Figure 4.1: Advanced DuPont Model
Source: Own contribution based on Petersen & Plenborg (2012)
4.1.0.1 ROE
ROE addresses the added value from the owner’s perspective (Petersen & Plenborg, 2012). The ratio indicates what shareholders earn on their investment. The ratio is a composition of RNOA, Leverage, and net borrowing cost. Netflix’s ROE has fluctuated between 2.96% and 25.58 % over the past five years. The average ROE in this period is 12.54 %, and ROE has over the period had a growth of 91.8
%, indicating a healthy development. A company with growing ROE is desirable as it indicates that the company has high profitability. The ROE shows that Netflix generates a return to their investors, which makes the company an attractive investment for potential shareholders. Netflix delivered an ROE of 25.58% in 2018, which is way above the industry average of 13.4% (A. Damodaran, 2019).
Netflix’s ROE as of 31. December 2018 also exceeds both Disney’s, AT&T’s and Amazon’s ROE of 20.5%, 13.5% and 27% (SimplyWall.st, 2019) & (MacroTrends, 2019).
Immediately, it seems as though Netflix has made substantial profits from a small amount of equity.
However, ROE does not provide us with enough information to determine the underlying drivers. In the following sections, we decompose ROE in order to understand if the higher net operating margins, higher net operating asset turnover, or higher debt drive the changes in return. Figure 4.3 displays ROE, the drivers, and their trend lines.
Figure 4.2: Drivers of ROE
Source: own contribution
4.1.0.2 Return on Net Operating Assets (RNOA)
Return on Net Operating Assets is the return on operating activities not affected by firms’ level of debt, i.e., financing decisions (Madison, 2017). The ratio is a good indicator of how well a company uses operating assets to create revenue. The equation below illustrates the formula for the ratio:
RN OA= N OI(N et Operating Income)
N OA(N et Operating Asset = N OI
Sales ∗Sales
N OA (4.1)
As seen in equation 4.1, RNOA can be divided into Net Operating Margin and Net Operating Asset Turnover. This decomposition is necessary to understand what drives the profitability of Netflix. RNOA has been declining in the period 2014-2016, due to a reduction in both Operating Margin and Operating Asset Turnover. RNOA has however increased between 2016 and 2018, despite a reduced Operating Asset Turnover, driven by an increase in Operating Margin.
Figure 4.3: Drivers of RNOA
Source: own contribution
4.1.0.3 Operating margins
The Operating Margin is expressed as a percentage of revenue and illustrates the revenue and expense relation for a company’s core activity (Petersen & Plenborg, 2012).
The Operating Margin of 10% is considered low compared to a gross margin of 36.89% i 2018. It seems as the firm obtains a reasonable premium on its products, but its prominent marketing and technology and development costs drive their Operating Margin down. The cost of revenue is the most substantial cost for the company, with an average of 67.21% of the revenues. However, the cost of revenue decreased from 68% in 2015 to 63% in 2018. In addition to high content costs, Netflix has high marketing costs, which likely will remain high, as the competition in the market demand an aggressive marketing strategy for the firm to maintain its market share. The Operating Margin was at its lowest in 2016, mostly due to higher cost of revenue concerning the international expansion. In the following years, the Operating Margin had an increase driven by lower marketing costs and content cost in relation to revenue in 2017, and lower content costs in relation to revenue in 2018.
Netflix may be able to further increase its margin in the future by reducing its costs relative to revenue.
The reason this might be possible is that a high amount of their costs are related to their content production, which is mostly independent of their amount of subscribers. High growth in subscribers will, therefore, be an essential driver for Netflix future growth in Operating Margin. The operating margin in the Entertainment industry was 13.5% in 2018 (A. Damodaran, 2019), and AT&T, Disney, and Amazon had correspondingly 14% 17.78% and 4.33%. This fact indicates the potential for Netflix to raise its margins, by for example raising the monthly fees. In the long run, the high competition in the market will most likely lead the operating margin to converge towards the industry average.
4.1.0.4 Operating Asset Turnover
The Operating Turnover Rate explains if Netflix’s profitability is driven by improved capital utilization.
It is attractive to have a high turnover rate, as this characterize an efficient producer (Petersen &
Plenborg, 2012). The Operating Turnover rate for Netflix has decreased from 2.4 to 1.23 in the period, implying the firm has decreased its utilization. The reason for the massive drop in the turnover rate is an increase in the net operating assets, which has grown from 53.8 % to 103.1 % of revenue. The highest growth originates from the non-current content assets.
The increase in non-current assets is due to the international expansion, where Netflix has invested heavily in original content and country-specific content in order to meet the needs and trends from different countries. This post includes content that will be available for streaming in one or a few years, indicating that Netflix is continually investing heavily in future content which has not resulted in a proportionate growth in revenues. The firm’s profitability is therefore not driven by improved capital utilization. This is reasonable as the net margin has increased, and as there is a trade-off between asset turnover (cost leadership strategy) and net margin (product differentiation strategy).
4.1.0.5 Financial Leverage
Financial leverage can be used to see how sources of finance impact overall profitability. Spread is the difference between RNOA and the net borrowing cost, and a positive spread means that the financial leverage will improve ROE (Petersen & Plenborg, 2012). The financial leverage for Netflix was 0.44 and 0.8 the two first years of the period and had since then increased to 1.911 in 2018. This change is resulting from an increase in the long-term debt from 11.4 % of revenue in 2014 to 65.6 % of revenue in 2018. It is common in the streaming industry to invest heavily in distribution rights, marketing as well as the production of original content, which has led to high debt activities in the industry. Hence, we expect the financial leverage to continue to stay at this level in the future.
4.1.0.6 Spread and Net Borrowing Costs
The last component of ROE is the operating spread, which is the difference between the Return on Net Operating Assets and the net borrowing costs. Net borrowing cost measures the cost of net financial expenses as a percentage of net financial obligations, and the costs have fluctuated from 4.2% % to 10 % during the period. A higher net borrowing cost (NBC) is contributing to a higher spread and a higher ROE. In 2015 the Operating Spread was negative due to a higher NBC than RNOA, resulting in a drop in the ROE, which decreased from 2014 to 2015.
4.1.0.7 Summary profitability analysis
The growth in ROE is primarily due to the increase in financial leverage as well as an increase in operating margins in 2017 and 2018. A lower operating spread, as well as a reduction in operating margin and asset turnover, caused a reduction in ROE in 2014 and 2015. An increase in leverage is causing a lower operating asset turnover for the firm, as the increase in assets is higher than the increase in sales. Additionally, the Operating Margin is profoundly affected by the high costs concerning Netflix’s content productions. Overall, Netflix has had a positive development in ROE the last couple of years, mostly driven by an increase in leverage.