Should Netflix (NASDAQ:NFLX) be valued as a distribution channel or a content company? And where does the value lay in the food chain, content or distribution? At the moment, Netflix is valued the same as AMC (NASDAQ:AMCX) and twice as richly as cable companies, on a price-to-enterprise basis, and dramatically higher on a price-to-earnings basis.
In an interesting article a couple of years ago, fellow SA contributor Dana Blankenhorn made the case that the content distribution channel will always have the power over the content companies. So back in the 1920's the theater companies held the power over the movie studios; and the TV and cable networks dominated the film and TV producers in recent decades. I think this is correct, the question though is whether Netflix is really similar to theater chains and cable companies? After all, a movie theater enjoys local quasi-monopoly power wherever it's sited. In addition, a theater chain shows hundreds of movies per year whereas a movie studio might only produce a handful per year. It therefore makes it much more important to a movie studio that it gets to show its movie in a theater than vice versa.
Unlike cable companies, there isn't any must-have programming on Netflix, like sports. In addition, switching cable companies' services involves a lot of friction: having to cancel a 2-year contract as well as returning their equipment, which isn't the case with Netflix. Consequently, there is much higher churn with Netflix subscribers than cable ones. Around 40% of subscribers quit annually on Netflix which is twice the typical cable company churn rate.
Indeed, Netflix seems to be conceding that it has little power as a distribution channel with its moves into original content and deals with cable companies to include Netflix as one of their subscription channels.
I think a better way of characterizing Netflix is to compare it with Google's (NASDAQ:GOOG) YouTube. Both are casual or add-on viewing to network and cable viewing i.e., neither of them is essential viewing. Both YouTube and Netflix are websites and mobile apps on various devices. They therefore compete with each other for people's discretionary leisure time. Now here are some differences:
· People watch 6 billion hours on YouTube compared to only just over 1 billion hours of video on Netflix.
· Content is generated by YouTube's users for free, whereas content is Netflix's biggest expense.
For YouTube this is completely, genuine, you-better-believe-it unscripted content.
· The vast majority of the content on YouTube is unscripted whereas all the content on Netflix is scripted. Yet unscripted content is very popular with viewers: the most highly rated shows on television over the last decade or so have been unscripted: Big Brother, Survivor, American Idol, etc.
· YouTube does have some scripted content: mainly old TV shows and films, some of which has been uploaded with the copyright's owner's permission, while others have not. This long tail of content is much larger - and longer tailed - than that found on Netflix itself.
· YouTube has strong network effects: viewers go to YouTube because that's where all the content is and content creators upload their videos to YouTube because that's where all the traffic is. YouTube is thus the content creator and content distributor. That's a very powerful position to be in. Netflix doesn't enjoy any kind of equivalent moat.
· YouTube is growing somewhat slower than Netflix; however, YouTube isn't spending any money on marketing to fuel its growth like Netflix is.
Now one interesting move YouTube has made recently is to let channels on YouTube charge their subscribers a fee for access. So far it hasn't been particularly successful, but it does open up the prospect of lots of mini Netflix's operating on YouTube. Each one could specialize in a certain category of content: foreign language films or old science fiction TV shows for example. By charging users a smaller monthly fee than Netflix does now, for access to a library of more specialized content, these YouTube channels would peel off subscribers from Netflix and at the same time compete with Netflix for content rights - a double whammy (these channels would need to negotiate with YouTube a better split than the current 55/45). And Netflix really isn't in any position to absorb any more competitive pressures as its margins are already razor thin.
When will it dawn on the market that it doesn't make any sense to pay so highly for Netflix, when it enjoys nothing in the way of a moat and is competing with a site that gives its freely obtained content away to viewers, for free?
Well the market can't seem to make up its mind on Netflix, twice it has visited $65 per share in the last three years and twice it has visited $300.
Where will it go next? My view is that it is just as likely to revisit $65 as it is to stick around the $300 level, given that even at $65, Netflix would still have a 85 P/E ratio - as high as Dish's current valuation.
Alternatively, one can value Netflix on the basis of "normalized" profits: the profits Netflix could earn once they cut back on the marketing expenses that Netflix have ramped up as they expand internationally. How high might these profits be? Well if you take the highest annual profits Netflix has ever recorded, which was $226 million in 2011 - before the Qwikster and price rise debacles, then $65 a share results in a much more reasonable 18 P/E ratio.
YouTube isn't a separate company and doesn't break out figures for revenue, profits or growth. However analysts have estimated that YouTube has net revenue of $2 billion.
Profits are much harder to estimate but they are likely to be at least $200 million per year. That's four times Netflix's profitability. YouTube is projected to grow at 20% a year, similar to Netflix's growth rate except YouTube will have achieved this without any marketing expense. So how much would you be willing to pay for YouTube if you're willing to value Netflix at $20 billion? Does $80 billion sound plausible? If it doesn't, you should consider selling Netflix.