It’s 2001 all over again. Netflix is being bought just because everybody’s buying. Netflix shares sell like hot cakes, even though they’re not generating a dime. Likewise, Facebook’s acquisition of WhatsApp was received euphorically by investors, with its stock price rising despite a 10% dilution of shareholder capital. Although Facebook is already a loser’s game, its small cousin (WhatsApp) was bought at an even more irrational valuation. It’s exuberance and excess again, just as in 2001; price doesn’t matter and whoever stands on the sideline is a fool.
What the Euphoria Is All About
Let’s see what the Netflix-euphoria is all about. The stock is currently selling at an astonishing US$450.- per share (total market cap of over US$27 billion), up from US$50.- per share only eighteen months earlier. Its P/E-ratio equals 250 with reported earnings of US$ 1.84 per share.
Netflix’s business model is pretty straightforward: Netflix-subscribers pay US$7.99 per month for unlimited access to Netflix’s series on demand. Blockbusters such as Breaking Bad and House of Cards are part of Netflix’s collection.
Urgent: Subscribers from Outer Space Needed!
OK: a straightforward business model and, apparently, a straightforward way to measure profitability. So what’s the fuzz all about? Plain and simple: it’s about the speculation on (unlimited?) subscription growth.
Investors in Netflix have an almost irrational focus on total subscribers. But with over 30 million paid (US-based) Netflix-subscribers, the question arises how realistic the forecasts of investors are when it comes to paid subscription growth. Current valuations seem to indicate that each of the seven billion habitants of planet earth will have a Netflix-subscription anytime soon, although the opposite may be more likely. Traditional cable companies have stopped growing their subscription base at around 30 million; why will Netflix be the great exception?
How Many Subscribers Do We Need?
To put the numbers into some perspective: the US has about 120 million households. So already 1 in 4 has a Netflix-subscription. Given the fact that some people simply do not enjoy following Walter White’s tongue-lashings in the newest Breaking Bad, much less pay for it, there seems to be some rational limit as to U.S. subscription growth. A limit that is not only drawn by the persons that are indifferent to television series, but by the severe competition from traditional cable companies and new video-on-demand competitors such as Amazon Prime ($6.66 per month and lots of additional benefits to Amazon customers) as well. And then we’re still leaving illegal streaming and piracy completely aside.
The news that Netflix managed to outgrow HBO in paid subscribers sent the stock through the roof, even while Time Warner (the parent company of HBO), in stark contrast to Netflix, generates over 2 billion US$ free cash flow every year. Netflix’s free cash flow is … non-existent (and in my opinion it’s very doubtful whether it will yield bountiful cash in the near future). If Netflix was a grocery store, it’s cash register would get emptier each year. Only borrowing money assures Netflix has some spare change (and that’s exactly what Netflix has done, more on that later), but for how long can they continue like this?
Major Problem: Costs Are Enormous, Prices too Low
That Netflix is burning through its cash shouldn’t be a big surprise to a diligent investor. A quick look at past year’s cash flow statement reveals a negative free cash flow of US$16 million, or about 26 cents per share. This is mostly due to content costs: in 2011 they’ve spent US$2.3 billion, in 2012 US$2.5 billion, and in 2013 over US$3 billion on additions to its streaming content library. Now, if we take the current 31.7 million paid users and multiple them by $96 dollars ($7.99 a month), they actually yield less than what Netflix spent on its entire content library. It should be no surprise that the only reason their cash balance has increased past year, was due to an issuance of debt (US$500 million in 2013).
However, these charges are not reflecting the true content cost: both Netflix’s current and noncurrent content liabilities have increased together another US$700 million in 2013. Perhaps a diligent investor should take into consideration that Netflix’s content costs are on a trajectory to the moon; an observation that should worry any investor.
So, do we have any hint that someday Netflix’s content costs will come down while being able to keep up revenues? My conviction is that this is a sheer impossibility. Netflix needs good content to attract and retain subscribers and series generally have a high fad- and hype-factor (evidenced by the fact that Netflix now amortizes content with an increasing rate). Indeed, Netflix will generally have to pay dearly for every new season that is added. Not adding new seasons is an impossibility; it would break their business down in no-time and would lead to customer dissatisfaction.
To be somewhat worth its current valuation, Netflix should be able to generate at least US$ 1 billion of free cash flow ever year. That means an increase of at least 10 million subscribers, assuming no cost increases and no other costs than content costs. Utopia, of course, since subscription growth in the US will level off, and international expansion will initially cost more than it will take in revenues.
Down the Speculative Road…
Netflix is a competitor in a red ocean, not a blue ocean; they will have to continually acquire (new) content with increasing content costs and will suffer from high amortization rates due to binge watching— binge watching means people watch in less than a month all episodes and seasons of a billion-dollar television series.
To counter rising costs, Netflix tries a more speculative approach to content acquisition: it buys series in an earlier life phase when success is all but guaranteed. Their acquisitions are getting more and more speculative and some seem long-shots in a quest to keep its (potential) customers engaged. Customers are, after all, one click away from cancelling their subscriptions, especially after binge watching the entire Breaking Bad-series (which I strongly recommend, by the way, for those who haven’t seen it yet) on a free trial subscription.
Up Go the Rates, Down Come the Subscribers
Price increases seem inevitable and so does a subsequent subscriber loss. Remember 2011? Netflix offered a US$9.99-plan for both streaming and DVD, but when they announced separating streaming and DVD, offering both for US$7.99 each (which equals a 60% price increase), near to a million subscribers cancelled almost overnight. Customers are not quite “locked-in” to the service; they can change their mind in a whim and destroy Netflix’s earnings power (in so far we can call it that) within no time.
International expansion has been a losing proposition so far, and that’s a definite weak point in its business model: its licenses for series are geographically bound. So their business model is not scalable worldwide. If they want to conquer the European market, they’ll have to renegotiate with the series owners to get a new price for a license for streaming in Europe.
Why I’m Short Netflix — Q Ratio & Overvaluation
I’ll spare you the gory details of why I chose, among other stocks, to short Netflix in anticipation of a 30-40% correction in the S&P500. The equity Q ratio is perhaps the most robust indicator of overvaluation in the stock market. Fair value of Netflix — based on my always uncertain forecast of future cash flows — ranges roughly from $80 to $200 dollars, which means, at current prices, a drawdown of 55%, while according to historical data median drawdown on the S&P500 currently lies around 40%.
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