Netflix (NFLX) has a tremendous business model and the first mover advantage in the subscription online-delivery space. In our estimation, Netflix will be relevant for years to come, but it will not be the only player in the space as various competitors continue to make inroads. As such, Netflix's operating margins are likely to remain under pressure and the current stock price of $180.97 grossly overestimates the inherent earnings power of the overall enterprise. After reporting earnings and issuing guidance that exceeded expectations, the market has sent NFLX to dizzying levels it has not witnessed since its last ascent in late 2010. However, this time around, Netflix is a much easier short. The domestic business is no longer in its early high-growth stages and the addressable market is more defined than two years ago. In short (pun intended), we have seen this movie before and it will end badly for bulls at these levels. We estimate the catalyst to be subscriber guidance or results for 2Q 2013 that will fall short of expectations and prompt a drastic multiple reevaluation by investors.
Our short thesis can be summarized as follows:
Two years ago, Netflix was operating with relatively limited competition. In the current environment, a number of well-capitalized entrants have entered the digital subscription space and continue to focus on expanding their respective content offerings. Hulu Plus has over 3mm paying subscribers (more than doubling over the past year), Amazon (AMZN) Prime offers over 36,000 titles but does not disclose the size of its member base and Redbox (CSTR) is poised to move past its beta version by the end of the first quarter and market the new Redbox Instant service to its 48 million email addresses.
By Netflix's own research, Amazon Prime offers 73 of Netflix's top 200 titles (top 100 TV shows and top 100 movies) and that number will only increase in the coming months. This is an ominous sign. While Amazon's service requires an annual contract, it effectively costs 20% less on a monthly basis and includes the additional benefit of free shipping on items purchased from Amazon.com. Despite the reduced flexibility to exit the service, the value proposition becomes more appealing as its content quality improves.
Reed Hastings, a visionary but also a highly promotional CEO, proclaims that consumers will subscribe to multiple offerings simultaneously similar to accessing the major networks (CBS, NBC and ABC) through their cable service provider. This fallacy is a misleading attempt to assuage investor concerns over the growing presence of formidable competition. Netflix, Hulu Plus, Amazon Prime and Redbox Instant will function more like premium cable stations (i.e., HBO, Showtime, Cinemax). In this model, consumers migrate from one premium channel to another based on content and pricing. In essence, I fully expect churn at Netflix to remain at elevated levels as subscribers come and go through the intentional revolving door that Reed Hastings alluded to on the fourth quarter earnings call. ("We don't focus on churn because we really want to make it easy to quit. I know that sounds strange but we spend a lot of time so that if you leave, you have a really good experience and that makes you much more likely to come back in.")
Lower Net Additions:
In light of increasing competition and the current mass-market adoption of Netflix's service, seasonality will become more pronounced within Netflix's subscriber numbers. Reed Hastings indicated as such in the fourth quarter letter to shareholders, "unchanged seasonality of gross adds would, due to the larger size of our existing subscriber base, result in increased seasonality of net additions. Thus we would expect fewer net additions in Q2 2013 than in Q2 2012, because Q2 is our seasonally lightest quarter." Based on our estimates depicted below, Netflix will likely experience a drop in unique subscribers during the Q2 2013. Of course, Netflix has made it more difficult to track these statistics as it continually reduces its reporting metrics (i.e., it no longer reports gross additions, churn or unique subscribers). Nonetheless, a drop in subscribers in Q2 2013 will disappoint the market and prompt investors to question the high growth multiple they are currently paying for the company.
Higher Content Costs:
In addition to more volatile and weakening net additions, the increasingly competitive landscape will create upward pressure on content costs. Amazon and Netflix are already fiercely attempting to best each other in producing original content and in gaining exclusive access to popular content. Hulu Plus has played a relatively minor role to date but its presence is growing. Hulu Plus spent over $500mm on content in 2012 (Netflix spent $1.7bn based on our estimates in 2012), increasing its title count by 40%. According to its blog posts, Hulu plans to expand its slate of original and exclusive series in 2013.
An unknown variable will be Redbox Instant. Despite paying for content on a per-subscriber basis, the impending entrance of the Redbox/Verizon JV into the fray will add another service to bid up content prices on either an exclusive or non-exclusive format. Content providers also benefit from the short-term nature of the licensing agreements, allowing for content prices to readjust to the prevailing supply/demand dynamic in short order.
In an effort to combat the rising cost of third-party content and to differentiate itself, Netflix has made a strong effort to create original content, spending a reported $100mm on two seasons (26 episodes) of House of Cards. As it relates to House of Cards, the decision to release the first 13 episodes simultaneously is difficult to justify in our opinion. Does it change viewing behavior? Yes. But if House of Cards becomes the hit Netflix anticipates, a viewer can watch the entire first season in one weekend.
This stands in stark contrast to the proven model HBO and Showtime follow, strategically airing new original programming episodes at least a week apart. We believe Netflix will have a difficult time recouping its investment under its current structure as the all-you-can-eat model dissuades perpetual usage. In order to break even, Netflix will need to add 6.25mm subscribers assuming each incremental subscriber churns off after viewing all the House of Cards episodes in three months (the first month is free).
Higher Marketing Spend:
Netflix has benefited from ubiquity among consumer electronic devices and effective customer acquisition in the United States. As a result, Netflix has been able to divert domestic spending toward content acquisition from marketing. Reed Hastings intimated in the fourth quarter conference call that "the main efficiency comes because most marketing is our members telling their friends about Netflix. It's not the ads that we pay for. And as we have more and more members, and as they are happier and happier with the service, then that benefits the growth and then you don't need as much paid marketing." However, we question if this low level of marketing spend is sustainable. Netflix is spending less than it did in the last three years as detailed below.
As competition continues to heat up, Netflix will be forced to defend its turf and spending on marketing will need to be ratcheted higher to maintain a continual stream of new subscribers to replace those that will inevitably churn off the service. A survey conducted by ChangeWave Research in September '12 showed Amazon Prime increased its share by 15pts since December '10 and an increasing number of Netflix subscribers were contemplating canceling their service and opting for Amazon Prime as its content selection improves. More noteworthy, Amazon Prime is making inroads in spite of not being heavily marketed as a stand-alone service.
Another wild card is if HBO, which boasts nearly 30mm domestic subscribers, separates itself from traditional cable subscription packages and markets HBO Go as a stand-alone service. Although this is not currently anticipated, such an event would present a major challenge for Netflix to maintain its market share. It also remains to be seen how aggressive Redbox Instant will be on the marketing front, but Reed Hastings would be remiss to believe reduced marketing spend going forward is sustainable.
Rising Capital Requirements:
During the course of 2009 through Q3 2011, Netflix aggressively bought back stock as it viewed future capital requirements as manageable within its internally generated free cash flow. In 2010 and 2011, the company repurchased $210mm and $200mm at an average price of $80.67 and $221.88, respectively. By the end of Q4 2011, management recognized that Netflix was going to endure a lengthy period of cash burn as content costs abruptly increased and subscriber growth began to slow. It raised $200mm of equity at $70.00 and another $200mm in zero coupon senior notes convertible at $85.80. This capital raise gave Netflix the flexibility to continue its aggressive acquisition of content but also highlighted management's limited visibility or insight into content costs and cash needs.
In early February 2013, Netflix tapped the capital markets again and successfully raised $500mm in 5.375% senior notes to replace its prior $200mm 8.5% senior notes. After paying fees and the "make-whole" premium on the 8.5% notes, Netflix has an incremental $275mm in cash to direct as needed. Conversely, Netflix will incur an incremental $10mm in annual cash interest. As such, Netflix has a higher fixed cost structure going forward to generate free cash flow. If Netflix is unable to consistently grow its subscriber base to offset growing content costs and the likely need for additional marketing spend, the company's investment bankers will likely benefit again at the expense of its other stakeholders.
Minimal Pricing Power:
Bulls will point out that with modest attrition Netflix maintains the ability to raise pricing over time to counter expensive content costs. We challenge this assumption as unrealistic. Netflix successfully raised prices by about $1.00 per DVD out at a time at the start of 2011, but faced a massive backlash when it attempted to do so more aggressively later in the year. The competitive landscape is also vastly different. In the beginning of 2011, there was no acceptable alternative but in the current environment many close substitutes exist at similar price points. Any price increase will make the other services more attractive and churn will rise sharply. Without higher prices across the digital delivery subscription market, it would be a blunder for Netflix to unilaterally increase prices.
We believe Netflix recognizes this dilemma and has shifted its focus toward original and exclusive content to improve the perceived value of its service. If successful, Netflix will be able to move its pricing closer to that of premium cable channels. Yet, the addressable market for such premium mediums is not materially different from Netflix's existing subscriber base (HBO - 30mm subscribers, Showtime - 22mm subscribers, Cinemax - 18mm subscribers), leaving little room for incremental growth. As such, without a highly valued array of original and exclusive content, Netflix will be beholden to the moves of its peers and likely constrained to tight margins.
By all accounts, Netflix's international effort is making positive strides and exceeding management's stated expectations. Subscriber numbers are moderately growing and the segment's contribution loss is guided to improve sequentially in 1Q 2013 for the first time since its Latin American launch. Regardless, there is limited visibility as to when the international segment will become a positive cash flow contributor. More concerning, there is evidence of slowing overall subscriber growth in its international markets as transcribed below.
In light of launching its service in the UK and Ireland in 1Q 2012 and the Nordics in 4Q 2012, at the high end of its range, Netflix is still guiding to lower subscriber additions year over year in 1Q 2013. At this point in its growth cycle, international subscriber numbers should be accelerating as Netflix builds its presence in more countries, but its guidance for 1Q 2013 indicates otherwise. Given that Netflix has been operating in Canada and Latin America for more than two holiday seasons, performance in the subscriber metrics for these countries would be highly informative toward Netflix's intermediate term traction in international markets. Knowing Netflix's tendency to disclose less not more, investors will remain in the dark.
Given the various threats and challenges to Netflix's long-term earnings power, it is mesmerizing to see investors/traders paying in excess of 65x 2014 consensus earnings (currently $2.68), but we are convinced this valuation will not last. Even under our most optimistic scenarios where competitive pressures subside, we believe Netflix will have peak earnings power no greater than $4.00 in EPS in 2014. Thereafter, it'll be difficult for Netflix to grow earnings further as its subscriber base matures and content renewals weigh on margins. We believe it is more likely that Netflix struggles to grow post 2013 given our numerous concerns outlined earlier. As such, we see significant material downside from current levels when the market realizes the business has limited profitable long-term growth prospects.
We estimate the catalyst for a reevaluation of the multiple investors are willing to pay for Netflix's business will be guidance or results for 2Q 2013. We envision a sell-off similar to the vicious and precipitous drop NFLX experienced in the summer of 2011 when its growth prospects stalled. High-growth stocks always fall the fastest and hardest once their promise/growth is diminished and rationality returns. We hope investors will be wiser this time around and more cautious before buying into the hype. After all, fool me once, shame on you. Fool me twice, shame on me. Either way, I believe the action over the coming weeks will mark the height of insanity surrounding this name.
Disclaimer: This is not a recommendation to buy or sell any investment.
Disclosure: I am short NFLX. We may transact in the securities of NFLX subsequent to publication.