Netflix shareholders are getting nervous

• Global
• FAANG, Free cash flow, Growth, Netflix, Return on equity, Revenue multiple, Valuation
• October 21, 2020

Netflix is the N in FAANG – but I maintain that it’s not the potential cash cow that the other Big Tech companies are. Perhaps N should stand for Nervous, a fair description for shareholders at the moment.

Netflix is the only FAANG company that I don’t directly hold shares in. This is because I don’t buy in to the fundamental cash flow profile of the company at these valuation levels.

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The problem is that Netflix isn’t purely an app or a website. It’s a vertically integrated business that creates and distributes its own content. Unlike Facebook that relies on the network effect (valuable because your friends are on it), Netflix is selling content. Content needs to be kept fresh – even Disney can’t just rely on its 100-year catalogue of the world’s most-loved characters.

Platform businesses typically burn cash while they build up users, but then generate super-profits once scale has been achieved. This is what keeps the venture capital market relevant. Entrepreneurs with big dreams need capital to scale and venture capitalists are happy to take a punt, hoping that one of the companies hits the jackpot.

Netflix growth has slowed

After robust growth in 2018, Netflix subscriber growth slowed in 2019. It was a cause for concern for investors, but then the pandemic arrived, and everyone was stuck at home. Subscriber growth skyrocketed, running as high as 27.3% year-on-year in Q2’20.

Naturally, this isn’t reflective of the sustainable growth rate. The Q3’20 growth was 23.3% but company guidance for Q4’20 is only 20.4%. Still, this will take subscriber numbers to over 200 million – a LOT of people.

Sport is back

Part of the current growth challenge is that sport has returned. In fact, you can only watch it on TV, as spectators aren’t allowed at most major sporting events. This is wonderful news for pay-TV companies like Multichoice but isn’t great for streaming platforms that don’t have any rights to broadcast major sports live.

Netflix has been clever with sports documentaries. Drive to Survive is arguably more entertaining than the live Formula 1 races. Still, it’s no replacement for live sport.

Competition for screen time is fierce

Netflix competes against everything.

They acknowledge in the Q3 earnings call that “we compete for time against TikTok and YouTube as well as HBO as well as Fortnite…so really the limiter for us is what’s the quality of our service, how often, how many nights can you say I want to go to Netflix and watch the next show.”

The only way to achieve this is to keep the content fresh.

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There’s the cash flow rub

As the chart demonstrates, free cash flows were negative in 2017, 2018 and especially 2019. Netflix is growing and generating profits but has to keep investing billions of Dollars in content.

Free cash flow generation swung into the green over lockdown, thanks to strong subscriber growth and a drop-off in content production due to social distancing restrictions. Since lockdown began, Netflix has only managed to complete 50 productions.

There are another 150 productions to come before the end of the year, which might explain why management carefully neglected to give a forecast for free cash flow in Q4 (despite giving forecasts for revenue and operating margin).

Netflix has nearly $8.4bn in cash in the bank, so the company won’t need to tap shareholders for cash. The company has guided that 2021 free cash flow will be somewhere between -$1bn and break-even.

A push into animation

Animated films are much harder and more time-consuming to produce than normal films. Netflix is aiming to produce six animated feature films a year, a run-rate never achieved before by a major studio.

For a company that is already burning cash on content at quite a rate, shareholders may feel concerned that Netflix is overextending itself on content production.

The flip side of course is that if Netflix can capture the kids’ market in the same way Disney has done for the past 100 years, the company may well justify its multiple.

An interesting tidbit: pricing varies by country

Netflix’s pricing varies by country, as do price increases. For example, Netflix put through increases in Canada and Australia recently, but not necessarily in other markets. The decision is based on the amount of local content in those countries as well as the competitive realities in each region.

The company is also experimenting with the funnel for new subscribers, for example there is a plan to offer Netflix for free for a weekend to people in India.

This is clever because it allows Netflix to experiment with what works in different markets, but it does raise questions about the likelihood of maintaining its operating margin as it grows into emerging markets that will have lower affordability but higher appetite for local content.

Another interesting tidbit: blockbuster shows make a bigger difference when growth is high

Popular shows do have a direct impact on subscriber growth at Netflix. If all your friends are watching something and you aren’t, then you’ll feel the FOMO and you’ll hit subscribe.

In a quarter of high growth, new shows have a proportionately bigger impact on the result due to the variability in the growth number caused by these shows. If a company is only growing at 1%, then variability in that 1% is less of a big deal than if a company is growing at 5%.

Importantly, this further supports my thesis that Netflix is never going to get off the content treadmill. The capex (capital expenditure) in this business has to remain high in order for Netflix to compete.

The power of curation: is this Netflix’s ace up its sleeve?

Netflix has fewer titles today than it did a decade ago. The company has focused on curating content in addition to creating it, rather than just offering an extensive library. I personally believe this is the right strategy.

I want Netflix to help me decide what to watch and they want to do that too, placing huge emphasis on the “recommendations” part of the business. The recommendation engine itself has substantial potential to generate revenue in future.

Hollywood studios can spend up to 100% of the production budget of a movie just marketing it. What if that spend was redirected towards Netflix? Will the importance of cinemas be lower in a post-Covid world, or will the Box Office bounce back?

Perhaps Netflix could act like Google for content, taking fees from other content producers to punt shows to more viewers.

Am I buying Netflix shares yet?

No.

I’ve only missed out on a 14% return in Netflix in the past 6 months, although the company has returned nearly 50% this year which is more painful to think about.

Nonetheless, I cannot bring myself to pay over 10x revenue for a company growing at just over 20% top-line. Return on Equity is only around 25% – 30% which is nothing special and especially not at this price point.

Netflix has done a wonderful job of building the streaming market but will need to put smart partnerships in place to return meaningful cash flows to shareholders, especially as competition heats up in this space.

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