Forecasting of the income statement

6.2.0.1 Revenue growth

The most critical input in forecasting, especially for high growth firms, like Netflix, is the revenue growth rate. This matter is because the revenue growth is the foundation when forecasting future results (A. Damodaran, 2012). Firstly, we will analyze the development of the historical revenues within the firm to forecast the revenue streams. Since Netflix has gone through tremendous changes during the last ten years, and since the video entertainment industry is highly innovative, we have chosen to weight the years for the analysis. The latest years will have the highest weights because these numbers are most relevant for our forecast. We have chosen to use the following weights:

Table 6.1: Annual weights

Year 2013 2014 2015 2016 2017 2018 Weights 0.04 0.09 0.14 0.19 0.24 0.3

Except for lower growth in 2015, Netflix’s revenue growth has been increasing over the historical period.

From the external strategic analysis, we concluded that the subscribers are quite price-sensitive, despite this Netflix’s disclosed that they intend to increase the price of the Standard plan with 18% (Rodriguez,

2019). Netflix cannot keep adjusting its subscription price by this much on an annual basis, and consequently, we expect the revenue growth after 2019 to primarily be driven by subscription growth.

By looking at the subscription analysis, the subscription growth has been the main driver for the increase in revenue, even though Netflix has increased its subscription price during the period. The weighted revenue growth average for Netflix in the period has been 30.73%, which signals that Netflix is a high growth firm. Furthermore, most of their costs are related to their content production and licensing of content, which is relatively independent of the number of subscribers. Hence, as the subscriber base grows, the costs will be relatively stable, indicating that it is crucial for Netflix to focus on subscription growth. As seen from the profitability analysis, the net operating margin in the Entertainment industry was 13.5% in 2018, while Netflix had an average of 10.16%. Netflix’s net operating margin is accordingly under the industry average, and to increase the operating margin, Netflix must focus on subscription growth.

If we look closer at the different segments of Netflix, which is Domestic and International streaming and Domestic DVD, we observe that they all have different growth rates during the historical period.

This circumstance is because the growth rate in the segments is affected by various factors, as well as the segments are in different stages of the product life cycle. Hence, we will examine the subscription growth opportunities in each segment.

6.2.0.2 Domestic DVD segment

Netflix’s Domestic DVD segment has had an increasing decline throughout the forecasting period, with the weighted average revenue growth of -17.03 %. In 2018, the Domestic DVD only represented 2.31 % of Netflix’s total revenue. The annual report states that the segment will continue to decline in the future. Netflix has announced that the company will continue to run this segment since there is no reason for them to eliminate the division as long as it remains profitable (Netflix, 2018). However, as the technology is changing at a rapid pace and the DVD segment has had a steady decline each year, we predict that the Domestic DVD will exist for only a few more years. This matter is also stated in a report in Variety, saying that Netflix has lost approximately 190 000 DVD subscribers every quarter for the past three years (Evangelista, 2018). Based on this, we forecast the DVD segment to exist in the first three years of the forecast period, with an increased decline during those years.

Table 6.2: Revenue growth 2019-2029, DVD segment

Year 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 Revenue growth -20% -27% -35% n/a n/a n/a n/a n/a n/a n/a n/a

6.2.0.3 Domestic streaming segment

As stated in the external analysis, the competitiveness in the industry will transition with the new substitutes and entrants. Both Disney and AT&T will enter the streaming industry by the end of 2019.

They both have competitive advantages as they have been suppliers within the industry. Both companies have the benefits of being large corporations with many resources, including financial support, which can help them provide lower subscription price compared to Netflix and other services. Additionally, their content is known by most users, making it easier to enter the market.

Netflix is heavily focusing on original content, and we predict that this will continue to attract new subscribers as well as keeping the existing once. There has been an enormous increase in viewing of original content and the heightened popularity and demand for original content will continue to expand in the coming years. The use of Big Data and algorithms in value creation will be improved in the future as Netflix continuously collect data. A result of this will be more attractive shows, better user experience on the interface, and higher subscription numbers. Additionally, increased focus on interactive television may lead to better usage of Big Data and algorithms as the interactive television reveal more details and preferences of the users. Furthermore, the AI technology solving the password sharing issue is being tested on several pay-TV services, and will soon be available as a solution for Netflix. We predict that this technology will be implemented by Netflix shortly, which will increase the subscription numbers, as people previously using other people’s account will have to buy their own subscription.

When an industry has high growth, and the competitors have high profits, it is an attractive market for new entrants, and eventually, high competitiveness in the industry will eliminate the growth. Other important forces that will have a significant impact on the industry in the future is taxation on streaming services as well as net neutrality. The law does not tax streaming services in the US market as of 2019. However, some states have started introducing taxes on streaming services, and there might be many changes in taxation in the future. Net neutrality is additionally an essential aspect for the competition in the market as this controls how much the ISPs, the suppliers of the networks, can control and discriminate in the industry. Net neutrality is especially essential when AT&T, being a ISPs, enters the industry. The laws around net neutrality might change in the future, as the laws have changed over the years, and many are against the no net neutrality that exists today.

The domestic streaming segment has had a weighted average revenue growth of 22.62 %. The increase has been relatively stable throughout the period. We expect that the revenue growth will have the most significant decline in the first few years, based on increased competition from new and existing competitors. For the medium and long run, we expect the growth decline to slow down, however

continuing until the terminal period. This assumption is based on increased popularity on original content, Big Data and algorithms continually improving as well as the AI technology solving password sharing issue, as mentioned in the strategic analysis.

Table 6.3: Revenue growth 2019-2029, Domestic streaming segment Year 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 Revenue growth 17% 13% 7.0% 6.0% 5.0% 3.0% 3.0% 3.0% 3.0% 2.0% 1.0%

6.2.0.4 International streaming segment

The highest growth has been in the International streaming segment with weighted average revenue growth of 59.13 %. This growth has been a result of the worldwide expansion in 2016, and the continuous development of international country-specific shows. Since the global expansion started took place in 2016, it can be argued that the full effect has not been extracted yet. It takes time before the company can fully integrate into the different countries and Netflix is continuously producing and licensing new country-specific shows that will affect the subscription numbers. Likewise, improvements with features like better translation in several more languages may also boost subscription numbers.

It takes time to develop up the same brand equity that Netflix has in the US market in other parts of the world, and when this is more integrated into the different countries, it may positively affect the subscription numbers. If for example, Netflix can expand to China, as the world’s biggest market, it could mean high future growth. However, the company has stated that they will not target the Chinese market until it opens up to more Western companies, we, therefore, predict there to be small chances of Netflix entering the Chinese market within the forecasting period.

As mentioned in the domestic segment, increased popularity for original content, Big Data and algorithms continually improving as well as the AI technology solving password sharing issue, will positively affect the international segment. Besides, as mentioned in the external analysis, the EU implemented the removal of geo-blocking at the end of 2018, now allowing all Netflix content to be available across all EU countries. We predict that this will have a positive effect on the subscription numbers in the short run, as the Netflix library will be significantly more extensive across the EU. Hence, we expect the short term to have high, but decreasing growth, because of competitiveness.

In the medium and long run, we expect the growth rate to decline similar to the domestic market.

Eventually, the new entrants in the domestic market will expand internationally and hence decrease Netflix’s growth. This competition in the market will reduce the operating margins and subscription adds, leading to a lower growth rate in revenue.

Table 6.4: Revenue growth 2019-2029, International streaming segment Year 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 Revenue growth 42% 35% 29% 27% 25% 23% 20% 15% 10% 5.0% 2.0%

The total revenue growth in our forecasting period will be the following:

Table 6.5: Aggregated revenue and revenue growth 2019-2029

Year 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

Revenue 20,289,637 25,241,431 30,200,685 35,906,988 42,590,466 49,978,341 57,865,864 65,012,998 70,593,374 73,716,520 75,052,633

Growth 28.46% 24.41% 19.65% 18.89% 18.61% 17.35%15.78% 12.35% 8.58% 4.42% 1.81% 1.00%

6.2.0.5 Cost of revenue

Cost of revenue, including content costs, as a percentage of revenue, has decreased during the period, from 70.48 % to 63.11 %. Cost of revenue includes expenses associated with content production, acquisitions, licensing and production of streaming content and other costs of revenue.

Cost of revenue consists of more than 75% content costs, which is a substantial cost for the firm. As stated previously, the costs are relatively independent of the subscription numbers, and the company will need to spend money on content no matter how the subscription growth, however, we expect the cost to continue to decrease similar to the historical period. Cost of revenue as a percentage of revenue has a weighted average of 66.06 %, however having a downward trend in the last three years. We predict that the cost of revenue will continue to decrease as a percentage of revenue in the forecasting period.

In the external analysis, we learned that investment in original content cost more up front but will lead to cost savings in the long run since the original content is overall cheaper than licensed content.

Netflix has just started with the digitalization of the content production, and as the development evolves, it will arguably have a positive effect on cost savings. Correspondingly, improvement of value creation from Big Data and algorithms will likely lead to reduced cost, for example through the translation system HERMES. Furthermore, we predict that content production will decrease during the forecasting period since subscribers only have demand for a certain amount of shows and movies. We will also use the streaming content obligations, which is stated in the annual report when forecasting the cost of revenues.

Table 6.6: Cost of revenue 2019-2029

Year 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

CoR 59.42% 57.13% 54.49% 50.78% 47.49% 43.82% 41.75% 40.64% 40.24% 40.39% 41.24%

6.2.0.6 Other operating costs

We predict that the other indirect operating costs, marketing expenses, technology and development and general and administrative will be relatively stable compared to revenue. The high range of substitutes and other streaming services generate a need for advertisement and marketing for Netflix to remain relevant. Consequently, the high marketing expenses will remain in the forecasting period. Considering technology is of great importance in the industry, and the different technological tools are rapidly changing, it is resulting in continued stable cost for technology and development. Hence, we predict that these expenses, as a percentage of revenue, will grow during the forecasting period, as a result of heightened rivalry in the industry.

Table 6.7: Other costs 2019-2029

Year 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 Other costs 27% 27% 27% 30% 32% 33% 33% 33% 33% 33% 33%

6.2.0.7 Amortization & Depreciation

Amortization and depreciation are relatively independent of the subscription numbers, and the company will need to spend money on this no matter the subscription growth. Amortization and depreciation as a percentage of revenue have a weighted average of 0.69%, with a downward trend in the last three years.

Due to increased subscribers and scale of economy, we predict that the amortization and depreciation will continue to decrease as a percentage of revenue in the forecasting period.

Table 6.8: Amortization of revenue 2019-2029

Year 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 Amort. 0.50% 0.48% 0.46% 0.43% 0.40% 0.37% 0.36% 0.35% 0.34% 0.33% 0.33%

6.2.0.8 Tax

The corporate tax rate changed from 35 % to 21 % in 2018, and since there are no predictions that the corporate tax rate will change in the future, we will base our forecast on the historical numbers.

Accordingly, we will use the effective tax rate, which has had a weighted average of 7.51 % throughout the forecasting period.

6.2.0.9 Net financial income

Net financial income as a percentage of net interest-bearing debt has had an average of 4.67 % during the historical period, and we will use this average throughout the forecasting period. Looking at the

NFI as a percentage of revenue, this corresponds to a decreasing percentage throughout the forecasting period, as we predict the net interest-bearing debt to decrease.

Table 6.9: Net financial income 2019-2029

Year 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

Net fin. income 3.08% 2.57% 1.40% 0.93% 0.75% 0.56% 0.47% 0.47% 0.47% 0.37% 0.37%

Table 6.10: Forecasted Income Statement

2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

Revenue 20,289,637 25,241,431 30,200,685 35,906,988 42,590,466 49,978,341 57,865,864 65,012,998 70,593,374 73,716,520 75,052,633 Cost of revenue 12,056,102 14,420,430 16,456,353 18,233,568 20,226,212 21,900,509 24,158,998 26,421,282 28,406,774 29,774,102 30,951,706 Gross profit 8,233,535 10,821,002 13,744,332 17,673,419 22,364,254 28,077,832 33,706,866 38,591,716 42,186,600 43,942,418 44,100,927 Sum other operating expenses 5,478,202 6,815,186 8,154,185 10,772,096 13,628,949 16,492,852 19,095,735 21,454,289 23,295,813 24,326,452 24,767,369 EBITDA 2,755,333 4,005,815 5,590,147 6,901,323 8,735,305 11,584,979 14,611,131 17,137,426 18,890,787 19,615,966 19,333,558 Sum amort. & deprec. % revenue 101,448 121,159 138,923 154,400 170,362 184,920 208,317 227,545 240,017 243,265 247,674 EBIT 2,653,885 3,884,656 5,451,224 6,746,923 8,564,943 11,400,059 14,402,814 16,909,881 18,650,769 19,372,701 19,085,884

Tax 199,428 291,915 409,636 507,002 643,618 856,665 1,082,309 1,270,704 1,401,524 1,455,774 1,434,221

NOPAT 2,454,457 3,592,741 5,041,588 6,239,921 7,921,324 10,543,395 13,320,505 15,639,177 17,249,245 17,916,927 17,651,663 Financial income, net (625,367) (648,326) (423,112) (335,371) (318,236) (280,079) (270,234) (303,611) (329,671) (275,405) (280,397)

Tax financial income 46,994 48,719 31,795 25,202 23,914 21,047 20,307 22,815 24,773 20,695 21,071

Financial income after tax (672,361) (599,607) (391,317) (310,170) (294,322) (301,125) (249,927) (280,796) (304,898) (254,709) (259,326) Net income w/o extraordinary items 1,782,096 2,993,134 4,650,271 5,929,751 7,627,003 10,242,269 13,070,578 15,358,381 16,944,347 17,662,218 17,392,337