As I have written, the basic fallacy with growth stock analysis stems from taking an unlikely but highly favorable future scenario, and discounting it to the present, thus coming to the conclusion that a stock is incredibly cheap even when it might be incredibly expensive.
This article will cover Netflix (NFLX) and how this fallacy can apply to it. To establish this I will first describe the Netflix bullish thesis, and then describe a scenario that's about as likely to happen. We'll see how rationally these two very distinct values can easily be defended.
I'll start with a simple characterization of Netflix's business.
Revenue and cost
On the revenue side, Netflix is pretty simple. We could say it's simply the number of subscribers times $8 times 12 months. This is obviously an approximation, because:
- Netflix doesn't cost exactly $8 everywhere;
- Netflix has a couple of products which cost more than $8, but they are minor;
- Not every subscriber is with Netflix the whole quarter/year.
Anyway, this simple approximation does cover most of Netflix revenue. For instance, in the latest quarter Netflix had an average of 44 million paid subscribers (including DVD subscribers) which generated revenues of $1.1 billion. This meant Netflix charged $8.38 per subscriber per month, on average. Pretty close to $8 per month. The average subscription is slightly inflated by the DVD-by-mail segment, which is fading away over time.
Where Netflix is more complex, is in what pertains to the content costs it supports to attract and keep its subscriber base. Netflix gets content from suppliers or pays to create its own original content. Both modes usually imply large up-front payments.
However, the cost of this content is not recognized upfront. Instead, it's recognized over the term of the contracts. That is, the cost of the content is recognized over the period of time over which Netflix can make this content available to its subscribers. While cost recognition is linear over time, the consumption of the content isn't. As we'll see, this has broad implications.
The bullish thesis
The bullish thesis on Netflix isn't too complex. We could say that Icahn's bullish thesis on Netflix represents the overall bullish view of the market. It goes like this:
…Despite its notable appreciation in just over one year to $323 per share, for the reasons set forth below, we believe the company remains significantly undervalued. As a subscription service priced at only $7.99 per month, we believe Netflix is one of the great consumer bargains of our time. We find it difficult to understand why a household would not subscribe to the service, considering the low monthly price, the robust content aggregation (which includes an increasing mix of premium and award-winning original series) and the dramatically superior user experience from both an interface and overall technology perspective. Netflix's predominately fixed content cost (variable primarily to the extent management chooses to further improve the service) gives the business model massive operational leverage. Our recognition of this operational leverage, combined with our expectations for both domestic and international subscriber growth with modest price increases over time, has been and continues to be the core of our investment thesis.
With respect to Netflix's opportunity in the United States, Reed Hastings' estimated range for a total domestic market size of 60 million to 90 million domestic subscribers implies that Netflix will add 30 million new domestic subscribers, using the low end of that range. While the timeframe is debatable, we share Reed's confidence in the overall size of this market, and we note that Netflix is currently adding six million net subscriber additions per year. Furthermore, at just $7.99 per month, we think Netflix has pricing power - and while we do not expect price increases for the next two years we think it is reasonable to anticipate that the company could ultimately raise prices to $9.99 per month over the course of the next five years (this equates to a very modest annualized increase of roughly 4.6%). Together, we expect these new subscriber additions and price increases would raise domestic streaming revenues by $4.3 billion annually. Even if the company decides to increase spending on cost of revenues (largely content) by $1 billion annually (a 55% increase) in order to seek to achieve this growth by further improving the user experience, the operating leverage would still be impressive, adding $3.3 billion to domestic contribution profit.
This thesis sees Netflix costs as being rather fixed, so when Netflix greatly increases its subscriber base and/or increases prices, Netflix stands to reap significant windfall profits from the fact its revenues expand while its costs do not.
I too believe Netflix might have up to $1-$2 per month in pricing power. Let us see what the bullish thesis for Netflix could broadly imply for the stock. For this we'll use hugely optimistic assumptions, including 120 million subscribers (60 million domestic, 60 million international), a $1 price raise, 40% content gross margins, 10% marketing costs, 10% other operating expenses, 30% tax on profits.
What this produces is the following "at maturity" Netflix.
And there it is, with those rosy assumptions, somewhere down the road Netflix would be earning $1.8 billion in net profit. With today's market capitalization of $19.85 billion, it would already be trading at 10.9 times those rosy estimated earnings. While not incredibly cheap (this takes place many years into the future, and does not account for debt or dilution) it is still within the realm of possibility.
But remember, those were extremely optimistic assumptions. This is thus a rather unlikely scenario - just the kind of thing one sees in the growth stock analysis fallacy.
What about an alternative? Let's discuss it
As we saw, the bullish thesis relies on content costs being rather fixed and changeable by management's will to provide more or less quality. However, this is not exactly true. Content costs for any given content are just fixed for the duration of the contract licensing Netflix to use the content.
There are three implications here:
- When a contract expires, Netflix does not hold any asset. It can no longer exhibit that particular content to its subscribers;
- While costs for any given content are mostly fixed over the life of a contract, they need to be renegotiated once the contract ends. This means that content costs might not be fixed over time even if the subscriber base stabilizes;
- And finally, content consumption is not necessarily linear over time. Indeed, there are signs that for the most popular content, the content that most drives adoption and keeping of subscribers, fresh content, the consumption patterns are hugely front-loaded. This is in stark contrast with the linear depreciation of content costs.
This last observation is crucial. The chart below depicts how consumption behaves (red line) and how Netflix depreciates a content asset (blue line). If depreciation was matched to the consumption pattern, as Netflix recently decided to do regarding original content, then content costs would be recognized earlier. As it stands, the present accounting treatment overstates near-term profits at the expense of long-term profits.
Not only that, but Netflix needs to constantly add new content due to the consumption pattern described above. If Netflix were not to add new content, the majority of its subscriber base would quickly run through all of the novelties and then would feel that the value brought by Netflix was fading. Think about it this way, what value would you give to a cinema which didn't add new movies for a year or two, where you could just select the movies you wanted to see from those that were carried in the last 3-4 years? The interest would quickly fade.
So Netflix is forced to add new content over and over, even if its subscriber base at some point reaches maturity. It needs to do so just to keep the subscriber base happy and interested. It's not a matter of budgeting $X for content for a Y subscriber base. To keep the perceived quality for a given subscriber base, the content needs to be renovated over and over. It's thus likely that for a couple of years after the subscriber base stabilizes, the content costs will keep on increasing - even ignoring the effect of content renewal negotiations.
Then there's another angle. Netflix paid customers are now watching 90 minutes of content per day on average. 90 minutes is around the length of a movie. So basically Netflix would have to convince the content owners to rent the equivalent of 30 movies per month for $8, or $0.266 per movie - and that's for the whole family watching, not just a single customer.
As big LCDs get more and more common and home viewing substitutes cinema, this will present a very unfavorable economic picture for content owners, unless they can push Netflix harder and harder on content pricing. And since that content needs to be renovated often, the chance for content owners to push on price gets replayed often as well.
What this means is that even if we keep all of the optimistic assumptions from the bullish thesis, we need to make an exception for the content gross margin. Instead of 40%, we must consider what happens at 20% or 30%. This is what happens.
(click to enlarge)At 20% gross margins, Netflix sees its entire profit be wiped out. At 30% content gross margins, its "at maturity" profit would be halved, and Netflix would already be trading at 21.9 times the "maturity" profits, which is clearly excessive. Yet, these scenarios are about as likely as the incredibly bullish scenario that seems to be informing the investors putting money into Netflix today.
While one can come up with a bullish scenario for Netflix where the present price is justified, it's just as easy - and fundamentally sound - to see scenarios where the company is wildly overvalued due to the dynamic surrounding content costs.
The market trades as if the bullish scenario is a certainty, when in fact the bearish scenarios are just as likely, if not more likely, to happen.