Netflix: Extrapolation Is Intuitive While Mean Reversion Is Not

| About: Netflix, Inc. (NFLX)

Summary

Only one earnings miss would be enough to create a permanent loss of capital for the current shareholders.

The international membership growth is driving the share price. However, this division will be much less profitable than its comparable in the United States.

Content is by far the largest cost. As more producers battle for the same viewers, the content expense will increase meaningfully.

If 80% of the United States population and 16% of the people with an Internet connection watch Netflix in the distant future, the stock is cheap.

It is not necessary to be an experienced security analyst to understand that at the current valuation, any glitch in the story could lead to a carnage in the stock. Investors are ready to pay lofty prices for membership growth while sacrificing expected return and embracing the risk of permanent losses.

Before going any further, I want to mention that I am an undergraduate student, not a financial advisor. This is not a recommendation to buy or sell the stock. This analysis reflects my own opinion based on my own and independent research. I reserve the right to be wrong and to buy put in the next 72 hours.

The popular series produced by Netflix (NASDAQ:NFLX) reflect pretty well the situation of the stock. With a market capitalization of $65 billion, Netflix is similar to a house of cards characterized by the strange fact that red is the new black. I still have trouble understanding how a business which burned $1.5 billion over the past twelve months deserves this kind valuation.

By attributing a multiple of 200 to the current net income of $186 million, we are still left with a massive valuation gap of $28 billion. It represents 43% of the current market capitalization. Even if universities continue to qualify risk as price volatility and beta, a multiple contraction is probably the biggest threat.

(Source)

Some investors argue that Netflix is overvalued because of its P/E of 337 or because of its P/B multiple around 25. Even if these numbers are technically correct, I do not believe in shorting on valuation motives only. Indeed, the streaming content represents 81% of the total assets which might justify partially the inflated P/B multiple versus a classic industrial stock.

It is also interesting to think about the P/E multiple as the number of years required to reimburse the initial investment. This concept is similar to the duration of a bond which is by definition the number of years it will take for interest payments to repay the invested principal. In other words, the business itself will deliver no return at all for the shareholders in the coming years. Similarly to the impact of a sudden interest rate move on a bond, a significant earnings miss is enough to create a permanent loss of capital for the current shareholders.

On this matter, the growth profile changed quite dramatically over the past few years. Back in 2013, less than 35% of the membership growth was coming from international markets. However, more than 90% of the membership growth was coming internationally in the second quarter of 2016. International markets will become increasingly important to fuel the growth that the street is looking for.

As the market in the United States become increasingly mature, it is perfectly normal that growth will come from other countries. At the first look, this fact has the potential to be interpreted as a good news. Sadly, I believe it represents one of the biggest challenges for the firm.

Netflix reports the profitability of its three distinct divisions with the contribution profit. The contribution profit is equal to the revenues minus the cost of revenues and the marketing expense. It is worth noting that the cost of revenues consists primarily of content amortization which requires considerable management judgment.

Based on factors including historical and estimated viewing patterns, the company amortizes the content assets in cost of revenues on the consolidated statement of operations [...­] The company's estimates related to these factors require considerable management judgment.(Source)

Because this expense represents almost 70% of the revenue, I think it deteriorates greatly the earnings quality. The management updated some inputs in the amortization calculation during the third quarter of 2016. These changes decreased the net income by $12.3 million or $0.03 per share for the full year. Considering the reported EPS of $0.16 in the fourth quarter of 2016, it translates into an EPS diminution of 16%. This number is a little bit too high because a portion of the third quarter EPS should be included. However, the exact timing of these changes is not mentioned. In other words, the reported EPS is not real earnings in my opinion. This fact is confirmed by the cash flow statement that I will discuss later.

Netflix does not report the net income for its different divisions. We must rely on the contribution profit to estimate the profitability of each segment. It is important to mention that this metric is far away from net income. In fact, it is not taking into account many other costs like technology and development or general and administrative expenses for example.

The contribution profit is rapidly increasing along with the growing revenue in the United States. Moreover, the contribution margin is also expending reflecting an interesting underlying business.

Combined with a reasonable valuation, the streaming business in the United States would be quite interesting. Sadly, the international segment is a totally different story. The number of members is growing more rapidly than ever, propelling the revenues to new highs. However, the contribution profit remains near its lowest level.

The international segment contains the revenue generated by the streaming business in 189 different countries. In aggregate, this division is losing money. Indeed, the contribution profits generated by the old school DVD business perfectly offset the contribution losses created by the international division.

The international membership growth is literally driving the share price. Ironically, it does not generate a dime of profit for now. At the current valuation, the market implies that Netflix will be able to generate the same margins internationally than in the United States. The market also implies that Netflix will grow these margins in the future.

The international market is extremely fragmented and the cultural differences among the regions could force Netflix to create a lot of local content. It will ultimately put a lot of pressure on margins. The point here is that the international division will be much less profitable than the division in the United States. Again, the current valuation implies that it will not be the case.

Our international operations involve risks that could adversely affect our business, including: the need to adapt our content and user interfaces for specific cultural and language differences. (Source: Annual report for the Period Ending 12/31/16)

Let's assume that my hypothesis on the local content putting pressure on margins is absurd. Even if Netflix is inherently able to generate the same kind of margins internationally, the competition will kill any excess profits.

The profit margin is probably the metric showing the most accentuate tendency to mean revert. Stocks appear most attractive on a fundamental basis at the peak of their business cycle when they present the worst risk-to-reward ratio. The last letter to shareholders is quite interesting on this aspect.

We are in no rush to push margins up too quickly, as we want to ensure we are investing aggressively enough to continue to lead internet TV around the world. (Source)

The truth is that Netflix does not have the choice between pushing margins up or to continue to invest massively. I see the mean reversion phenomenon acting in two different ways putting even more pressure on the net profit margin.

First, the content expense is by far the largest cost. As more and more producers battle for the same viewers, the content expense will increase meaningfully. Let's call this phenomenon ''Peak TV.'' As the following table shows, the online providers are starting to be major players in the scripted series mix.

We can clearly see an increase in the quantity of content produced. Meanwhile, the number of hours per day that people are watching television has probably increased only slightly as well as the total number of people watching television every day. However, the increase of these variables is nowhere near the growth in content produced. It reflects the intense competition and the cost inflation I was talking about earlier.

If this hypothesis is correct, we should be able to see an increasing proportion of revenues invested in content. To estimate this variable, I used the line named ''additions to streaming content assets'' in the cash flow statement. The cost of the revenues in the income statement does not represent the real cost in my mind. Effectively, this expense consists mainly of amortization instead of real cash outlay. To build the following graph, I simply divided the additions to streaming content assets by the total revenue figure.

Despite spending more than the totality of its revenues in new content during the first and the third quarter of 2016, Netflix reported a positive net income in each of these quarters. It helps to understand why the dichotomy between operating cash flow and net income is larger than ever.

For now, Netflix is issuing debt to fund its content expense. With $3.4 billion in interest bearing debt, it does not seem too worrying. The picture changes quite dramatically when you add the total content liabilities of $6.5 billion and the $8 billion of obligations that are not reflected on the balance sheet.

For motives I discussed above, I believe that the content expense will continue to reach new highs driving the operating cash flow in further negative territory. Consequently, Netflix will continue to issue more debt causing the interest expense to soar. With $1.7 billion in cash and short-term investments combined with the current burn rate, I believe the firm will issue new debt before the end of Q2 2017.

Issuing $1 billion at 5% would increase the interest expense by $50 million a year. With an average monthly revenue per paying membership of $9.21 and a contribution margin of 40%, it would need 1.1 million new paying members just to cover the increase in the interest expense. The contribution margin is negative internationally, so these new members must be in the United States for now. During the past four quarters, the firm added 2.4 million new members. We can see these two variables converging quite rapidly. On the other hand, the solvency is not really a problem with its inflated market capitalization of $65 billion.

We expect to significantly increase our investments in global streaming content, particularly in original content, which will impact our liquidity and may result in future negative free cash flows even after we achieve material global profitability. (Source: Annual report for the Period Ending 12/31/16)

With all these problems, it is excessively difficult to believe that the growth will be strong enough to match the expectations of the street on a long-term basis. Moreover, I don't want to speculate on quarterly results.

Netflix believes it can reach 90 million members in the United States only. If an account is shared by two people on average, it represents 180 million individuals or 56% of the total population. By removing the people under 5 and above 60 years old, the penetration rate becomes astronomical.

Let's make 4 hypotheses: 1) that everybody will adhere to the premium plan, 2) that the price of the premium plan will jump to $15 per month, 3) that the international margins will be the same than in the United States and 4) that Netflix will be able to generate a net profit margin of 10% despite the relentless competition.

I think the only possible hypothesis is that the premium plan price will increase to $15 per month but let's play the game and be very optimistic. The most optimistic hypothesis is that the profit margin will be the same internationally than in the United States. If all of these hypotheses become true and that more than 50% of the United States population watch Netflix in the future, the current valuation is justifiable.

To put in perspective the 125 million paying members internationally, it represents 12% of the total people with an internet connection on the planet based on two people sharing the same account. It is worth mentioning that China is included in the number of people with an Internet connection. Netflix does not have any paying customer in this country.

I was not comfortable with this table because it represents one scenario only with many moving parts. I decided to build a Monte Carlo simulation to generate 2,000 different scenarios. The following table illustrates the variables used and the range given to them.

With these variables, the minimum P/E multiple generated is 8.73 and the highest is 31.90 with an average of 16.82. I would like to be clear on one aspect. It is not impossible to justify the current valuation but when looking at the assumptions made behind, it is very unlikely that these numbers occur. The following two graphs show the distribution and the cumulative distribution.

The table below summarizes what you need to justify a forward P/E of approximately 9 and, by the same way, the current share price. Again, please take into consideration the very unlikely assumptions behind these numbers.

In conclusion, the tendency of public to favor well-known companies is definitely tangible. Ironically, people think they are getting a bargain in buying Netflix due to the impressive growth shown by the firm. Any significant earnings miss would cause the multiples to contract severely. The losses for the current holders have the potential to be colossal. As Benjamin Graham said, an investment is an operation which promises safety of principal and a satisfactory return. Based on this definition, I will qualify Netflix as speculation. While it is hard to quantify, I would characterize the investment component as negligible versus the prominence of the speculative component.

Netflix is a wonderful short candidate, period.

Disclaimer: This article reflects my opinion only. I am not a financial advisor. Please do your own due diligence and consult your financial advisor before taking any decision. I am not a financial advisor. The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone acts upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in NFLX over 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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