The streaming service Netflix (NASDAQ:NFLX) is ubiquitous, but investors sometimes have less knowledge about its history of splitting its stock. While a stock split doesn't change the inherent value of the underlying firm, some investors look at stock splits as a sign of management confidence in the business. It can also have an effect on liquidity in the option market for a firm, as the lower stock price makes 100 share lots (which is the minimum for options) accessible to more investors. Finally, they can be a near-term catalyst simply because investors think it's a catalyst. And that's a self-fulfilling prophesy if the split causes demand for the stock to go up.
Netflix Stock Split History
NFLX has done a stock split before, in fact they've split their stock twice. The first was only a couple of short years after their 2002 IPO, when they underwent a 2 for 1 stock split in 2004. Then, they didn't split the stock again until 2015 when they split 7 for 1. The 7 for 1 split followed a meaningful run up in the shares, and they traded up again on the announcement. I think it's reasonably likely that a split would be at least a short-term catalyst were they to announce one again.
Will Netflix Stock Split in 2021?
In my opinion, the best place to look for clues as to whether Netflix, Inc. will split their stock again is to consider the last time they split. The biggest clue last time they split was that they requested an increase in the number of authorized shares outstanding. This was necessary to complete the split, as the previous number of authorized shares was insufficient to split the stock, so they needed shareholder permission. However, that clue is unlikely to be helpful now, as the number of shares authorized is nearly five billion (see table below), while only about 442 million are outstanding at present. So they could even do a 10 for 1 stock split without needing to increase the number of authorized shares, and I doubt they would do a bigger split than that anyway.
Source: Netflix 10-K
A potentially more potent clue is the current share price. In 2015, Netflix shares were approaching $700 when they split last time, they closed at $681.17 pre-split on the day of the announcement. A variety of reasons were mentioned at the time, but most of them revolved around making the shares more accessible for investors. A constituency that seemed especially notable to me was Netflix employees, as it makes sense the company would want their share purchase plan to be accessible.
NFLX has a very unusual option plan for their employees. Unlike every other company I've come across, the employees (whose compensation is described as top-of-the-personal-market) actually have to purchase their stock options. I've included the slide from their employee benefits site below, but essentially Netflix employees pay 40% of the face value as an option premium for options with an at-the-money strike price and a 10 year expiry.
I think that's an exceptionally good deal, assuming their compensation is higher to account for the options not being free. Black-Scholes isn't reliable in my opinion for very long term options, and the longest available Netflix LEAPs (with less than 2 years of time remaining) trade for almost exactly 20% of face value for at-the-money calls. The next 8 years being the same price seems like a bargain to me. I suspect employees accumulating large amounts of very long term options (that they paid for!) is significant in both aligning interests and motivating employees.
Source: Netflix Employee Benefits Site
The notes from below this example are both interesting and relevant. Specifically the following:
Source: Netflix Employee Benefits Site
Netflix employees (who are paying for the options) don't get fractional options. And with the current stock price, each option costs over $200. I suspect for junior level or lower-paid employees, it might be de-motivating to see the number of stock options received from a potentially significant payroll deduction be only 1 or 2 options per pay period. I believe retaining and motivating qualified staff is likely a key strategic priority for a business with a limited supply of tangible assets, so I think they will eventually consider a stock split to make sure employees don't end up getting zero options in a pay period for their payroll deduction.
The exact timing is hard to predict, but I think if Netflix shares take another leg up at any point the company will almost certainly consider a stock split.
Is Netflix a Buy Now?
While Netflix is certainly not a traditional small cap value stock (which is mostly what I write about) it has a significant attraction in a market that is probably "winner-take-most." It seems to me that the streaming universe is likely to end up carved up between a very small number of winners, with smaller players forced to either sell out to the winners or combine for scale in some sort of bundle. But the economics of a bundle are less appealing because the payments have to be shared between services, and also with some sort of bundler. Verizon (VZ) seems to be pursuing a bundler strategy, and that might make it hard for smaller services to avoid paying for distribution. By contrast Netflix has enough scale in the market that consumers will probably continue to purchase a Netflix subscription even outside a bundle, which either improves the lifetime customer value to Netflix OR enables them to charge less to customers improving the customer value proposition.
That's a pretty meaningful competitive advantage from being the leader, and I haven't even mentioned the main advantage of being the biggest, which is that they can amortize content investments across a larger base of subscribers. That should allow them to pay the most for any piece of content.
And that scale benefit extends into niche content types as well. Guggenheim noted that they have a significant advantage in pursuing regional content as well. That should allow them to continue to draw both subscribers and content creators in regional markets, increasing their critical mass worldwide.
It makes sense for a firm with those significant competitive advantages in a worldwide market to trade at a high valuation because it's a great business. Growth continues to be fast, and in fact subscriber additions have been accelerating in recent years.
Source: Netflix 10-K
They could slow their growth and still double subscribers within 7-8 years. They have also been taking operating margin gains, even without significantly raising prices. Operating margin went to 18% in 2020 up from 13% in 2019 on a 1% increase in average revenue per user. If we assume that in 7 years they have 400 MM subscribers with a net income margin of $5 per subscriber per month that implies earnings of $24 billion per year. That level of income per subscriber will require both operating leverage and price increases, but they've demonstrated both recently without issue. At 20X earnings that would imply a value in 7 years of $480 billion. I'm neglecting their debt here, which should be covered by their current cash and future cash flow generation.
I always use a 10% discount rate for equity investments, and discounting that $480 billion by 10% for 7 years gives a present value estimate of $230 billion. The current market cap is $238 billion, so effectively they are trading at my estimate of current fair value.
While my estimates for subscriber growth and margins 7 years out are 100% likely to be wrong, I think it is useful to have an idea about what kind of long term assumptions are required to justify the current market price.
I don't think doubling the subscriber base is an aggressive assumption, especially if they get more aggressive on users sharing passwords, as has been reported. The margins side is a bit tougher to forecast, but their operating leverage has been meaningful. If they can start to bend the curve on content development costs they should be able to achieve that level of profitability per subscriber.
Conclusion
I think Netflix is trading at approximately its fair value, so I don't own any shares at present. It wouldn't take a big decline in the share price to have me interested. That said, I do think that if they split the shares, that would be a near-term catalyst, so those who are considering buying may want to layer into a position ahead of that possible news.
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