My reflection of Netflix’s Valuation — Still Relevant after 3 Months
Note to readers: This is a translated work which I first published on Nov. 3rd 2018 through my Chinese social network, Wechat Official Account page. You can check that out as you wish:
In the link above, I stated that I first had noticed the problems of Netflix in summer 2018 and started to short NFLX shortly after. In the following 4 months, NFLX dropped almost $200 from its high of $413 to $315 (when I published the article on Wechat) and then further down to $ 233 in December. Furthermore, in the last two earning seasons, NFLX was down more than 5% in the trading session following each of the last two earning releases, despite an overall market bounce back.
Some of the numbers may not be accurate today since I am too lazy to update the numbers based on the latest earning report, but I do feel the arguments are still relevant. Thus, I had my investment thesis translated and I hope it can now appeal to a broader audience. Some explanations or modifications that are added to the translated essay to give readers correct time perspectives. Those notes are italic and in parentheses.
Netflix has grown exponentially in popularity in the past few years. If you’ve been holding Netflix shares since 2013, by now you must have made tremendous profits. Even if you didn’t start investing in Netflix until the beginning of 2018, by the end of July last year, you would have secured a return of 118 percent. Many people were caught by surprise, however, that Netflix had plunged more than $140 per share in less than 125 days since July 2018 (till Nov. 3rd). Even more surprisingly, a week after Netflix released its latest quarterly report (Q3 2018), its share price plunged $100. What happened and why?
Is Netflix a tech company or a media company?
On a Sunday night in late June, I was having dinner with my friend in Midtown, NYC. I asked him if Netflix was overvalued. He replied that “if Netflix is a tech company, it’s not overvalued; if it’s a media company, then it is.”
That answer trigged my thoughts. Yet, how could I determine if Netflix is a high-tech corporation? To do that, I gathered some information from the annual reports of Netflix, Facebook and Google in recent years and made a comparison.
What I found was that Netflix’s investment in technology and equipment is far less than that of Facebook and Google, and Netflix’s spending on R&D and technology never exceeds 10 percent of its revenue. Most of Netflix’s expense is on marketing and content production — especially after it adopted the “original content strategy”. In contrast, Google’s investment in R&D last year (fiscal year 2017) was 15 percent and its investment in marketing was 12 percent; Facebook invested 19 percent in research last year (fiscal year 2017) and 11.6 percent in marketing. If Netflix qualifies as a tech company, then so does Disney! But why does one company have a P/E ratio of 80 whereas the other has only around 15?
In fact, a media (production) company generally has a low valuation, which is also true in the Chinese market. This is because the company’s revenue is often unstable. If the media company managed to produce some popular shows, such as “House of Cards,” the company’s quarterly revenue would probably skyrocket. On the other hand, if a production lacked in viewership, then previous investment would become a fruitless attempt. Of course, marketing strategies and publicity can help boost viewership, which is true for Kevin Spacey’s ‘Billionaire Boys Club.’ But investors generally don’t like this kind of uncertainty. Incidentally, Netflix’s quarterly report depicts an unstable performance.
Only growth matters
The chart below comes from Netflix’s Q2 shareholder letter, which lists Netflix’s quarterly forecast of user growth as well as actual user growth per quarter since 2016. If we take into consideration Netflix’s latest 6.96 million forecast for the third quarter of 2018 and the actual 5 million user growth, Netflix has a standard deviation of 1.1 million in predicting user growth. That is to say, the guidance given by the management team is very unreliable. They don’t know how many new users Netflix generates in each quarter, nor do they know where new users are coming from, and why are they here to stay.
For investors, however, their investment reasoning has been backed by Netflix’s user growth, especially after Netflix transitioned into streaming services. But in the case of Netflix, the statistics of user growth are too misleading, and even the management team fails to explain why sometimes there is one million more and sometimes one million less.
In its recent Q3 earnings report, Netflix’s management team emphasized that the growth of total users is not a good indicator of the company’s growth potential, and therefore they will only provide the guidance for paid membership from now on. I looked at Netflix’s 2011 annual report to find data regarding paid membership in each quarter. According to my research, that growth rate is indeed very stable — even though it is a steady downward trend
Pay attention to the fluctuation occurred at the beginning of 2013. The first season of “House of Cards” was aired in February 2013.
Let’s take a look at Netflix’s third quarter report in 2018. Netflix’s user base has increased by 400,000 in the U.S. market, or 55 percent more than expected. This expansion is a huge beat even in the international market. But there is a hard question we need to answer. If this increase is driven by users who actually spend money to subscribe, why the revenue missed the target? Although Netflix’s approach to net adds remains to be studied, it’s true that some of its users do not need to pay for their subscriptions. In late 2017, Netflix and a telecom operator inked a partnership to offer free Netflix membership to some users. If I am one of these lucky users, I will definitely watch Netflix happily — until the company starts to charge me a subscription fee. There are quite a few Netflix promotions like this — especially at times when the U.S. market has almost reached saturation and the input as well as output from foreign markets are relatively low. As a result, it’s not difficult to understand why new ARPU has hardly improved for Netflix (Average Revenue Per User, regardless of the price increase factor, which is a common problem for platform-like C2C companies. I will discuss this in later series).
Moreover, Netflix has not disclosed the average amount of time these users spend on Netflix, nor how long will they keep their subscriptions. Based on data retrieved from an online site that analyzes website traffic, the traffic on Netflix had a downward trend in the past six months. If the total number of subscribers really increased, then the average time spent by each user on Netflix had significantly declined, while the traffic on websites that compete with Netflix had surged. This is not a promising sign.
The capital market doesn’t care about romantic idealism. In only believes in profit and ROI. If the market believes in idealism, people would not say that iron man Elon Musk has mental disorder. If the market believe in idealism, how can Tesla’s market value (I will talk about Tesla as well, cautious bullish on Tesla now) is only one-third of that of Netflix! Tesla generates more revenue than Netflix does, but why is Netflix more expensive? The long-standing answer for most people is: Tesla misspends money and doesn’t make money. Netflix has earnings, and its earnings often surpass expectations.
In some quarters, it is indeed true that Netflix’s user growth, sales and net profit can be significantly higher than expected, realizing a Triple Kill. But if we take a closer look at Netflix’s cash flow statement, it’s hard not to feel disheartened. Ever since its transition, Netflix has earned zero profit, yet lost up to $10 billion in cash.
From 2012 to the present, Netflix’s cash flow generated by business-related activities is all negative and this momentum keeps going.
Most of Netflix’s cash and assets are borrowed. Netflix can just borrow more if it fails to pay these back. As the beloved company on Wall Street, Netflix continues to generate earnings, the share price continues to soar, and the balance sheet remains glossy. But even so, Netflix’s debt-to-equity ratio is getting bigger and bigger.
Moody’s, the well-known financial corporation that provides analysis on credit risk, considers Netflix’s market capitalization of $135 billion as robust. But if Netflix’s debt-to-EBITDA ratio reaches five, Moody’s will lower its rating for Netflix.
Netflix’s debt-to-EBITDA ratio has already reached four after the second quarter of 2018. Moreover, because Netflix has a new $2 billion debt, the ratio is now 4.95.
In current economy, how many quarters will it take before Netflix’s D/E ratio reaches five? As you can see from the chart below, Netflix’s revenue (green column) is not only far less than its cost of goods and services (blue column) — it cannot even cover its own sales and operating expenses (orange).
Long-term growth investors might argue that Amazon has not made a profit for more than a decade, but isn’t it still the best-performing tech stock in FANNG? It’s undeniable that many people compare Netflix with Amazon. Some even argue that Netflix’s business strategies are inspired by the success of Amazon. But Amazon’s cumulative cash flow has reached $70 billion since 2012, whereas Netflix has a $10 billion debt. It’s also worth mentioning that based on my research, Amazon’s average D/E ratio has been as low as 1.3 since 2008.
Where did Netflix’s borrowed money go? Where did its net income come from?
This question is also related to whether Netflix is a tech company or a media company — Netflix spent tons of money on making and buying small movies as well as producing shows. By creating these contents, Netflix succeeded in turning the borrowed money into its own intangible assets and tangible profits, as reflected in its share prices. Such a brilliant business model!
The key to profitability is amortization. For example, let’s assume that Netflix borrowed $100 million and spent $80 million to produce the first season of “House of Cards” in 2015. Suppose that Netflix gained one million users from “House of Cards,” and each user paid $9 per month. Thus, as a result of the new show, Netflix had boosted its revenue by 100 X 9 X 6 = $54 million in the past six months. The show would continue to attract new users and original users in the following months, turning it into an asset of Netflix. Yet, a few years later, when people are no longer interested in “House of Cards,” its value is cleared and becomes zero.
Companies that produce TV shows typically use amortization to spread production costs across multiple financial reporting periods. In the case of Netflix, it might have spread the cost of $80 million across five reporting periods, turning the cost per half year to only $8 million. As a result, the income statement shows that Netflix earned a net profit of $46 million in 2015. What a smart trick! (Note: the above numbers were chosen randomly to illustrate the point)
I don’t question the legitimacy of this approach — it’s not uncommon in the industry. I am more skeptical about Netflix’s value of assets calculated by the company’s CFO. Is he analyzing the true value of Netflix’s content rights reasonably?
Netflix’s 2018 Q2 report shows that the total value of its current and long-term intangible assets was $17.1 billion — while Disney’s valuation of its intangible assets was $38.2 billion over the same period. Netflix as a media company started producing shows less than 15 years ago, whereas Disney has been around for more than a century and produced a variety of classic IPs. How is it possible that Netflix’s intangible assets worth about half the value of that for Disney? Doesn’t it come as a surprise that TV and animated series such as “House of Cards,” “13 Reasons Why,” “Shameless,” “BoJack Horseman” and a bunch of low-budget shows worth about half of that for the Marvel Cinematic Universe, “Pirates of the Caribbean,” “The Incredibles,” “Zootopia,” “Coco,” and many more classic names?
Dear readers, whose production do you think will be more long-lasting? I don’t think that in 10 to 20 years, Netflix can open a magical theme park based on its own film and cartoon characters. Either Netflix is overvalued, or Disney is undervalued. There must be a disconnect somewhere.
Netflix’s high share price leads to financing opportunities and boosts the company’s popularity, yet it also inspires other blue-chip media companies to take a serious look at the streaming service. In 2019, Netflix will face an increasing number of major competitors, and I think the most challenging ones will be Amazon’s prime video, ATT’s DirectTV/Hulu, and platforms to be launched by Disney. All these companies, with solid financial prosperities, will go head to head with Netflix. When Amazon, the world’s largest online retailer and largest cloud-computing company, announced in 2017 that it would purchase Whole Foods, share prices of other retailers plunged significantly. AT&T is the largest telecom operator in the U.S. and also owns Time Warner, the iconic American cable television company. I don’t even need to mention Disney, whose business has been giant and lucrative for centuries. Netflix also faces key competitors such as Apple, Google, Walmart, Showtime, Starz, and so forth. All of these competing forces can undermine the business strength of Netflix going forward.
Perhaps, Netflix has a heavy debt now because it is caught in a deadlock. Disney announced that it would take down all productions by Walt Disney Studio and Pixar Studio from Netflix in 2019 and 2020, and it’s likely that other companies will follow suit. To make up for that vacancy, Netflix needs to create more contents as soon as possible — an effort that requires a lot of investment. Moreover, to expand its international market, Netflix has to generate contents that cater to local people across countries. This approach might drive down its investment returns because Americans may not like Korean dramas, whereas Japanese viewers may not fully appreciate movies with a touch of Latin-American culture.
Yet, while Netflix spent $10 billion a year to purchase and produce scripted original series, its services turned out to be nothing more than mediocre. Last September, Streaming Observer looked at the scores for scripted U.S. original series calculated by Rotten Tomatoes and Meteoritic in order to rank the quality of major streaming companies’ original productions. Unfortunately, Netflix ranked in the seventh place, lagging behind its major competitors such as Hulu and Prime Video.
These competitors are making investments in order to seize more market shares. As you can see from the chart below, although total visits of DirecTV and Prime Video only add up to 10 percent of Netflix’s total visits, these companies are growing exponentially.
At the same time, Amazon stated at the most recent earnings conference that they would continue to invest in Prime Video. Under the premise that Netflix is not likely to enter the Chinese market in the near future, and growth rate in Indian market is low, I really can’t think of any big growth potential for Netflix. Of course, Netflix can probably include more advertisements and charge higher subscription fees (which it did a couple weeks ago).
In sum, considering signs of global liquidity tightening (I will discuss this later), short-selling Netflix stock while diversifying your portfolio is probably a safer investment option. Many institutional investors had ‘’voted with their positions’’ and sold Netflix shares before the company’s third quarter report came out.
As we can see from the chart above, between the second and the third quarter, more than 30 million shares were sold, only 15.9 million shares were bought, and the net number of shares sold reached 14.1 million. If you calculate Netflix’s closing price after the Q3 quarterly report, the number of shares sold was 11.6 billion and net value sold reached an astonishing $5.56 billion. Institutional investors are worried about the future of Netflix.
Don’t be fooled by sell-side analysts on Wall Street. Many firms on the street started a Netflix Price Target “Arm Race” in the first half of 2018. For example, some big bank adjusted Netflix’s target price from $360 to $440 on Sept. 6, shortly after another big firm raised its Netflix’s target price to $400-ish. Of course, we all know by now that in two months after the price adjustment, Netflix’s share price dropped to $280. Oops. It hurt.
