Shocking ABOVE-THE-LINE Numbers At Netflix!

| About: Netflix, Inc. (NFLX)

Summary

Netflix unit subscriber growth is not accelerating, having flattened through the first nine months of 2016 (12 million net additions).

The current market capitalization of Netflix implies the company must grow consolidated operating earnings by 8-fold to be considered fairly valued.

The content cost thesis is a well-traveled one, but the market is missing the vast overhead expenses (marketing, G&A) related to Netflix’s business.

Netflix’s sources of upside: pricing leverage, contribution margin improvement, a potential buyout, and new ancillary business lines: advertising, licensing, consumer products, etc.

We continue to believe shares of Netflix are vastly overpriced, with a beta-driven sell-off the catalyst for shares during the next downturn.

"Not all growth is good. Economic-profit-generating growth is good, and with Netflix's consistently negative free cash flow, it's hard to make the case the company is generating value for shareholders." -- Brian Nelson

Many stock market participants love it when Netflix (NASDAQ:NFLX) reports quarterly results. Valuation experts will tell you that Netflix's intrinsic value is difficult to estimate. Even small changes in the expected trajectory of its business over the long term (brought about by new information coming to light in any one quarter) can have a large impact on estimates of the company's intrinsic value. Or so this is what I believe.

Traders and speculators may not ascribe to this notion. One thing they do like to do, however, is jump on the bandwagon, in either direction. The result? Often 20% moves up or down in Netflix's stock on the trading day after the release of each quarterly report. The company's third-quarter earnings report, released October 18, was no different, with the market being a big buyer of its shares. Netflix's stock performance is now roughly flat year-to-date 2016.

For those following Netflix, let's recap Valuentum's work, released in February, "Alert: 5 Reasons Why We Think Netflix's Shares Will Collapse." Back then, we said "(Netflix) may be setting up to be one of the worst equity performers in coming years should credit markets balk at its "true" leverage metrics and equity investors grow concerned about its negative free cash flow proposition, deteriorating competitive position and negative-IRR cash costs related to streaming content acquisition." Though the credit markets (bear point 5) have loosened up on junk-rated credits like Netflix since the beginning of the year, we think our long-term thesis on Netflix is still valid, and our multi-year time horizon still offers us a window to be correct…in a big way.

Full disclosure: I'm a Netflix subscriber. My 5-year-old son loves it. For me though, I've pretty much watched everything that has caught my interest on the platform, and my wife has recently become disappointed by their content removals of late. But a Netflix subscription is still a rather small "entertainment" outlay for my family, so we keep our monthly subscription, even though we also have Amazon (NASDAQ:AMZN) Prime. I still venture to the Red Box (NASDAQ:OUTR) every now and then, too, and I also go to the movies frequently, the latest show I watched being Lions Gate's (NYSE:LGF) Deepwater Horizon. BP (NYSE:BP) was not portrayed well in the film at all, by the way. I have to stay up with the trends, you know.

But what am I getting at? Well, I may not be Netflix's "core" consumer, but it goes to show that, while Netflix's library is inadequate from my perspective, the content shortfalls may not be enough to drive mass cancelations either. Though Netflix has experienced quite a bit of pushback every time it tries to up prices, it seems, I think it's also worth another reasonable assessment: what's an extra dollar or two a month for a subscription? Seriously--even in the face of encroaching rivalries? There's still a lot of potential at Netflix, and rumors that other media companies are interested in it aren't out of left field. Disney (NYSE:DIS) or Apple (NASDAQ:AAPL) could be buyers…some day, but at what price, right?

Building the probability of an unannounced takeout is a fool's errand when it comes to sensible valuation techniques, so the main question that we're battling is not whether Netflix will continue to grow rapidly in the future, but whether its share price is overestimating its long-term normalized free cash flow stream. We think it is. The biggest red flag: Netflix continues to generate positive earnings ($0.12 per share in the third quarter), while cash flow from operations remains negative (-$462 million in the third quarter), a classic no-no. During the period, free cash flow was a use, negative $500+ million, and management expects it to be equally "bad" in the current quarter. This must resolve itself in time.

Netflix's net subscriber additions in both the US and internationally came in better than expectations during the third quarter, but globally the pace of growth plateaued (it added 12 million global members through the first nine months in 2015 and 2016). Segment contribution margins also improved. Netflix only lost ~$70 million in its 'International Streaming' division on a segment level, as it added a respectable 3.2 million net customers, implying that the company is able to grow outside the US without the spending gushers at full-steam ahead. Domestically, spending was also held in check, too, with its contribution margin coming in at 18.8%, up a full percentage point from last year. But why isn't this strength translating into free cash flow? It may not be for the reasons you think.

The market may very well be valuing Netflix on the basis of its consolidated segment profit performance, which exclude overhead (marketing, G&A) considerations. For example, looking at Netflix on a pure segment basis reveals a company with total contribution profit of $813 million in the quarter ($407 million +$475 million -$69 million). That's pretty good. Annualizing that on a run-rate basis gets to ~$3.2 billion and implies a business that's trading at only 15 times earnings ($50/3.2). Reasonable? I suspect some on the buy side are valuing Netflix like this without even thinking about how much overhead resides in its operations.

However, consolidated reported operating income came in at ~$106 million in the quarter (see image below), a far cry from the $813 million segment profit performance due in part to excessive marketing and G&A spending, which surged from levels in the year-ago period. Annualizing the ~$100 million quarterly operating-income performance gets to a $400-million run rate, implying the company is trading at 125 times operating income. Assuming Netflix would command a 15 times normalized operating-income multiple on long-term steady-state performance, to grow into its current valuation, Netflix's current consolidated reported operating income would have to increase 8-fold!

Click to enlarge

Image Source: Netflix

Said differently, the market is expecting Netflix to be 8 times its business…today, ignoring the costs of the time value of money (or the weight on value that does not come to fruition until years into the future).

That said, there are a few things that could offer considerable option value to Netflix, even outside a direct buyout by Disney, another studio or even Apple. First, the company generates zero advertising revenue; with 86.7 million members, there's a huge opportunity. Second, there's an interesting ancillary benefit that comes with generating content in-house and that's its own licensing stream; there may be long-term fundamental upside. And third, the follow-on to the second point: consumer product sales tied to characters developed by its original content strategy may be good business. Its Marvel series (Luke Cage, The Defenders) and its agreements with Disney may be telling of an eventual consumer-products and/or licensing strategy.

All in, we still think the market has this one wrong. Netflix won't grow its operating earnings by a factor of 8-fold tomorrow, and therefore, shares remain irrationally overpriced. The company certainly put up a solid third quarter with respect to subscriber performance, but the ballast that will inevitably weigh down shares will be its valuation assessed on consolidated operating earnings (not on non-GAAP segment contribution profit). The next economic downturn will be the catalyst, disguised as a beta-driven sell-off that will send shares a-tumbling.

We're staying as far away from Netflix's shares as possible.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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

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