Netflix: Still Too Expensive Despite 6% Sell-Off

• Netflix down ~6% after hours on 20% earnings miss and lower subs
• All about cash flow – targeting break-even for 2021
• $500 is too much to pay for this growth business

Yesterday my blog opened with this comment:

“Today was another “deal is off” day for the market. Democrat House Speaker Nancy Pelosi gave the Senate Republicans 48-hours to get a deal done before the election – otherwise it’s off. Markets lost a few points. Tomorrow it will probably be another “deal is on” day – and markets will catch a bid”

Well today it was the “deal is back on”… and guess what… market’s caught a bid. 

It’s anyone’s guess what tomorrow will be… toss a coin. 

Let’s put the shenanigans of Congress to the side – and focus on one of the most anticipated earnings calls of the week… Netflix.

Netflix stock has surged over $100 the past few months – as the “stay-at-home trade” resonated with investors.

But how much good news was already priced into the stock?

Too much in my view (which I think is the case for most of big tech sector) 

Today we learned the streaming leader missed earnings by ~20% – making it the stocks biggest miss since going public ten years ago. 

After-hours the stock is down around 6%. 

It may open higher or lower by tomorrow morning after analysts digest the earnings call.

Given this is a widely-held stock – I will use tonight’s missive to share my thoughts on why this stock is still too expensive.

NFLX Q3 Key Metrics

Let’s start by reviewing today’s numbers:
 

• Earnings per share: $1.74 vs $2.14 expected
• Revenue: $6.44 billion (up ~25% YoY) vs $6.38 billion expected; and
• Global paid net subscriber additions: 2.20 million vs. 3.57 million expected

The good news – Netflix continue to add millions of subscribers every quarter.

And the pace of consumer acquisitions they experienced over the first half of the year was not expected to be sustained. And the market knew that. 

CEO Reed Hastings reiterated this today – saying he sees subscriber growth reverting to pre-COVID levels next year (which is still strong). 

What’s also impressive is their revenue growth – it’s up by around 25% YoY.

Net-net – this is good business. But it’s on the expensive side. 

For example, you’re paying a trailing PE of 90x; and a forward PE of around 60x for Netflix’s growth

In other words, Netflix will need to keep growing in the realm of 25%+ YoY to justify multiples of this order

Can they do it? 

In a moment, I will pose four key questions that investors need to weigh…

Let’s start with the chart and assessing the trend. 

Netflix – Expect a Pullback

Not unlike other “quarantine” names – investors have piled into this stock post March 2020:

NFLX – Oct 20 2020

As we can see, Netflix was trading below $400 per share in April

Since then the stock is up over $100 per share. 

Whilst the stock has been in a weekly bullish trend since January of this year (before COVID) – it looked overbought in recent weeks (as can be seen by the RSI in the lower window). 

For me, I like Netflix closer to $400 to $420 per share – a previous level of resistance and likely to become new support. 

Now that’s a long way below the after-hours (post earnings release) of around $490 per share – but don’t rule it out on any reversal of sentiment. 

And should Netflix trade back below $290 per share (the last major low) – I would exit the stock. 

4 Things to Consider

Further to my preface, investors are paying large multiples for owning a slice of Netflix business. 

And that might be okay… on the caveat the stock can keep growing at break-neck speed. 

And maybe it can?

But here are 4 questions I have (and maybe you have others). 

Let’s start with (big) competitors coming into the space… they are lining up.

1. Competition is strong, well funded and growing

The streaming market today is starting to become a crowded space.

For example, there are at least 12 leading providers ramping up their (unique) content offerings – as they compete for consumer’s $10 to $50 per month.

Leading names include Apple, Disney, Amazon, CBS, HBO Now, HBO Max, NBC’s Peacock, Hulu, Showtime, Starz, Sling TV, AT&T TV Now and YouTube TV

YouTube is perhaps the most expensive – coming in at US$65 per month (which I subscribe to) – however it offers live content (as do competitive services like fubuTV and Sling) 

But most streaming service providers average anywhere between $5 and $50 per month (pending on what content package you choose)… 

Which brings me to my next question… 

2. What much will people pay for streaming?

This is a difficult question to answer – but you would have to think that it would be somewhere in the realm of $10 to $50 per month (at a guess).

The question then is how is that “$50” divided among the 12+ providers above?

As I say, I’m paying around $65 per month today for the content I enjoy (and I don’t watch much TV!)

As a benchmark – a Sept 2019 PC Magazine survey of 1,001 US streaming subscribers found that customers would pay an average of $33 per month for all their streaming services combined. 

The survey suggests there is only room for only a handful of subscriptions in each streaming consumer’s monthly budget. 

On average, respondents said they’d be willing pay about $10 a month per service, though 37 percent of respondents chose $6 to $10 as their ideal price range (more on this in a moment when I ask the question of pricing power)

Another 30 percent said they’d pay $11 to $15 per service, and 20 percent chose only up to $5. 

My personal view for those only wanting to pay $5 – offer them a service which is heavily subsidized by advertising (not unlike free-to-air)? A service by the name of Tubi is doing just that (acquired by Fox this year for $440M)

Interesting, only 8 percent of respondents said they’d pay $16 to $20 per service, with the final 5 percent of streaming users saying they’d drop $21 or more a month on a single offering.

And whilst there’s no doubt Netflix is the market leader (estimated as much as a 70% total market share) – how much pricing power do they have (based on this analysis)?

For example, could they raise prices per month without losing subscribers? And would people “happily” pay another $1 per month? $2? $5? 

At some point – I think Netflix is going to flex its muscle and test what consumers are willing to keep paying before they say no (more on why when I talk to the question of cash flow)

3. How will Netflix Differentiate? 

To that end – I wonder how Netflix are going to:

(a) keep their (budget conscious) subscribers; and
(b) differentiate from the growing list of competitors? 

For example, when I look at what Netflix are doing – I don’t see a lot which is likely to disrupt the game over the likes of say Apple, Disney, HBO and Amazon?

Because if the answer is simply “more exclusive content“…  then I see further pricing pressure. 

I think Netflix should be watchful here – especially opposite the likes of Apple and Amazon. 

For example, I would not be surprised to see these (well funded) behemoths bundle a number of their other services to secure subscribers… just a thought. 

Netflix don’t have this ability… 

4. Free Cash Flow

My final question is one the market’s been asking for at least the past five years; i.e. when will the company be consistently cash flow positive?

For example, despite Netflix being in business for 10 years (and enjoying more success than any other streaming business) – they are still burning through incredible sums of cash.  

Here’s CNBC:  

The company’s free cash flow was positive for the third straight quarter, and is at positive $2.2 billion for the first nine months of 2020.

It said it expects to be slightly negative on free cash flow in Q4 as production restarts.

It expects free cash flow to be about $2 billion for the full year 2020, up from its previous break-even to positive estimate.

But for 2021, Netflix said it expects free cash flow to be -$1 billion to break-even.

This year Netflix basically ceased all production – helping them show a positive FCF result. 

But if we look ahead to 2021… they could burn through as much as $1B to fund new content (assuming of course it continues to grow subscriptions and revenue). 

This remains an open question… and one that is concerning.

Rupert Murdoch suggested that content is king… 

If that’s the case for Netflix – they’re going to have to keep spending.

But will that be enough to differentiate their service (or content) over the increased competition? 

Maybe it will. 

But I have to ask that if you can’t make money after 10 years (whilst commanding more than 70% of the market) – what does that tell us about the ongoing cost of content development?

It’s a tough business and about to get tougher… as there are some cash-rich giants (Apple, Disney and Amazon) all wanting to grab a share of consumer’s “$33 per month ‘all-in’ streaming wallets”. 

In closing, I think Netflix is a good business… but at the right price. 

For me, $500 is a high price to pay for this stock given the risks. Something closer to $400 looks like better risk/reward. 

Regards,
Adrian Tout