Description

Summary:

I am recommending a short position in Netflix Inc. (“NFLX”). I believe long-term consensus expectations for non-US subscriber and revenue growth are unrealistic given the inferior value proposition for non-US vs. US subscribers. I also believe NFLX’s business model is becoming more risky because large media companies have become more reluctant to sell NFLX great content at great prices leaving NFLX increasingly reliant on producing their own great original content. Finally, since NFLX is cash flow negative (~$1bn cash flow loss in each of 2016 and 2017) and thus reliant on raising financing for continued growth, I believe that if the stock market loses confidence in NFLX’s longer-term business model this could have reflexive consequences for the stock.

Details:

I am a long-time NFLX subscriber. I think they produce some quality shows (Daredevil is a personal favorite) and my kids find plenty of content to keep them engaged when my wife and I need a break. Thus, the $10/mo that US subscribers pay to NFLX seems like a good value proposition relative to the average $96/mo US Pay-TV bill (SNL Kagan estimate). I look at the monthly NFLX cost / Pay-TV cost as a “Value Ratio” and this is 10% in the US. Given the good Value Ratio in the US, I believe that 2019 consensus estimates of NFLX reaching 61m US subs (vs 47m today) at ~$10.50/mo ARPU (vs ~$8.75/mo today) seem reasonable.

However, I believe consensus non-US subscriber estimates (79m non-US subs paying ~$8.50/mo by 2019) are far too optimistic. Since non-US TV viewers have a much lower propensity to spend on content than US viewers, I believe non-US ARPUs could end up being much lower than the US ARPUs, non-US subs could end up being much lower than projected, or some combination of both.

Let’s take a look at the aforementioned Value Ratio for non-US subscribers using 2015 Pay-TV ARPUs (estimated by SNL Kagan) and local NFLX pricing (for their 2-HD stream package). NFLX’s incremental geographic expansion is happening in countries with a much worse “Value Ratio” which I do not believe is being properly factored into consensus estimates. The average Pay-TV bill in Western Europe is ~$33/mo with a wide range of ~$18/mo in Germany and ~$54/mo in the UK. Thus, NFLX Value Ratio in Western Europe averages 33% with a range of 20-63%. The Value Ratio gets much worse when you go outside the wealthy countries. The largest Pay-TV market that NFLX launched in 2016 is India where the average monthly Pay-TV bill is ~$2.75, which results in a Value Ratio of 350%.

Another thing to keep in mind when thinking about the international Pay-TV market is the huge cost of sports rights relative to Pay-TV revenues. TV rights costs of the English Premier League eat up ~25% of Pay-TV revenues in the UK and TV rights costs for the Bundesliga suck up ~15% of Pay-TV revenues in Germany. Analysts estimate the German football rights could go up 40-50% when the new contract is awarded later this year which means 20-25% of German Pay-TV  revenues would go to the Bundesliga. Compare this to the US where ~6% of Pay-TV revenues go to the top 3 sports leagues (NFL, MLB and NBA). This is relevant because NFLX does not compete for live sports and thus their addressable market for Pay-TV dollars outside the US is much smaller when you strip out sports rights. When adjusted for sports rights, the relative Value Ratios in the UK and Germany look even worse than outlined above.

A few years ago, NFLX was the scrappy start-up who pioneered the streaming video model. I believe the big media companies (DIS, FOX, TWX, etc.) formerly viewed NFLX as an incremental source of revenue for their old movies and TV shows as NFLX created a new monetization window for them. Thus, it seems NFLX was able to cherry pick the best product from these deep libraries at the big media companies and secure relatively inexpensive, exclusive rights for this content. Over the last year or so, the big media companies have seemingly woken up and started viewing NFLX as the biggest threat to their lucrative cable network businesses. Thus, the media companies have become a lot more reluctant to sell their best shows for good prices to NFLX. They are increasingly talking about keeping the rights for their own streaming services (e.g. the jointly owed Hulu) and/or selling rights to other competitors (e.g. Amazon) to create more competition. As a result, NFLX has increasingly been focusing on creating its own original content. Over the next several years, I believe NFLX’s favorable content contracts will start to roll off and will have to be replaced by NFLX original content. I believe that the transition from being the de facto sole buyer of streaming rights for the best shows created by the best content producers to being one of many entities trying to create the next best show creates a lot more business risk for NFLX.

Per management’s own comments on the Q1 earnings call, NFLX is expected to burn ~$1bn/yr of cash in each of 2016 and 2017. The biggest source of cash burn is their spending on content. In 2015 NFLX spent $4.6bn of cash on streaming content, which exceeded their income statement content amortization of $3.4bn. They are forecasting content amortization of ~$5bn in 2016 and over $6bn in 2017, with cash spend exceeding those figures. This content spending is largely fixed in nature as reflected by their content obligations on their balance sheet of $12.3bn and off-balance sheet liabilities of $6.6bn (both as of 3/31/16). If NFLX’s subscribers do not ramp as fast as consensus expects, I believe this could result in a serious margin squeeze and greater than expected cash burn. This risk is clearly outlined in NFLX’s own 10-K “Given the multiple-year duration and largely fixed cost nature of content commitments, if membership acquisition and retention do not meet our expectations, our margins may be adversely impacted…To the extent membership and/or revenue growth do not meet our expectations, our liquidity and results of operations could be adversely affected as a result of content commitments and accelerated payment requirements of certain agreements.”

Based on consensus estimates, NFLX currently trades at TEV/EBITDA of 84x, 42x, 25x and 17x for 2016, 2017, 2018 and 2019, respectively. Let’s assume that NFLX can hit consensus estimates in 2019 (which assume 61m US subs @ ~$10.50/mo and 79m non-US subs @ ~$8.50/mo) and trades at 25x EBITDA. This upside case results in a stock price of $150/sh or $113/sh today (+14% upside) when discounted back by 10% for 3 years. Alternatively, a 2019 downside case based on 60m US subs @ ~$10.50/mo and 73m non-US subs @ $7.50/mo  results in a 2019 EBITDA that is -25% below consensus. If you put 20x EBITDA on this number and discount it back by 15% for 3 years, this results in a downside stock price of $57/sh (-43% from today’s price). If NFLX gets into a reflexive situation and has difficulty raising money to support its $1bn annual cash burn, I believe the downside price could be much lower than $57/sh. I don’t place undue confidence in my ability precisely forecast any business out 3 years, particularly one as dynamic as NFLX. However, the preceding target prices illustrate the stock price sensitivity to relatively small reductions in non-US growth assumptions. In my opinion, since consensus estimates based on non-US growth assumption that are far too optimistic, NFLX represents a compelling risk/reward short.

Catalyst

Realization that consensus estimates for non-US growth are too optimistic