Bill Ackman's NEXT Billion Dollar Bet

Billionaire investor Bill Ackman has the power to move markets with what he says. Unlike most investors, he rarely buys and sells stocks. That is why it is a big event when Bill Ackman announces a new investment he has made within his closely followed Pershing Square fund that he runs. Recently, Ackman announced via Twitter that he bought more than 3.1 million shares of the company Netflix. This stake is worth over one billion dollars and makes Ackman and his fund one of the largest shareholders in Netflix.

Now, I'm not going to lie; as someone who closely follows Bill Ackman's portfolio and investment strategy, this investment frankly came as a little bit of a surprise. This is because Netflix is a tech company, and in past interviews, Bill Ackman has said that he doesn't invest in tech companies. So that raises the billion-dollar question: Why did Bill Ackman invest in Netflix? Thankfully for us investors, we have the answer and don't need to speculate. Ackman put out a three-page letter detailing his thought process around investing in Netflix. I went through the letter line by line and will be providing the main takeaways that you need to know in this video.

Even more important, I will include what takeaways you can apply to your own investment portfolio and research process. All I ask for in exchange is for you to hit that like button. Seriously, that's all I want. Okay, now let's get into the analysis.

Netflix stock has struggled in recent months. The stock was trading around 690 dollars a share just a few months ago, in November of 2021. Now, the stock has fallen nearly 50 percent and was hovering around 370 dollars a share when Ackman announced that his fund had purchased a significant stake in the company. Here's what Bill Ackman had to say about it: "We acquired more than 3.1 million shares of Netflix Inc (NASDAQ: NFLX), making us a top 20 shareholder in the company. The opportunity to acquire Netflix at an attractive valuation emerged when investors reacted negatively to the recent quarter subscriber growth and management's short-term guidance."

Netflix's substantial stock price decline was further exacerbated by recent market volatility. As Ackman alluded to, Netflix stock crashed by nearly 20% almost instantly when the company reported that its growth in the number of subscribers it had was lower than what Wall Street analysts had expected. Even worse, management's estimate for subscriber growth for 2022 was lower than what many investors had anticipated.

Netflix was around a 225 billion dollar market cap at the time it released earnings. This means that the 20% crash in Netflix's stock price caused the company to lose over 40 billion dollars of its market cap value almost instantly. This dramatic fall in the stock price presented Ackman with a buying opportunity.

I think this is one lesson that other investors can take from this: develop a watch list of companies that you like and think would make great investments if the price for the stock was right. While the price for the stock may be too high to purchase right now, this situation with Netflix shows how quickly things can change, and you have to be ready to act quickly. This is what Ackman had to say about that: "We have greatly admired Netflix both as consumers and as investors but have never previously owned a stake in the company."

Netflix is a primary beneficiary of the growth in streaming and the decline in linear TV, driven by superior customer service, a vast and diverse amount of superb, constantly refreshed content, global improvements in bandwidth, and the proliferation and continuous improvement in convenience of devices on which one can watch.

Speaking of researching and developing watch lists, that brings me to this video sponsor, Quarter. I reached out to Quarter to sponsor this video, as my research process for this video is made way easier by using the Quarter app. I was able to read through earnings call transcripts for Netflix and see what Wall Street analysts were saying about the company. The best part of this app is that it is completely free. Download the app at the link in the description.

Okay, now back to the video. Now Bill Ackman may have gone to Harvard, but you don't have to have a degree from Harvard to figure out why he would like a company like Netflix. It's subscription-based, highly recurring revenues, which have enormous future growth potential. Subscription-based business models have become extremely popular with investors and have gotten a ton of attention in recent years. Honestly, a lot of that attention is deserved.

To demonstrate just how powerful a subscription-based business model can be, let me demonstrate it using the most simple business of all time: the classic lemonade stand. In this example, we are going to have Jack and Jill. Jack has a lemonade stand on the side of a busy street. How many glasses of lemonade he sells on any given day depends on a variety of factors: the weather, how many people walk by his lemonade stand, and even whether or not people are carrying money to be able to pay for the lemonade. Jack starts out each week with zero sales and hopefully he's able to make sales throughout the week.

On the other side of this example, we have Jill, who also has a lemonade stand on the side of the road. However, in addition to the lemonade stand, Jill has been very effective at marketing and has a unique strategy. She also has customers who get one gallon of her lemonade at the start of the week delivered directly to the customer's house. Every week, Jill is able to add a couple of more customers to the subscription lemonade service. Let's say Jill has 50 customers that are subscribed to her weekly lemonade delivery service. This means that every week, Jill knows she's going to have at least 50 sales of her lemonade from the customers on her subscription list.

Compare that to Jack, who, like I said earlier, starts out with zero sales each week. This example, although very simplified, shows the power of a subscription-based business model. You don't have to go out and win customers every single day like Jack. With a subscription-based business model like Jill's, you win a customer once by having them join the subscription, and they are a customer every single week or month.

In the case of Netflix, they have over 215 million subscribers. Let's say that each subscriber pays 10 dollars a month. This means that Netflix starts out with 2.15 billion dollars in revenue per month without winning a single customer. Subscription business models benefit from this little aspect of human behavior psychologists call "the law of least effort." Notice how once you are signed up for Netflix, they bill you automatically. Imagine how much lower the renewal rates would be if you had to enter your credit card information every single month to renew your subscription. Since the subscription automatically renews and the amount you pay is a relatively small amount of money, most people don't even notice it.

Subscription models are so powerful because most of these consumer subscription companies have customers that forget they are customers but still pay every single month. Not a bad thing if you're a Netflix shareholder. A truly best-in-class management team and unique high-performance culture. Netflix's founder, Reed Hastings, wrote a very well-received book that had the words "Netflix and the culture of reinvention" in the title. A great way to sum up Netflix's culture is reinvention. Bill Ackman, in the past, has not invested in technology companies for this reason. While a tech company may have the most dominant technology and product right now, that doesn't mean that will be the case five years from now.

The list of technology companies that were once winners that quickly fizzled out and struggled includes names like Nokia, Kodak, Blackberry, Yahoo, and even the legendary IBM. But this is the nature of technology: what is modern technology today will be legacy technology in the not-so-distant future. As a result, it is difficult to predict the operating results of a tech company five to ten years into the future, like Ackman likes to do for his investments. This is why his portfolio consists of companies like Lowe's, a home improvement retailer; Chipotle, a fast casual restaurant chain; and Hilton, a hotel chain.

But Netflix isn't the typical technology company in the sense that it has successfully pivoted multiple times throughout the company's life. Netflix started out as a DVD rental company by mail. You would order what DVD you wanted, and Netflix would ship it to you. Extremely innovative for the time. The first pivot came when the company transitioned from this business model to streaming, where the content library could be accessed by the customer instantly to view over the internet. Then came another pivot: Netflix quickly realized that by only offering other companies' movies and TV shows, there is nothing truly unique about their offering, and it could be easily replicated by competitors. So this is when Netflix decided to begin developing their own exclusive content, only available on Netflix.

Netflix has gone all in on developing original content, so much so that the company spent 17 billion dollars developing its own content in 2021. It's very rare that a company can make one pivot, let alone two pivots like Netflix; and Ackman believes this is a direct result of Netflix's culture, economies of scale, and superb quality in its industry-leading content, which should continue to drive future growth and widen the company's powerful competitive moat.

Netflix's moat, or put another way, its competitive advantage, is the company's original content. The ability of Netflix to spread its costs and develop this original content is a perfect example of economies of scale. Let me show you what I mean: Let's say Netflix has to spend 20 billion dollars every year on developing original content. Let's see for this example Netflix's subscriber base is 200 million people. When we take that 20 billion dollars in spending and divide it by the 200 million subscribers, that means Netflix is paying 100 dollars per subscriber every year to develop the original content.

Now, let's say Netflix is able to double its subscriber count over time, from 200 million subscribers to 400 million. Assuming the original content spending stays roughly flat at 20 billion dollars per year, this means that Netflix is now only paying 50 dollars per subscriber every year to develop the original content. This is a perfect example of what is referred to as economies of scale, which is just a fancy way of saying that as a company grows, it benefits from that size and the cost of providing its product or services to each individual customer decreases.

This is why, for streaming companies like Netflix, the number of subscribers is so important. The more subscribers Netflix has, the more people can use to spread out its original content development costs. Pricing power, derived from the enormous value it delivers to consumers compared with other alternatives. Netflix and other streaming services have led to a trend known as "cord cutting." This is where consumers cancel their pricey cable TV plan and instead opt to only have a streaming service. The current price for Netflix here in the United States is around 15 dollars a month.

Now I'm on the younger side, at 24 years old, so I personally have never had a cable plan. However, I do know that my parents pay something like 80 to 100 per month for their cable package. Frankly, I would rather have a streaming service like Netflix than cable, even if the price for both was exactly the same. This provides Netflix a huge opportunity over time. Netflix's revenue is a simple equation: the number of subscribers times the price each subscriber pays. Most of the growth in Netflix's revenue has come from growing the subscriber part of that equation.

However, how much value the Netflix service brings to its customers, Netflix may be able to seriously grow its revenue by increasing the price part of the revenue equation. If Netflix is able to raise its price by one dollar for its monthly subscription across, let's say, 200 million customers, that's an additional 200 million dollars in revenue each month. How many people do you think would cancel their Netflix subscription just because it was one dollar more expensive? The Lachman's bet is not very many. This means Netflix could generate an additional 2.4 billion dollars, which is 200 million dollars times 12 months, in revenue each year just by raising its monthly subscription cost by a measly dollar. Not bad at all.

Substantial margin expansion, with the opportunity for continued improvement due to economies of scale and the company's rapidly growing global subscriber base. This next point here ties in pretty well with the point about pricing power. The great thing about Netflix being able to generate an additional 2.4 billion dollars in revenue simply by raising their monthly subscription price by a dollar is that the vast majority of that revenue is going to fall down to the bottom line of the company's profit. Think about it: when Netflix raises the cost of their subscription service by a dollar, what is the additional cost that the company incurs as part of doing that? Pretty much nothing.

They already have spent the marketing dollars acquiring the customer and the billions of dollars creating original content. Compare that to Netflix instead growing revenue by acquiring a new customer. I've seen estimates that say it costs Netflix around 150 dollars to acquire a new customer. This is because it takes marketing and advertising to convince a customer to sign up for the service. This is why it is very costly and expensive to build the subscriber base. Just use Disney as an example, with the company spending billions of dollars to build out its Disney+ service.

However, in the case of Netflix, the true magic of the business model happens when they are able to raise prices for the large customer base they have already acquired. An improving free cash flow profile should allow for continued investments and growth as well as the return of cash to shareholders. As you can imagine, building out such a large subscriber base and a library of original content is not cheap. Netflix's free cash flow was negative 900 million dollars in 2015, negative 1.6 billion dollars in 2016, negative 2 billion dollars in 2017, negative 2.9 billion dollars in 2018, and negative 3.1 billion dollars in 2019. The company was able to turn the corner and generate nearly 2 billion dollars in free cash flow in 2020.

However, in 2021, the company went back negative and had free cash flow of negative 100 million dollars. Bill Ackman's thesis is that the company will be able to generate a ton of free cash flow moving forward based on all the other things we talked about so far in this video. Things such as continuing to grow subscribers, spreading out its original content development costs over a larger subscriber base, and raising prices for its services over time. All of these things, if Netflix is able to accomplish them, would make for a very profitable company and allow Netflix to generate a ton of cash flow for shareholders.

With all of that cash flow, Netflix could continue to reinvest in the business and develop more original content and grow the subscriber base. Or if Netflix starts generating more cash than it knows what to do with, the company could start repurchasing shares or even pay a dividend. All of these things can be very favorable for shareholders.

So there you have it! Let me know your thoughts about Bill Ackman's investment down in the comments below. I'm curious to hear what you guys think. As always, thanks for watching the video. Make sure to like this video and subscribe to the Investor Center if you aren't already because it is my goal to make you a better investor by studying the world's greatest investors. Talk to you next time.