Netflix and Chill-vest

Subscriber growth in the first quarter of 2020: 15.77 million. That’s a big number.

$14.17 billion is also a big number. That’s how much debt Netflix had at the end of March. They’ve just announced a debt raise of another $1 billion in junk bonds, so it’s only getting larger.

Netflix is an investment anomaly, to be honest:

  • The valuation suggests that it’s a tech company, trading at a price-to-earnings (P/E) ratio of over 100x
  • The strategy (and the financials) suggest that it’s a fledgling media company in an incredibly competitive content market

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Usually, when there’s a mismatch like this, investors get hurt.

Is Netflix actually a tech company, or is it a media company that simply uses tech as a way to distribute content? That’s the most important question any potential investor should be asking.

Despite this inherent concern, there seems to be no shortage of investors lining up for a company that burned through -$3.3bn in free cash flow in 2019.

What would you need to think about in making a decision to invest (or not) in Netflix?

Is it all about the users?

The market puts a lot of emphasis on Netflix’s user growth numbers. This is typical of a tech business. The investment thesis is “build now, monetise later” which sometimes works (Amazon; Facebook) and sometimes doesn’t (MySpace; StumbleUpon).

I’m no tech expert, but intuitively this strategy is only helpful if the user base can eventually be monetized for a far greater value than it cost to acquire in the first place.

This either requires the business to:

  • Sell new products to that user base (increase revenue per user); or
  • Grow revenue off a fixed cost base (increase margin per user)

Achieving both is the holy grail of value creation in the modern world.

Netflix gave guidance to the market in January that they would sign up 7 million new users in the first quarter of 2020. Then lockdown happened. Suddenly, stuck at home and with nowhere to go, the world started streaming more content. Netflix more than doubled their anticipated user growth in these three months.

The market certainly loved this, promptly driving the share price up by 28%. If you got in on time, you’re smiling.

Should you take profit? Should you stay invested?

If you missed out, should you invest now?

Let’s look a bit deeper at some of the things you may want to think about.

Analysing the source of user growth

A single data point (like 15.77 million) is great to give you a sense of scale but is useless by itself in assessing trend and mix.

If user growth is a key metric for Netflix, then we need to delve deeper into this number:

  • UCAN (United States and Canada) appears to be reaching maturity for Netflix with 70 million subscribers (5% year-on-year growth)
  • EMEA (Europe, Middle East and Africa) and LATAM (Latin America) are powerful markets, combining a meaty number of existing subscribers with a high year on year growth rate
  • APAC (Asia Pacific) is a massive growth opportunity with only 20 million subscribers and a 63% year-on-year growth rate off a low base

User growth is definitely a source of excitement for investors.

Netflix has demonstrated an ability to be a global player, attracting subscribers across the world and growing strongly in key markets. If you wanted to, you could do further analysis on internet access in these territories and average income per capita in an attempt to calculate Netflix’s total addressable market and existing market share.

Or, you could ask yourself whether Netflix is as attractive to shareholders as it is to customers…which might save you a lot of time, depending on your view.

Content creation is a treadmill

Consider Facebook for a moment, a true technology company. Facebook benefits from the network effect – the value of a product increasing as more people use it. Google will tell you how hard it is to compete against a network business (they gave up with Google+).

Netflix doesn’t really have that benefit. Sure, you want to discuss Tiger King with your friends and you can’t do that unless you have Netflix, but the network effect in a Netflix context would rely on consistent blockbuster content that you can’t get anywhere else.

Not all blockbusters are shot with a handycam in a cat zoo. They usually need huge investment.

That’s the crux of this whole thing. If your business is reliant on content, you aren’t a tech company in my books. You’re a media company that happens to own your distribution network.

Netflix’s CEO Reed Hastings said it himself in March 2019, arguing that Netflix is a media company because it spends most of its money on content. The company made a deliberate decision to pursue Netflix Originals, which hugely increases expenses but also increases customer growth and retention because the content isn’t available elsewhere.

In case you still aren’t convinced, take a look at this chart that shows the disconnect between rising user numbers and net cash flow generated for shareholders:

“2-year CAGR” stands for two year compound annual growth rate. In other words, it’s the growth rate over 2 years required to get from the number in 1Q17 to 1Q20.

Revenue and Operating Income have growth strongly. The fact that Operating Income has grown much faster than Revenue tells you that Operating Income margin has improved (which is fantastic).

Unfortunately, Netflix just bleeds cash on an ongoing basis. The only quarter of positive cash flow generation in the past 2 years is 1Q20, which is because you can’t film new content during lockdown!

Netflix might be cheap for consumers, but not for investors

Why, then, is the market valuing this company like a tech business?

Look at these (rounded off for simplicity) traded multiples:

  • Disney: 19x P/E; 2.5x P/Sales
  • Comcast: 13.5x P/E; 1.6x P/Sales
  • Fox: 9x P/E; 1.4x P/Sales
  • Discovery: 8x P/E; 1.4x P/Sales

And then we have Netflix:

  • Netflix: 105x P/E; 9.7x P/Sales

Traded multiples help you compare companies of different sizes. You must always compare companies that are at least in similar industries. Looking at a mining company next to a tech or property company makes no sense.

The P/E ratio takes the share price and divides it by earnings per share. Crudely, it tells you how many years of earnings you are paying for when you buy the share. It suffers from a number of shortcomings well beyond the scope of this post but is helpful as a quick and dirty comparison tool.

Price/Sales is also a useful tool in industries that place emphasis on customer growth. I’ve included it as an additional data point.

No matter how you cut it, Netflix looks far more expensive per Dollar of earnings than businesses like Disney, Comcast (NBC; Sky) and the like.

Clearly, the market believes Netflix is a tech business even if the CEO thinks otherwise.

What about growth?

When a company trades at a vastly different multiple to its peers, that could indicate that it is growing a lot faster.

Let’s assume the following:

  • Company A: 20x P/E; 5% earnings growth rate
  • Company B: 40x P/E; 10% earnings growth rate

Immediately, Company B looks expensive. However, although you pay twice as much per Dollar of earnings, those earnings are growing twice as quickly.

We therefore use a PEG ratio (Price/Earnings divided by growth) to try and even the playing field. In both examples above, the PEG ratio is 4.

Perhaps Netflix is expected to grow incredibly quickly? How do we find this out?

It’s amazing what information you can get for free online

Yahoo Finance is an incredibly useful way to get data points like this, especially for offshore shares. They provide a 5-year PEG estimate sourced from Thomson Reuters, which is an average of what analysts in the market expect to happen:

  • Disney: 5.5x
  • Netflix: 3.2x
  • Fox: 2.9x
  • Comcast: 1.1x
  • Discovery: 0.8x

Based on how much you are paying per unit of growth, Netflix is only cheaper than Disney in this indicative media peer group. No matter how we look at this, Netflix is an expensive share.

That doesn’t mean it isn’t a good investment, it just means that there is more risk of the company being overvalued and investors seeing flames as a result.

Interestingly, Netflix ($186bn) and Disney ($182bn) have very similar total values (called market capitalization). You’ll need to consider whether that seems right.

Another issue: exchange rates

Netflix is a U.S. company that will incur most expenses in USD. Remember from our user analysis that the UCAN market is growing slowly for Netflix, so other markets are really important. This is especially true for emerging markets.

Growing revenue in emerging markets is great, but those currencies are notoriously volatile and tend to weaken against the USD over time (like our beloved Rand).

Netflix is effectively an exporter of services from the United States, so the company loses out when the USD strengthens. This is a long-term trend that I would think about carefully before investing. Netflix cannot mitigate this as it can never price its services to emerging markets in USD or it will be completely uncompetitive in those markets.

The only natural hedge I can think of off-hand is the production of local content with associated costs in that currency. The problem is that Netflix still has to spend a fortune creating content in the U.S. that users across the world want to watch.

DSTV subscribers in Africa want to watch the English Premier League, not just local soccer. You can’t compete on the basis of locally produced content alone.

Let’s wrap this up

Personally, if I had been smart enough to buy Netflix before the lockdown, I would now take my 28% profit and feel very proud of myself.

I struggle to see why Netflix is a tech company and not a media company. The day they decided to create their own content, rather than aggregate and distribute content created by others, is the day they became a media company in my opinion.

If the market starts to value Netflix in the same way it values other media companies, shareholders in Netflix will suffer immensely. There’s a potential 60% – 80% unwind in the share price in that situation.

On the flip side, if Netflix can find smart ways to monetise an ever-growing user base or cheaper ways to produce winning content, then the valuation may well be justified. It’s a powerful brand with global reach and a strong trajectory in user growth. There’s no disputing that.

My sources tell me that the top-rated international analysts generally have Netflix on a BUY rating, based on rapid subscriber growth and presumably an assumption that the cost of content won’t increase in proportion. I don’t necessarily believe that, but they know a lot more than I do!

If nothing else, I hope you’ve learned that the long-term investment decision isn’t as easy as “oh good, everyone is at home watching Netflix this month” – there are many things to consider before you pull the trigger and invest.

There were many concepts that I applied in this analysis that you can apply to any company. Be skeptical and think carefully!

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