Netflix (NFLX) is a great service, but is it a great stock?
I’ve brought up Netflix before here at the blog, saying that I expected very little from it. I have to own up for my error — it’s rocketed since I published that article.
I’m willing to admit defeat on this one, but I still think it’s temporary.
A Cursory View of Netflix
One of my biggest complaints with Netflix is that it is a commodity provider. It buys content from creators and sells it to the end user for a flat monthly fee.
After some back and forth with the SEC, it now discloses more about how much it pays for content ($500 million per quarter) as well as how it calculates its subscriber numbers. Recent filings show $2.37 billion in streaming content liabilities due in the next year. We can gather that on a run rate it will spend $500 to $600 million each quarter to keep streaming.
The streaming business relies on simple economics. The sum of all subscription payments should be greater than the cost of content plus all sales, general, and administration expenses, as well as the cost of building out the technology capable of handling all that bandwidth.
If you look at the numbers, though, you quickly find that Netflix is not profitable by the most fair assessment of profitability — free cash flow.
Netflix engages in accounting trickery at the income statement level, which I believe is to make the numbers appear much better than they really are.
Netflix originals like House of Cards are a valuable asset once complete. A new show requires a one-time investment that should pay dividends for years and years to come.
Thus, Netflix amortizes its investment in new shows over the course of many years, so there is a discrepancy between its third-party acquisition spending and depreciation in any one quarter. That difference is attributed to slower amortization of its original content.
This is fairly standard in the content business. DreamWorks, for example, amortizes new movies at 50%, 75%, and 90% of their cost of production in the first one, two, and three years after release, respectively. If DreamWorks values a movie at $300 million at release, then by year three it will be worth less than $30 million on its balance sheet.
Prerelease, a movie is worth a fortune. Three years later, there’s not much residual money coming in. It’s only natural to devalue the asset over time.
DreamWorks actually owns its movies, however, so it can exploit them for long-term cash flows by licensing them through various distribution channels, including Netflix.
Netflix does not own its own shows. House of Cards merely made its debut on internet TV. The independent studio owns all the rights, and all the money that comes from non-Netflix sources.
The show is already available elsewhere. Apple’s iTunes has episodes at $1.99 a pop; Amazon will sell you the DVD of the first season, or individual streaming episodes online. Amazon Prime members can watch episodes for free.
So one should wonder why Netflix assigns longtime value to an asset it doesn’t own? Will old House of Cards episodes really bring new viewers to the service year after year? I find it difficult to believe, especially as the show ages and it becomes available on other platforms and in physical media.
Furthermore, it’s difficult to ascribe value to an asset you don’t control when it’s packaged with a portfolio of other streaming shows. Did new users sign up just because of House of Cards, or are they signing up because of House of Cards and its thousands of other movies and TV shows? There’s no way to know.
How Long Can Netflix Keep it Up?
Money has to come from somewhere. Proper GAAP free cash flow numbers are negative. Where is Netflix finding the cash to stay solvent, let alone invest in new content?
The answer is from debt and equity investors. The company issued junk debt earlier this year at 5.35%, issues which still yield more than 300 basis points more than comparable U.S. Treasuries. It also diluted investors to the tunes of billions with new share issuance.
Without any path toward profitability and no cuts to its content acquisition costs, I worry that it will be a continuous client of Wall Street, selling stock and debt to finance its aggressive spending. That may keep sell-side analysts singing bullish praises to win a banking customer, but it does nothing for shareholders.
Even if we believe Netflix’s income statement accounting, any company trading at more than 100 times forward earnings estimates should be the target of scrutiny, especially when the top line is growing at only 20% per year.
As for when the party ends, it’s anyone’s best guess. Netflix’s ultimate path to profitability is incredibly risky. It could continue to spend heavily for untested shows like House of Cards, hoping to suck in new members willing to pay nearly $100 per year for access to a single show. It could raise prices and risk a revolt like in 2011. Or it could begin to slash its budget for third-party content, which also risks a customer exodus.
I just don’t see how these risks are priced in to a company trading at 100 times very managed forward earnings. At 100 times optimistic forward income, I think the risks heavily outweigh the rewards.
This is a company I’d love to short, but with in-the-money LEAPS coming in at 25% of the equity value, you’d need a 25% drop in 18 months just to get your money back. Clearly, option investors are just as concerned about valuation.
What are your thoughts on Netflix valuation, and its long-term probability of success?