The Reasons I'm Short Netflix: Irrational Valuation And A Broken Model

| About: Netflix, Inc. (NFLX)

Summary

The net book value of Netflix's rights to stream content are just $1.8b vs. its $40b market cap. This seems to make no economic sense.

Domestic profits and FCF are reaching maturity.

Perpetually negative FCF internationally - regulatory hurdles and vast regional differences ensure that economies of scale on content/marketing investment will not develop like they did domestically. Investors are capitalizing hope.

Continued negative FCF will force the company to raise debt in 2016 while its market cap-to-net debt ratio plummets likely causing expensive changes in its capital mix.

Continual insider selling.

I have a material short position in Netflix (NASDAQ:NFLX) by way of June 2016 puts with a $50 strike price purchased for a $0.95/contract on January 27th, 2016, when Netflix was trading at $96/share.

Here's why.

Netflix has $7.2 billion of content streaming rights assets, financed by $5.4 billion of content streaming rights liabilities, for a net balance sheet investment in content streaming rights of $1.8 billion. This compares to Netflix's current enterprise value of ~ $38 billion.

Think about that: the market is valuing $1.8 billion of book value investment in limited life rights to stream content at $38 billion ($60 billion at $125/share).

Further, consider this: Netflix's cumulative P&L spend on marketing, technology and G&A for the last five years was $5.9 billion. Add this to the $1.8 billion above, and add $0.2 billion for Netflix's fixed assets, and arguably, Netflix can be "recreated" for about $8.0 billion in capital. Why are investors paying $38 billion for this in the stock market?

Some would argue it's because Netflix has competitive advantages, growth runway and future profitability at scale. Maybe Netflix's business can't be "recreated" or competed with, and therefore is worth more than the historical cost of all of its business investments. Even if you could recreate and compete, maybe there can be more than one winner?

If this is your argument, consider this: In 2015, Netflix started the year with gross content rights of $4.9 billion, and bought an additional $5.7 billion in new content, for a total of $10.6 billion of content with streaming value in the year. It amortized $3.4 billion of that content in 2015, roughly a third of the gross content. Prior years were even higher, suggesting that content amortizes very quickly (as perhaps reason would dictate). Also, in 2015, roughly $2.0 billion of the content rights acquired in the year were amortized within the year.

Two things should be apparent when thinking about these numbers in the context of the streaming business model: (1) making content investments is a never ending treadmill getting faster every year, challenging the notion that Netflix will achieve content leverage, especially internationally, and (2) there is nothing magical about Netflix's content library that others cannot replicate, and Netflix has no special access to purchasing or developing content that others cannot do as well. That $38 billion market value should seem less and less economically plausible.

But what about future growth?

It is clear that US growth is maturing. It does, though, have a positive contribution margin (the way Netflix defines it ignoring technology and admin costs) and has some economies of scale on its domestic content library. And this stands to reason - the domestic market by definition is a generally homogeneous audience, requiring maintenance of just one fairly well-defined content mix/library, making subscriber adds very profitable at the margin. Projecting lower mature domestic growth and profitability into the future can be done with reasonable visibility and there is some value in that cash flow (if you ignore technology and admin costs), even if there is some competition domestically.

But it is unlikely that Netflix will have the same experience worldwide - every region and country are obviously vastly different, and therefore, to grow worldwide Netflix will require multiple and vastly diverse content mixes/libraries. The international growth in top-line is impressive, but there is no evidence that there will be the same content, marketing and technology cost economies of scale in the out years, making discounting the future cash flows a garbage-in, garbage-out modeling exercise at best.

In its 10-Ks for 2012, 2013 and 2014, Netflix disclosed the value of its streaming rights broken out by domestic and international segments. It stopped this practice in 2015 (lumping domestic and international streaming assets together). It seems plausible that Netflix does not want users of its financial statements to be able to calculate international revenue per dollar of international content investment.

It also appears that the long investor in Netflix is not considering or discounting the complexity of regulation, customer tastes and viewing habits, disposable incomes and internet infrastructure that are already creating challenges for Netflix that it did/does not face domestically, creating more operational risk and a wider set of potential outcomes for the international business. With $1.9 billion in revenue in 2015, the international business is roughly half the size of the domestic business, with a contribution profit of negative $389 million, and its cumulative contribution losses are now $1.1 billion (before accounting for content investment). When the domestic business last generated roughly the same revenue, $2.2 billion in 2012, it had a contribution profit of $369 million. It is abundantly clear that the international business, while its top-line growth is impressive, has vastly different economics. The market value today is capitalizing hope.

Aside: the Q&A on pages 7, 8 and 9 of Netflix's Q4/15 Earnings Call Transcript are revealing in terms of the struggles the company faces on the issues of return on content investment and international expansion.

What about the near term?

Netflix currently has $2.3 billion in long-term debt and has $132 million in annual interest costs. Its debt/EBIT is roughly 7.0x and its interest coverage (EBIT/interest) is 2.3x. Its free cash flow is negative. Lenders and shareholders are clearly giving the company a pass in the short term. And the company's CEO Reed Hastings touts the company's market cap-to-net debt ratio as evidence of the company's financial strength and cushion. If one financial metric doesn't look so good, just point to another one.

Besides being an irrelevant metric, relying on the market cap-to-net debt ratio to justify your financial strength is dangerous. One day your market cap may not be there to bail you out, and it has shrunk by roughly $20 billion in just two short months. Netflix's management has stated that given its increasing investments in native content, increasing purchases of third-party content, and continuing negative operating cash flows, that the company will need to raise additional debt in 2016/2017 (Q4 shareolder letter, page 6). Perhaps another $1.0-2.0 billion by any reasonable estimate.

Will lenders play ball? On what terms? Will the company have to raise additional equity? At what valuation? What will the market reaction be? This is not a range of outcomes that I want to be long on in 2016.

What about Reed Hastings?

Reed seems to be a fairly well respected executive and is responsible for Netflix's operational success to date. That said, I want to explore a couple of comments made in an interview with Reed conducted in November 2015 by Andrew Ross Sorkin of CNBC at the annual Dealbook conference in New York. The interview is highly recommended for longs and shorts, and for me, some of the things Reed articulates reveals, at best, his naivety, and at worst, stock promotion.

At around the 8:40 minute mark, Sorkin challenges Reed on the investments in content and plans for debt issuance planned for the upcoming year (2016) and then reads him a quote from David Einhorn from a recent Greenlight Capital investor letter, ("…but apparently Red Ink is the New Black… whether the spending proves successful won't be known during the investment horizon of most Netflix shareholders. In today's market, the best performing stocks are companies with exciting stories where accountability is in the distant future").

Reed first reaffirms his belief in the market cap-to-net debt ratio as the indicator of his company's health, which I have addressed above. But then, he goes on...

He uses the company's free cash flow losses and its $50 billion valuation as evidence of long-term orientation of his shareholder base. Sure, according to Morningstar, ~75% of the shares are held by institutions and funds, but this means the balance is the true float that's establishing market value. That float is approximately 100 million shares, and with average daily volume of over 20 million shares, the float turns over every five days. To me, this is where Reed reveals his naivety. He goes on to say if there is any short-termism, its providing great liquidity. Who cares? It does help with insider selling I suppose. According to insider activity tracking firm INK Research, in the last 12 months, directors and officers, including Reed, have sold shares worth a total of $278 million.

The above are my reasons for owning medium term puts on Netflix's stock with a strike price of $50.

Disclosure: I am/we are short NFLX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.