Netflix (NFLX) surprised investors on Wednesday evening when it announced earnings. The stock has ran a whopping 73% in three days mainly on the backs of margin calls and massive short-covering from $98 on Jan 23 to $169.56 as of the Friday close. Such a move is rarely (if ever) seen for a mid-cap, non-biotech stock whose fundamentals have barely changed. This however, does not mean that the rally will necessarily stop here.
The Short Run
As Benjamin Graham says, while the market is a precision weighing machine in the long-run, in the short-run it's a voting machine. The factors driving NFLX price now are massive short-covering, fear of the stock returning to $300 just as fast as it dropped to under $60 and accumulation of shares in the hands of experienced, strategic investors who are not willing to give them up on the cheap. (Carl Icahn and Whitney Tilson), In brief, in the short-run, there are only buyers in the market who need to cover due to margin calls and fear at any price and very few sellers who are mostly sitting on the sidelines watching the stock price rise. Given the low float in NFLX stock, it would not be surprising to see the stock run to $200 or even $230 before any sellers step in and the stock takes a breather. Both fundamental and technical analysis is basically useless at this stage as the chart shows no levels and valuation metrics are irrelevant when the broker covers short shares. To add insult to injury, this past week, you had a rotation out of AAPL, which disappointed and seems to be out of fashion, with mutual funds seeking a home for the money they have allocated to tech. It is therefore no surprise that stocks like Priceline.com (PCLN), Amazon (AMZN), Google (GOOG) and Netflix (NFLX) all moved higher on the heels of Apple's (AAPL) disappointing results.
In the long-run things can be a bit more complex ...
The Earnings Report:
The actual earnings report was not that impressive. The net profit was a mere $8 million and although it beat lowered estimates, for a company that has almost $1B in quarterly revenues, numbers can be easily massaged to make that happen. If one recalls the Q42011 report, it sounded awfully similar and with a large jump in stock price right after it. Ironically, it was followed by three quarters of disappointing results and stock price declines right after the Q1, Q2 and Q3 2012 results (check the chart). All the analysts now rushed to upgrade their estimates by boosting 2013, 2014 and 2015 earnings growth to astronomical levels and my expectation is that they will be revising those downwards as they get a reality check. Despite all that, only one analyst set a price target of $200, with everyone else almost doubling their estimates to anywhere between $120 and $170.
A changed industry:
In the long run, the most critical factor is competition. For those arguing that we will soon see $300 again, one needs to realize that the company is now much more different than in 2010 or 2011. It's a technology company focusing on streaming, rather than mail-in-DVD. Netflix rose to stardom on the backs of an outstanding DVD-by-mail fulfillment system and mastering USPS deliveries, taking old-school mammoths with high marginal costs and higher pricing structures out of business (see Blockbuster). At the time, Netflix would charge less than half of a similar cost to Blockbuster, it would be more convenient for the consumer and it would face no competition from other players. Its nascent at the time streaming business was nothing more than an experiment for studios and content providers who were willing to license their content on the cheap to get additional revenue. This era is forever gone. Numbers show that NFLX is focusing on streaming, that streaming is the future and that the DVD-in-mail business is in perpetual decline. Even Reed Hastings agrees to that.
Looking further down the road, NFLX is also trying to become a content provider (HBO-style) focusing on generating exclusive content, rather than a content distributor as it has been. This is a move that is made out of need mostly due to increased competition and might completely transform the business model but more on that later…
Competition: Hitting on all 4 cylinders
The competition in the streaming market is intense. AMZN is offering a broader content for subscribers of Amazon Prime for $79 per year (lower than NFLX) and has a huge war chest to fight that war. Reed Hastings argued in November that Amazon might be losing $500M-$1B per year from Amazon Prime and singing content deals, but Jeff Bezos sports a market cap of $130B, more than 10 times that of Netflix. He can afford to spend that kind of money in Amazon Prime for a long time, probably long enough to take NFLX bankrupt. Amazon is aggressively trying to set up exclusive content deals and is willing to pay more for them than NFLX, as the EPIX deal showed lately. Unlike NFLX that relies on streaming to make a living, Amazon's model for Prime is that of a loss leader, making up the difference in more retail sales. Granted, NFLX has a first-mover advantage in the business but AMZN has a bigger bank. It will be an interesting race. Another formidable competitor in streaming is Hulu, which is partly owned by Disney, NBCUniversal and Fox. Although rather small still, it's offering streaming service at the same price point as NFLX and (being owned by the studios themselves), it has a higher potential for quality programming. Finally, In the declining DVD business, NFLX is facing competition from Coinstar's Redbox service.
Strategic value, Carl Icahn and potential for acquisition
Carl Icahn's investment thesis for NFLX at $58/share was that the industry is ripe for consolidation and that potential suitors could be Amazon, The Studios via Hulu, Google/Youtube or Apple/Itunes. We agree with him that NFLX would nicely fit as part of those businesses and it's clear that all those potential suitors have enough cash in the bank and don't know what to do with it, so they might overpay. However, as described above, it seems that so far most of those players have opted to develop their own businesses rather than acquire someone else, especially NFLX. This can be driven by the fact that it's actually cheaper to develop that business organically rather than pay to buy NFLX (especially when NFLX was at $200+ per share) or by the fact that Reed Hastings does not want to sell NFLX.
It appears that both factors are in play and NFLX will not be acquired any time soon. Hastings does not want to sell his baby to Jeff Bezos or Apple and lose management control and he rebuked Icahn's calls for unlocking strategic value by implementing a poison bill right after Icahn announced his stake. He believes that he can survive in a very competitive landscape through a combination of exclusive content creation and customer loyalty to the first mover. Icahn on the other hand admitted on the air after the earnings report that one might pay $100-$150 per NFLX share but it's doubtful that anyone will pay $200+/share to buy NFLX. So, we would be looking at Icahn unloading his stake in the company in the next few months at a blockbuster profit and moving on to his next target (most likely RIG).
The only potential suitor we see for NFLX is AAPL. It's sitting on a huge pile of cash, it does not offer a flat subscription service, it does have access to content via iTunes, it lost its chief innovator (Steve Jobs) and can potentially overpay (accept a price that Reed Hastings is happy with).
So, how come the studios are not willing to buy NFLX and its 30 million subscribers? This takes us to our next issue…
Higher content costs, shift in focus from a content distributor to a content creator.
During the birth of streaming, the studios were willing to license Netflix their content for really cheap prices. They were making the bulk of their money from DVD sales and streaming revenue was a drop in the bucket for them. However, with the landscape changing and consumers moving to streaming, the studios:
- Raised content licensing fees across the board
- Made a conscious investment into Hulu or other proprietary streaming services (HBO Go etc) that sport exclusive content.
Basically, the NFLX business (online content streaming distribution) is a relatively easy business to replicate and the studios know that the value is in the content and they own the content. All they have to do is build their own distribution channels and keep charging high fees for content to the highest bidder (which now seems to be Amazon). So NFLX is stuck between high content costs, vendors that are competing with it and a competitor that is willing, ready and able to pay more for premium content. NFLX still has the first mover advantage and don't get me wrong - this is a HUGE advantage with benefits such as the largest subscriber base, brand recognition and focus on niche necessary for company survival. Yet, being stuck in between higher content costs and deep-pocketed competition can translate into slow death for Netflix in the long run.
Reed Hastings understands that and is trying to steer the ship into a new hybrid business model. Just as the studios invested in Hulu, he is investing in exclusive content creation (House of Cards). He is doing this more out of necessity rather than choice. As his content costs are becoming prohibitive and as AMZN is stealing content by being willing to pay more, NFLX is left with no choice but to pay through the nose for content or create its own exclusive content, therefore becoming a studio. One thing is for sure: the excessive margins of the early DVD-in-mail business are history and now Netflix is competing with the studios in their own turf. If he creates a blockbuster series, then maybe he will come out a winner, but that is a big if. This takes us to our next point.
Investment in the future, subscriber growth and new markets
Netflix is investing 120% of cash generated in new content and as a result they are starved for cash. As a result, investing in new international markets is becoming very hard for them. In the conference call, they said that they will not be entering new international markets until at least the end of 2013, giving a first mover advantage to other large competitors (Amazon has Lovefilm in the UK etc). International markets require a huge investment outflow (NFLX lost $105M in this past quarter from international operations). And although subscriber growth is strong domestically and subsidizes international expansion, we believe it was mostly driven by holiday sales and free trials. We do not expect to see this being replicated for the next three quarters. As a result, we see it as necessary for NFLX to continue with debt and/or equity offerings to be able to finance future growth and go head-to-head with larger competitors.
So where does all this leave us for the long run? It seems that NFLX has unique challenges on the horizon. Competition is now fierce and the content providers do not see streaming as a negligible profit center. The days of excessive margins from the DVD-in-mail business are forever gone but NFLX has large value as a strategic partner due to its existing subscriber base. As Whitney Tilson said in Feb 2011, covering his short at $200+/share, if NFLX executes to perfection, this can be a $300 stock once again but it's definitely not a good value up here unless it all goes perfect. It was definitely undervalued at $60 and it might see $200 before it sees $100 but the headwinds are strong and it eventually might end up being gobbled up on the cheap or driven out of business.