Morpheus: Let me tell you why you're here. You're here because you know something. What you know, you can't explain. But you feel it. You felt it your entire life. That there's something wrong with the world. Like a splinter in your mind - driving you mad. Do you know what I'm talking about?
The Unintelligble Investor: Netflix is overvalued?
I feel like I'm in the movie Groundhog Day. I woke up this morning to see Netflix (NFLX) trading at $348 per share, a full 2 years after I wrote this article explaining why NFLX was wildly overvalued at $300 per share. That article proved prescient (at least for a time), as NFLX promptly shaved 3 quarters of its market cap after the debacle that was the abruptly aborted Qwikster spin-off. But NFLX shrugged off the negative investor sentiment and ploughed ahead with its domestic and international growth plans and, as of 14Nov2013, we find ourselves right back where we started. Like I said, Groundhog Day.
I always say I had 4 father figures growing up: my father, my grandfather, Optimus Prime, and Hulk Hogan. Collectively, they taught me to never give in to the forces of evil, always eat my vitamins, and that it's okay to make mistakes. BUT they also taught me it's important to learn from those mistakes. The average market investor clearly didn't have the same positive male role models in his/her life. In fact, the market might be the most clear evidence that most people never learn anything at all and are simply unconscious meat-sacks reacting to external stimulus. How else would you explain NFLX's Ben-Affleckian style comeback? (For the record, now would be a great time to short stock in Ben Affleck. If this isn't the sign of a top, I don't know what is.)
A déjà vu is usually a glitch in the Matrix. It happens when they change something.
I decided to reboot my old model from 2 years ago and see if anything really has changed. To refresh, I chose to model a scenario in which NFLX is fairly valued and then look at the outputs of the model to assess the likelihood that the scenario would actually occur.
In order to value the company, I believe you have to consider 4 elements.
1. Growth in subscribers
As I mentioned in the previous article, I believe NFLX's maximum penetration to be ~50% of all households in the US. This is probably an aggressive figure given that, currently, 20% of the US population does not even use the internet. Also, consider that a single subscriber account could have multiple households. I know a family that shares a single account in 4 different homes, including one cross-border (I can neither confirm nor deny that the family is mine).
International subscriber growth is harder to predict. As of today, only about a third of all the people in the world have internet access, although the growth of penetration in the past 10 years has been staggering. Still, about half of everyone on Earth lives on less than $2 a day, not exactly the kind of wage that can support even an $8/month Netflix habit. Then, there are certain jurisdictions that NFLX will surely never enter, such as China or parts of the Middle East.
Reed Hastings, CEO of Netflix, often states that NFLX's closest analog is HBO. Well, HBO has 41 million domestic and 73 million international subscribers in the over 60 countries it does business … and HBO has been around for 40 years.
Then there is the question of competition. There used to be only 3 network broadcast TV stations. Now there are more cable channels than there are subscribers to watch the channels. Surely, NFLX won't be the sole monopolistic practitioner of streaming media. Amazon Prime is already up to 10 million subscribers. And it offers a lower rate than NFLX and free shipping on DVDs.
2. Change in ARPU
You know, I know this steak doesn't exist. I know that when I put it in my mouth, the Matrix is telling my brain that it is juicy and delicious. After nine years, you know what I realized? Ignorance is bliss.
You may have heard that Carl Icahn bought a large stake in NFLX after its nosedive 2 years ago (although he recently halved his stake after a +400% return). Icahn thinks Netflix has operating leverage because its content costs are "fixed", meaning Netflix can increase prices without any additional costs and significantly increase its operating margin.
I'm not so sure. It's easy to forget this given the massive success Netflix has had, but Netflix's largest competitor charges exactly nothing for its content. That competitor is piracy … and it is a testament to Netflix's strong product that they've been able to earn as many subscribers as they have in the face of that competition. BUT, at what point will Netflix subscribers say enough is enough and make like Carlito and go back to their old criminal ways? $10/month? $15/month?
HBO is a supposedly "premium" pay television offering and it costs between $15 and $20/month depending on your provider. Would NFLX, the Wal-Mart of video services, really increase its prices to be equal to that of HBO? I would surmise that the closer in price NFLX gets to HBO, the closer in subscriber base NFLX will get to HBO. In fact, the cable industry has already experienced significant subscriber losses in recent years, at least in part due to its increase cost.
In fact, NFLX ARPU has actually been declining in the past year as its DVD subscribers have declined. By my math ARPU actually declined YTD 2013 to $9.35/month from $9.91/month for F2012. This is due to declines in combined DVD and Streaming subscribers which paid a higher rate.
3. Growth in profit margin
NFLX is running large deficits in its international business, due to up-front costs and new content development. In fact, if it wasn't for the legacy DVD business and its $329 million in contribution profit, NFLX would have lost more than $200 million in YTD 2013.
So, when the front-end costs have subsided (and the DVD business kicks the bucket), what will the true profitability of the business model be? And when will it be reached?
The effect of the faster amortization of original content is small enough that we are not changing our domestic contribution margin targets (400 basis points Q over prior year Q) or our global profitability targets (stay profitable despite international investments).
You probably noticed that's not a quote from the Matrix. It's actually from the 3Q2013 earnings release. As you can see, NFLX has set the loft target of staying profitable as it grows its international segment. Not exactly an aggressive goal. NFLX profit margin in YTD 2013 was 2% and I think based on NFLX statement this level will remain stable for at least the next few years. Then, steep improvements in margin will likely be seen similar to the 400bps increase in contribution margin NFLX anticipates in its domestic streaming in 2014. This is a bit of a deviation from prior communications, as 2 years ago their stated target was a long-term profit margin of 14%.
Furthermore, other television and film content providers such as Time Warner and CBS have profit margins around 10%. There is really no reason to believe NFLX will find a way to develop more successful content at a lower cost.
4. Growth in content costs
Even if Netflix could increase pricing at will, I'm not so sure their content costs are fixed. Content providers are surely going to want a piece of the action if Netflix profits increase, so there will be increasing content costs even if Netflix doesn't add new content.
Also, Netflix seems to believe that its original content is going to be a major driver of future subscriptions. NFLX can provide a low cost basis for non-original programming, but it is increasing its investment in original content at a dramatic rate (10% of global content expenses in 2014). This content will surely come at a higher expense per unit than the rights to decades-old movies.
For comparison, HBO spends about 50% of its revenue on content development, as does CBS. Again, there is no reason to believe NFLX can do better.
Free … Your … Mind
So with all that in mind, my model makes the following assumptions:
- Based on estimates of US population growth and household formation, my model projects NFLX will have 106 million domestic subscribers by 2028 (this is actually above the high end of Reed Hasting's own projection of 60 to 90 million). This represents 56% penetration of all US households in 2028.
- I assume international subscribers will reach 329 million by 2028, nearly 4 times that of domestic subscribers. This is almost 3x HBO's current worldwide subscriber base.
- I assume ARPU will decline 5% per year for the first 3 years (bottoming at ~$8/month), then increase 5% per year thereafter.
- I assume profit margin remains flat (2%) for the next 3 years, increasing 200bps per year thereafter until it reaches a 14% profit margin in 2023, where it remains.
- I assume content costs increase 10% annually until 2028, which is significantly less than revenue growth over the same period. This is more aggressive than my last projection, when I said content costs would increase 1:1 with revenues.
- I assume 10% discount rate and 3% terminal growth after 2028.
You have a problem with authority, Mr. Anderson. You believe you are special, that somehow the rules do not apply to you. Obviously, you are mistaken.
Netflix has a somewhat bizarre cash flow statement and it adds complexity to the calculation of NFLX's Owner Earnings (OE). Traditionally, OE is simply this:
Net Income + Amortization - Capex
For NFLX, its actual physical spend on PPE is negligible compared to the cash required to obtain streaming content. As such, I have considered streaming and DVD content outlays to be capital expenditures. Additions to the content library and change in content liabilities as they are recorded on the cash flow statement are not non-cash operating accounts. They are in fact changes in net working capital, which would typically not be included in OE. Still, I believe it is appropriate to incorporate them. I have calculated OE as follows:
Net Income plus Amortization of streaming and DVD content plus Depreciation of PPE less Additions to streaming content less Acquisitions of DVD content less changes in PPE.
You'll note this calculation shows Owner Losses of $445 million in YTD 2013.
Bore-you-to-tears aside: Some subtract only maintenance capex to calculate OE, assuming that capex used to grow the business is effectively "free". I disagree. If your model incorporates growing free cash flow over time, this results (at least in part) from the investment in growth capex in prior quarters. So growth capex is not "free" as it is required to reach the future cash flow figures that are incorporated in the model. Clear as mud?
Ohh, what's really going to bake your noodle later on is, would you still have broken it if I hadn't said anything?
And so what is the outcome of all this?
Intrinsic Value = $22.5 billion
Current Market Capitalization = $20.61 billion
Some interesting points of note:
- Revenue in 2028 will be $58.9 billion, more than CBS and Time Warner combined.
- Profit in 2028 will be $8.2 billion.
- Revenues grow at a CAGR of 17% until 2028.
- Net profit grows at a CAGR of 38% until 2028.
- Total NFLX subscribers are 341 million, or 10% of all households on the entire planet.
- ARPU per customer is $14.40 by 2028, on par with HBO costs today.
- Content acquisition costs are just 20% of revenue by 2028.
Do not try and bend the spoon. That's impossible. Instead, only try to realize the truth. There is no spoon.
Now, is such a remarkable growth trajectory possible? Are substantially lower content costs possible? Yes, of course they're possible. I could also spontaneously combust as I write this article. Sarah Palin could have been elected Vice President. But buying a stock at a price that represents the upper bound of possibilities is more often than not a losing proposition. That is the truth and no matter how hard investors try, they won't be able to bend it … unless this really is the Matrix and Reed Hastings is the One.