Netflix (NFLX) seems to be a very simple business model. With an ARPU of $10.6 and a subscription cost of $20.64, it has some serious strategic issues. It is a business with shrinking profit margins, rising subscription cost and several other financial problems. Despite such financial problems, Carl Icahn - the famous turnaround investor - has called NFLX an undervalued stock and has announced a 10% ownership of it.
This news came as a shock to us, as the business appears to be on very different footing than what Icahn described. Although Icahn has called it an undervalued stock and prices have soared by 34% since the October-24 low, we still feel that the stock is a no-go for investors.
Can the "Icahn Value" Exist?
A Business Model Analysis:
We would have agreed with Icahn's valuation, if the business had been profitable in the long-term i.e. its ARPU had been greater than its content subscription cost. Following is the cost and ARPU analysis for NFLX.
*2013, 2014 are sell side estimates*
It is evident that NFLX can only bring improvements by lowering its loss ratio. This can only happen if:
- It increases the number of its subscribers. As the company pays a fixed fee to media content sellers, high investment in streaming and subscription would be justified only if the addition in the number of subscribers meets the expected target of the company. In this way, the average cost per subscription would go down. However, despite this heavy investment in streaming and subscription, the company has not been able to increase its subscriptions as much as it expected. The company provided an estimate of 7 million customers at the beginning of the year. However, it has only announced an addition of 1.65 million customers for the final quarter, reducing the original estimate from 7 million to 5.1 million.
- It increases its price. This does not seem a viable option because of intense competition in the market. Amazon (AMZN), one of NFLX's biggest competitors, has challenged NFLX by launching a customer friendly monthly option.
- It decreases its content acquisition cost. This too is not a viable option in the long run because high quality content acquisition is the only distinct competitive advantage of NFLX.
The consensus of analysts also points towards a similar story. "We are skeptical that a buyer will find more value in NFLX than building a content offering organically," states Barclays Inc. It indicates that the low value is associated with the existing business model of NFLX.
A Valuation Based Analysis:
Many digital companies are valued on price to sales or price to EBITDA ratios. As the profit margin of NFLX is very low, it makes more sense to value the company based on P/E rather than P/S. When analyzed from this perspective, there is a potential danger for NFLX - a story that an analysis of its P/E tells clearly.
Currently, the Forward P/E of NFLX is 180x. A company with declining margins cannot afford such a high P/E ratio. This clearly indicates that NFLX is overvalued. The implications from this analysis raise some serious concerns regarding the stance taken by Icahn.
What about its Financial Position?
The first reason behind our stance on NFLX is the unsatisfactory financial performance of the company. The results of the third quarter came as a shock; because the performance of the company was lower than the consensus predicted by analysts. The company could not manage to add as many subscribers as it promised. A more comprehensive financial analysis of the company reveals that although total revenue increased by 83% after 2010, gross profit has increased by only 30%. This is mainly due to the high subscription costs, which have risen by 132% since 2010. This has also resulted in reduction in its operating margin and net income by 72% and 76% respectively.
The following graph shows the widening gap between revenue and gross profit. This is mainly because of a high subscription cost, which is 90% of the total cost.
Following chart shows how its gross and net profit margins have declined over the years.
Despite the apparently bullish statement by Icahn, we feel that NFLX is not in a position where investors should consider taking a long position in its stock. We disagree with Icahn's bullish stance and argue that NFLX is a company which is not only facing financial problems but also serious flaws in its business model. Moreover, it is also important to note that Carl Icahn has seen many failures in the past. He has been involved in four failed takeovers in less than a year, which raises serious concerns regarding his credibility as a turnaround specialist for NFLX.
This makes us believe that taking a bullish stance because of the recent poison pill would not make much sense either. Moreover, the literature indicates that the poison pill itself is not welcomed by the stock market. Research done by Arikawa and Mitsusada (2007) indicates that the announcement of the pill is considered as the revealing of inside information of the company's management and, therefore, the stock prices begin to decline. Similarly, the research work done by Turk et al (2007) also indicates a similar relationship.
Our analysis indicates that NFLX is a company with:
- Weak financial position
- Overvalued stock
- Worsening business model
- Shrinking margins
While Carl Icahn feels that the company is undervalued. We strongly feel that it is an overvalued stock, which does not make it a very attractive option for most investors.