NETFLIX NASD:NFLX

Authored by N.A.S.M. at Sprout8.com

Date: 18/7/2018
Current Price: $380

PE Ratio (TTM): 172

Disclosure: Sprout8 analysts have initiated a short position in Netflix at $382.20

Netflix the Sore Tooth in FANG?

Short view – heightened headwinds at a time of historical high valuations in tech

  1. Netflix throughout its history has earned a place in the pantheon of “Disrupters” and delivered significant returns to investors in a decidedly tech focused growth environment;
  2. The wider business community but especially tech, have utilised cheap debt in a period of Quantitative Easing (QE) to spark fast-paced growth leading to an overweight investment thesis globally of growth > value;
  3. This easy and abundant access to cheap debt works effectively as long as debt remains cheap or growth outpaces the negative outcomes associated, and provided there is a cash flow positive “end in sight” as customer acquisition at all costs turns, ideally, to high profit margins on a mature customer base;
  4. While originally focusing on being a disrupter, famously changing how we consume media and giving birth to the “cord-cutting” phenomenon – Netflix has slowly been transitioning to a publisher / content creator as competition drive licensing risk;
  5. According to Netflix, in 2018 they have estimates for over 700 original programming titles in 2018, circa $8b USD budget on a profit/loss basis (85% to original content and 15% to licensed content);
  6. With Netflix not having a single quarter of positive free cash flow since 2014, the company has been looking to junk bond markets (with 5 bond issuances over $1b in last 3 years) to finance their expansion and appetite for original programming. As of June 30, 2018, Netflix has long term debt obligations of $8.3b, most are 10 year bonds with yields between 4.5% and 6%. As we are nearing the end of this long term, cheap credit cycle, Netflix’s use of debt will have increasingly negative value to shareholders as cost to finance debt will go up and the cost to refinance existing long term debt will go up;
  7. Via analysis from 7Park Data in April 2018, 80% of Netflix US subscriber viewing time is licensed content and 20% original content. Representing declining value for dollar for Netflix, as debt begins to increase in cost to service at the pace of which Netflix is burning cash;
  8. Original content has become a great focus of Netflix due to competition from studios and other media companies to create their own SVOD (Subscription Video On Demand) capabilities. Representing a significant risk to Netflix that well-known, brand licensed content will continue to disappear, leaving Netflix primarily as a content creator vs an aggregator.

Ultimately this leaves Netflix in the conundrum of being part of the problem that they were trying to solve. By necessity, creating 100’s of new content titles every year, financed with debt, in the hopes of keeping subscribers happy and finding value in their service – they are requiring subscribers to pay for a catalogue that they may only watch 10% of the titles on. Sound familiar? All those cable channels that you never watched, but were forced to subsidise with your cable bill?

Additionally, as Netflix’s long term value is closely correlated to international subscriber growth, there is substantial risk that Netflix will be competing (again, utilising debt facilities) with a number of content creators + SVOD ventures in each country/region, that are highly in tune with local markets. Worth noting is that Netflix, depending on account plan, can provide for up to 4-5
devices and shared across households which may have the potential for creating a ceiling on paid subscribers.

 

(Figure 1 – Netflix Total Subscribers Over Time)

With competition on the rise by those such as: Hulu, Amazon Prime, Disney, Apple, etc – there could be a situation coming, in which “cord-cutting” may soon be coming to SVOD market as consumers could only be willing to pay for and focus their time on 1-2 SVOD services. While all the content creators around the world are trying to become Netflix, Netflix is slowing transforming into the content creators. Which could leave it in a precarious situation based on the fact it is valued as a tech company, not a content creator (for example, Disney). Content creation is a challenging industry based on the amount of competition in every local market around the world, plus the amount of misses (loss-making content) vs hits (profit-making content).

Consequently, our view is that Netflix represents a significant short opportunity over the mid-long term due to a confluence of headwinds for Netflix, while tech sector enjoys all time high valuations.

The Cavities Forming

Competition:

Disney – One of the most common comparisons vs Netflix, and identified as a scary competitor moving forward, Disney has made quick strides over the last 18 months to stifle Netflix’s growth opportunity while creating value for themselves. A bastion of household named content, Disney are pulling their titles from Netflix in 2019 while launching their own direct to consumer service. With a tremendous catalogue (further bolstered by their acquisition of 21st Century Fox), Disney will be a must have subscription for most SVOD users. Additionally, part of the risk we see for Netflix, is replacing the family focused Disney titles that resonate with children with such studios as Walt Disney Animation, Pixar, Marvel, and Lucasfilm being Disney assets. Disney also have a slate of programming timed to the prospective launch of their platform, which we maintain will create a strong impetus upon launch, to add Disney as a subscription for many households.

Amazon Prime – The most immediate competitor to Netflix, is investing in original programming and distribution deals while building capability and market share on a global scale with an estimated content budget of around $5b. Amazon is willing and able to put lots of cash into Amazon Prime Video as it enables stronger acquisition and retention rates for Prime membership. Additionally as Amazon pushes their core offerings further into markets, they will organically grow Amazon Prime Video alongside, helping to stifle Netflix growth over time in international markets. Amazon Prime Video has also had a number of interactions with sports rights, as they streamed some NFL Thursday Night Football games this past season (similar to Twitter streaming various MLB games). This could be testing the waters for sports broadcasting rights as various contracts in the USA come up for renewal over the next couple years (NFL, MLB, NHL, and NBA). If Amazon Prime Video splashed some of Amazon’s cash at gaining significant pieces of those rights, it would erode Netflix’s position of being the #1 SVOD with Amazon playing an ancillary role at the moment.

Apple – The quiet giant waiting in the bushes with $267.2b in cash on hand as of end of March quarter (more than the entire market cap of Netflix), has been building their 40+ team and recently signed onto the master agreement with Writers Guild of America with additional terms to cover “free to consumer” services. Apple is keen to grow their Apple Music subscriber base to 100M+ in the next three years from a base of circa 38m now. The formation of that could come in a lump bundle with Apple Music, iTunes TV/Movies (which for now are rent/buy only now), original programming, AppleCare, etc – offering greater value to consumers. Worth noting that Apple has well-established relationships with major media companies from working with them via iTunes.

Locally Focused

Europe: Within the past 12 months the following headwinds have formed in Europe.

1) Three leading French media companies (one public and two private), representing over 75% of current French TV programs, have banded together to create a SVOD competitor with a proposed monthly subscription of 5 euros per month. Providing both films and TV programs (live and catch up), representing strong local value to French consumers.

2) Across the Channel, three English broadcasters (BBC, ITV and Channel 4), have started early stage discussions regarding a SVOD venture – in order to compete and ensure a digital future for English broadcasters.

3) In Germany, ProSiebenSat.1 and Discovery have created a joint venture called 7TV headed up by a former Google executive, to provide in-house TV series, films and live sports streaming courtesy of Eurosport.

South East Asia and Australia: For the high growth area of South East Asia, there is a myriad of strong local competitors.

1) iFlix, a Malaysian SVOD platform operating in over 28 countries which strong representation and growth opportunity based on footprint growing in Malaysia, Indonesia, and Philippines (over 400m population total). iFlix focuses on offering content in local languages, and having a pricing plan that matches the majority of the population. The business also has growing representation in the Middle East area that a US company such as Netflix could have geopolitical risks associated with.

2) HOOQ, a JV between Sony Pictures, WarnerMedia, and Singtel, they have growing footprint in 4 countries in SEA plus India (total population footprint 1.6b). HOOQ through Sony Pictures are able to deliver Hollywood movies to a competitive marketplace and invest sparingly to targeted original content.

3) Stan, an Australian SVOD company via JV between two of the largest Australian local media companies, have developed a strong business model with positive market penetration based on content deals bringing high quality programming from overseas and specifically targeted original programming. Stan has gained over 1m subscribers in three years of operation, representing 1/25th of Australian population but based on estimated 8m households, 1 in 8 have a Stan subscription, and growing.

Africa: As Africa gains infrastructure and digital penetration throughout the continent, Africa’s 1.2b population will grow in importance for SVOD industry.

1) iFlix, previously mentioned as a major player in SEA, also has an established presence in Africa catering to the mass market with a lower price point than Netflix ($2.50 USD vs $8 USD on a per month basis). This allows them easier access to growing lower and middle class mobile/smartphone penetration for scale.

2) Showmax, an SVOD platform launched in 2015, owned by Naspers in South Africa, has reach into over 36 countries within Africa. Showmax focuses on localisation content strategy + key international licenses titles while utilising partnerships with leading telcos throughout Africa to gain penetration to the marketplace.

India: Perhaps the most important market for Netflix to win based on population + digital penetration growth; it is also the most competitive with over 25 various OTT (Over-The-Top) businesses in the marketplace. Mobile data prices have plummeted and smartphone sales are booming with over 650m total mobile phone users and smartphones in the hands of 300m currently (roughly the population size of the USA).

The most important competitor to Netflix in India is Hotstar which operates on a freemium model and counts ~100m active monthly users (only around 5% would be paying subscribers with the rest using the ad-supported option). Hotstar is putting investment into local languages by offering 7 local languages plus English currently, and coupled with the affordability of the platform, this is helping the business to reach urban and rural users alike with massive growth rates. Additionally Hotstar owns the streaming rights for IPL (cricket) and EPL (football) which help Hotstar be a “must have” in India vs a luxury premium as Netflix may be considered. But the greatest threat that Hotstar brings to Netflix is that Hotstar is currently owned by 21st Century Fox, now being folded into Disney. This puts one of Netflix’s biggest threats globally, in the front seat of the one of the biggest growth markets, India.

Regulation:

Content Requirements – A movement in governments around the world is to consider imposing a content requirement for SVOD services due to that fact that most of these companies: 1) have few, if any, local employees in most countries and 2) produce their original programming in areas that are financially agreeable to them with a lack of benefit to most countries.  In April 2018, the European Union Parliament voted to require that Netflix and other online streaming platforms will have to dedicate 30% minimum of output to European movies and TV via commissioning programming within Europe or by contributing to national film funds. There are still hurdles to enact this into law but it represents the potential for disproportionate cost to companies as they enter local markets. We see the risk for Disney, Amazon Prime, and Apple significantly less than Netflix in comparison as they have much deeper pockets and are not solely focused on SVOD services. In another example, the government and media community in Australia have been floating the idea of a 10% content requirement on Australian revenue basis, for SVOD platforms, as local media companies have those requirements already. We see risk that this could become commonplace and have growing acceptance once the “first dominoes” start to fall.

Digital Tax – In 2017, Australia enacted a 10% goods and services tax, on digital products / services purchased in Australia for overseas companies. This tax helps to close a loophole formed in the digital economy where overseas companies did not have collect GST on digital products exported to Australia. This digital tax has been proposed and debated across a variety of geographical areas around the world, including in Europe. It was proposed in March 2018 to institute a 3% tax on turnover for digital products/services, like Netflix, as there is no physical product, and that allows overseas tech companies to shop around Europe for the lowest tax rate. Based on European Commission, digital companies pay around 9.5% effective tax compared to 23.2% for traditional businesses. Singapore has also announced starting from 2020, they will be collecting a tax on imported digital products/services including SVOD. Certainly this tax represents relatively equal pressure to most major SVOD platforms (aside from local content competitors as they already pay those taxes); however, Netflix due to their current reliance on debt and the continuation of high profit margins could be under disproportionate pressure. Similar to content requirements, we believe this could be the start of a global movement to require a digital tax which would erode Netflix’s ability to compete as easily as they currently do against local competition.

Peer Valuation – A widely held comparison is between Disney and Netflix, in which, Disney at this time of writing has a market cap of ~$165b vs Netflix ~$158b. First quarter 2018 revenue for Disney was $14.55b with free cash flow of $3.46b compared to Netflix revenue of $3.7b with free cash flow of $-273.93m. Netflix’s valuation is based on being a high growth, high profit aggregator, not a content creator such as Disney. As Netflix continues to evolve into primarily content creation, their valuation should retrace downwards and be more closely aligned with their peers.

At a time when Nasdaq Composite is at or around historical highs (Figure 2 below) – Netflix is trading at a valuation disconnected from mid-long term headwinds as detailed throughout this research note.

Nasdaq Composite – 45 year historical chart

(Figure 2 – NASDAQ Composite Over 45 Years)

Disclosure Section:

The information and opinions in the above research report prepared by Sprout8 are for the sole purpose of educating family and friends. Do your own independent research. The above should not be treated as financial advice.
The analysts N.A.S.M. at Sprout8 hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received direct compensation in exchange for expressing specific recommendations or views in this report.

The authors of this post hold short positions at the time of writing in NASDAQ: NFLX.