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).

Australia: As Safe As Houses

It’s often difficult for many Australians to consider investment options beyond property. And to be fair, it’s hard to blame them. Australia’s 27-year run (and counting) without a recession driven shock has led to exceptional returns for banking and property investors alike. A generation of uninterrupted house price growth has created the seemingly irrefutable but equally concerning mantra ‘as safe as houses’.

However, the longer the uninterrupted expansion continues the larger the risk within the Australian banking system grows. Since 1991, Australian banks have increased loans to the housing market from $85bn to $1.5tn, representing loan growth of 12.2% p.a. This growth has been much greater than any other type of lending, and as such, housing loans have gone from 20% of all bank loans to 60% today. Australia household debt now sits at over 200% of income, making the country one of the most leveraged in the world. As a point of reference, this metric hit 128% in the US in 2007, prior to the GFC.

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Where we go from here is anyone guess. The point of the above is not to try and predict a housing crash (I’ll leave that to people selling newsletters) but to illustrate how late in the game Australia is. With wage growth currently tracking at around 2% p.a. I believe an ‘optimistic’ scenario would be 3-5 years of flat/minimal growth (in real terms). This is clearly what the RBA is hoping for with Phil Lowe, the Governor of the RBA, openly stating that he’d like to see a “run of years” of little to no growth in household debt.

Why I Love Whole Foods but Can’t Buy the Stock

I want to start by saying that I love shopping at Whole Foods. The retailer offers a superior customer experience and provides an extensive range of natural produce. However, despite the company being well positioned to benefit from the long term structural growth trend in organic food consumption, I just can’t bring myself to purchase the stock.

Last week, the company announced that same-store sales had turned negative, down 0.2% for the quarter. While total sales increased 6%, this is still the weakest results since 2010. In addition, the company indicated that comps will probably stay flat next year. Margins also remained under pressure – gross margins declined 96bps due to an increase in cost of goods sold.

These disappointing numbers are not overly surprising. Whole Foods operates in an intensely competitive industry – one where switching costs are virtually non-existent. Their success over the last few years was bound to attract new entrants. This has certainly been the case as competition has intensified from firms like Trader Joe’s, Kroger, Wal-Mart, and Costco. In light of this, it seems logical that Whole Foods would be eager to reinvest heavily in the business. The company has flagged it plans to increase spending in numerous areas, including its online presence, the cloud, point of sale systems, customer loyalty programs and 365 by Whole Foods. This reinvestment will prove vital as it will be the key to ensuring Whole Foods can maintain their price premium and sustain traffic in the future.

However, the one thing I can’t understand is why the company is using its current free cash flow (and borrowing an additional $1bn!) to buy back stock… Its hard to believe that buying back a substantial amount of stock is really the best use of capital for a company that has under invested and needs to “get back to basics” (as Co-CEO John Mackey put it). To me, leveraging the balance sheet to boost EPS is a short term play – and one that is hard to justify when the stock is trading at 19x.

In any event, the question becomes can Whole Foods return to being the phenomenal growth company it once was?

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