Netflix Shares Are Showing The Impact Of The Streaming Wars But Much More Downside Lies Ahead

Begun the streaming wars have. While that is a cute quote and Yoda would certainly have been a competent financial analyst, it only hints at the harsh reality facing market leader Netflix. Netflix’s first-mover advantage has been disappearing, and CEO Reed Hastings is clearly worried, as indicated by his quote in Variety this morning

While we’ve been competing with many people in the last decade, it’s a whole new world starting in November…between Apple launching and Disney launching, and of course Amazon’s ramping up.

This is an inflection point for Netflix. The shares have shown that of late, now down 27% in the past 12 months and well off their all-time high of $411 per share hit in June 2018, but I believe there is more downside for Netflix shares. Despite the recent pullback, including today’s 7% price slide, Netflix is still trading at 82x the analyst consensus EPS estimate of $3.26 for 2019 and 47x the 2020 estimate of $5.68.

The longer-term issue facing Netflix has been management's decision to use debt ($12.6 billion at June 30th, after issuance of $9.2 billion in debt in the past two-and-a-half years) to finance the company’s massive content liability ($8.4 billion at June 30th.)

If Netflix can grow earnings at a 74% pace, as is implied by the consensus forecasts for 2020 and 2019, that debt can be financed. If not, Netflix is going to start looking a lot like Tesla. As I have mentioned in many Forbes columns Tesla shares are massively overvalued, but the market has at least partially realized that, sending Tesla shares down 20% in the past year. In contrast Netflix shares were trading at $64 per share in September 2014 versus the $268 level at which the shares are trading hands today.

So, by pricing Tesla shares lower on September 20, 2019 than they were on September 20, 2014—a period in which the Nasdaq 100 has doubled—the market has told Elon Musk that Tesla simply does not have the balance sheet strength to fight off much larger and appropriately-capitalized competitors such as GM, VW and Daimler. Well, I can’t think of two better-capitalized competitors than Apple and Disney, and Amazon, Comcast, Facebook and Alphabet are hardly starving for cash, either.

So, is it time for the market to deliver the harsh message to Reed Hastings that it has–”funding secured” shenanigans, aside–delivered to Musk in the past five years? I believe the answer is “yes” and I am working on short strategies involving Netflix shares for my new trading venture, Excelsior Capital Partners.

I have spent my entire adult life time analyzing companies, and I have learned that competitive pressures tend to show up in a company’s margins before it loses market share.  Reed Hastings may be right that Netflix only has 5% of viewing hours, and therefore has not nearly reached saturation, but Netflix doesn’t charge per-hour, per-day or per-show.  No, Netflix charges per subscriber, and those subscribers are being confronted with new options. These include Disney’s gargantuan line-up of billion-dollar tentpole franchises and Amazon’s linkage with its hugely popular Prime shopping service (of which I am a member.)  Also, when one broadens the market to include other sources of streaming content, such as Facebook and Alphabet’s YouTube, that increases the field with two more incredibly deep-pocketed tech behemoths.  

Netflix has become an international growth story.  Netflix’s domestic subscriber count actually declined in the second quarter (causing the stock to plunge on July 17th, when those earnings were released.  While the market focused on the sequential decline in U.S. subscribers, the year-on year growth in 2Q19 was only 7.4%, hardly indicative of a stock that would carry an 82x P/E.  

Netflix’s international subscriber base, in contrast, grew by 2.8 million sequentially in 2Q19, and that represented 33.7% year-on-year growth.  Netflix is enjoying the first-mover advantage abroad that it had in the U.S., but I believe that advantage is just as tenuous. Amazon has been especially aggressive in building its international original content, and while I have been fortunate to travel to all the inhabited continents, I have never been anywhere where I wasn’t confronted with advertising for at least one of Disney’s tentpole franchises.  

The financial issue for Netflix is that its U.S. streaming operations produced a 37.1% contribution margin in 2Q19 versus the 16.3% contribution from international operations.  Netflix is accepting lower margins to grow subscriber counts abroad, but given the strength of competition and its scalability, I don’t think Netflix’s international margins will ever reach those currently recorded in the U.S.  

 Hastings and Netflix management have presented 2019 as a transitional year.  Netflix burned more than $1 billion in the first six months of 2019 and management forecast a $3.5 billion cash outflow for the full year 2019, with a smaller cash outflow forecast for 2020 and a “clear path towards positive free cash flow” in the out years.  I would equate that to Musk’s fulsome promises of profitability at Tesla, none of which have ever borne fruit.  

Netflix spent $13 billion content acquisitions in 2018 and has spent $6.3 billion in 2019.  What the market seems to be belatedly realizing is that Netflix has to spend that much to maintain its subscriber base.  Disney, Apple, Amazon Hulu (67% owned by Disney with the balance owned by Comcast) and NBCUniversal (owned by Comcast) all can produce original content with costs that barely register on their massive corporate balance sheets.  Disney can also throw content from Marvel, Pixar, Lucasfilm as well as their corporate brand at the consumer. Amazon, Facebook, and YouTube are all branching into live sports, a lucrative business for Disney’s ESPN and ABC, and one which Hastings noted in the Variety interview that Netflix has chosen not to enter.   

That leads to the bottom line of my investment thesis.  I believe that competition will eat into Netflix’s margins and that each incremental subscriber will become less valuable.  As growth in that subscriber count slows, the stock market will continue to “de-rate” Netflix shares. Owing to their high valuation, there is plenty of room for that.