Some Thoughts on Netflix

As Netflix’s share price continues its unabated journey to the moon, it seems timely to consider what exactly is baked into its valuation. Competition in the space is rapidly heating up and the company’s cash burn continues to worsen. At 14x sales the stock appears to be priced for perfection – and then some. Whilst I do think Netflix is a decent business, I don’t believe it will come anywhere near living up to the hype implied by its current valuation. For me, the company’s financial position and valuation are massive red flags. At this point in time I have no interest in investing, but for those that do, below are a few observations that I think are worth consideration.

Content obligations continue to outpace revenue growth. Since 2010, content obligations have grown at 42% p.a. while revenues have grown at 24% p.a. This trend is clearly unsustainable. In the long run the true cost of Netflix’s business model will become apparent as capitalised production and licensing costs drag on earnings for years to come.

The company’s financial position and negative cash flow are concerning. In addition to $9.0bn of debt, Netflix has an additional $17.7bn in streaming content obligations off-balance sheet (~$8bn of which is due within 12 months). In effect, Netflix has effectively mortgaged its future success, meaning that any stumble could prove disastrous. As content obligations continue to increase, the firms cash flow only grows more negative – with OCF going from negative $1.6bn in 2016 to negative $2.0bn in 2017. In its current state, the company is reliant on continually tapping the junk bond market in order to fund it’s operations.

Valuation makes no sense. There is a striking valuation gap between Netflix and other TV networks such as Disney, CBS, Viacom, and HBO parent Time Warner. One could argue that Netflix deserves a premium over these other stocks due to its first mover/data advantage, however I don’t believe this will prove durable in the long-term. Simply moving faster than everyone else won’t lead to a defensible moat.

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To illustrate the extent of Netflix’s overvaluation let’s consider an extremely optimistic scenario – Netflix is able to grow its revenue at 20% p.a. for the next 10 years and triple its operating margins to 22%. EBIT would be $15.6bn in 2027. If we assumed that Netflix (1) could earn this into perpetuity, and (2) had no debt (highly unlikely), and (3) a 10% discount rate, then we would get a future valuation of $156bn or $360/share. Assuming a 10% hurdle rate, we arrive at a present fair value of ~$140/share (i.e. less than half the current share price of $350).

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