the competition between Netflix and Prime Instant Video 2 years ago is anything close to what it is today. Prime had a tiny content library when it launched; now it is in the same ballpark as Netflix.

    At the end of the day, I guess you think the original content is enough of an attraction to keep most subscribers around, even with a price increase. It would help if NFLX provided any sort of data on viewership for these shows. I suspect that while each show has its hardcore fans, there is a large swath of Netflix members who are not that committed to the originals, or the service overall. That's where you stand to lose with a price increase.

    As long as Netflix is adding 5-6 million subs per year, I'd be surprised to see them increase prices. It's just not worth the risk. Only when organic growth disappears will Netflix look for a new lever to pull to boost revenue/profit.
    Nov 18, 2013. 04:33 PM | 1 Like Like |Link to Comment
  • Netflix: Asking Key Questions For 2014 [View article]
    I don't think you quite understood my point. It's not that the subscriber count will drop; it's that it will stop growing, leading to multiple contraction. In the year ending Q2 2011 (before the last price increase), Netflix added 9.6 million domestic subscribers (nearly 60% growth). Prior to the price increase, that growth rate was actually increasing.

    After the price hike, while the subscriber number only dropped for one quarter, the growth rate was much slower. It's taken 2 years to get the next 9.6 million streaming subscribers (growth of about 20% annualized). If the next price hike causes a similar slowdown in growth (to 10% or less), I think multiple contraction would more than offset the EPS increase.
    Nov 18, 2013. 02:08 PM | Likes Like |Link to Comment
  • Netflix: Asking Key Questions For 2014 [View article]
    Bill,

    I'm not sure P/S is a very helpful way to think about Netflix, because it's meaningless outside the context of the company's long-term margin profile. If you think Netflix will be earning 30% or 40% pretax margins someday, then an internet company P/S is reasonable. But if you think pretax margin is going to be more like 15%, then it can't really be grouped with those higher margin companies.

    I think the price increase sensitivity analysis is a good exercise, but I think you vastly underestimate the impact of raising prices. The last time Netflix reported churn, it was losing about 5% of its customers each month! I'm sure churn is much lower now: maybe 3%? (It would be great if NFLX would start disclosing this again.) If Netflix loses 3% of its membership base every month under normal conditions, would it really lose just 5% more in total after raising prices by $2/month, or 25%?

    I think a better way to think about it is that a price increase would increase churn, which would then gradually come back to normal over time. Suppose NFLX increases prices starting Jan. 1. In Q1 churn might be up by 200 bps to 5%, and then decline 50 bps each quarter, coming back to 3% by Q1 2015. With a starting member base of 33 million, you'd have 5 million additional cancellations over the course of the year. So at the end of the year, you've given up 15% of your subscriber base in order to charge the rest 25% more.

    Then you have to think about the 55-60 million broadband households in the U.S. that don't have Netflix. By definition, these people aren't willing to pay $8/month, so at $10/month they will be even harder to win over. The end result is that you get a quick bump in revenue and earnings, but higher churn and lower new subscriber acquisition... i.e. much slower growth.

    I think that's why Netflix's management has been so opposed to raising prices. A price increase on Jan. 1 could probably take Netflix from $2 of EPS this year to $6-7 next year. But subscriber growth would fall off so much that Netflix could be a $200 stock (or less) when all is said and done.

    Adam
    Nov 18, 2013. 10:43 AM | 2 Likes Like |Link to Comment
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