The Potential Market For Netflix And Its Valuation
Summary
- The potential market for Netflix is bigger than it is now but might be smaller than most might think.
- The US media market is far bigger, more developed, more expensive and more profitable than the rest of the world.
- Netflix lacks synergies in their content since it only has one platform of using it.
- Netflix is still a fairly small company with a small content library for its valuation.
Thesis
Investors in Netflix (NASDAQ:NFLX) have seen the value of their stock holdings increase to a the level where its market cap is closing in on Disney (DIS). Netflix has delivered great results and growth in 2017. The important question though is how large Netflix can become to value it correctly, given that size makes it more difficult to grow fast and markets at some point are saturated with certain products.
Overview
Netflix is the dominant OTT platform for watching series and movies with currently 111M paying customers at the end of 2017 and a market cap of $122B. 53M customers are living in the US while 58M customers are in international markets. The US and international markets are in different stages of development and are therefore analyzed separately.
US Markets
The US Market is the homebase of Netflix. It is the market in which it has its strongest position and already reached profitability. The US market still saw good growth for Netflix during the year, increasing customers from 48M to 53M.
Assuming customer growth continues at 5M in the US for another five years would result in an increase of roughly 50% in customers to 78M. After this growth, it is likely that growth will level off because people are sharing accounts and the US has only 126M households. Combined with this growth in customers, revenue is in my view likely to double to $12.3B. While price increases might help competitors become more competitive, it's needed to fund new content and compensate for inflation. Currently, the profitability of Netflix's entire operation is only $560M. But given that the international operations are still unprofitable, when other operating expenses for infrastructure, AWS from Amazon (AMZN), and general plus administrative expenses are equally distributed, the current profitability in the USS might actually be close to $1.2B. With increasing customer numbers and revenue, profit in the US might actually reach $5B after five years. More abnormal returns after five years are not likely given market saturation, increased pricing, and additional competition.
International markets
Given potential saturation in five years, Netflix is expanding abroad into international markets. Netflix bulls are very optimistic about the prospects of Netflix abroad. The international markets, however, are difficult to conquer profitably. First of all, they are extremely diverse with all kinds of differences from languages to cultural preferences. Secondly, the international pay tv market is not as developed as the US market.
Source: Broadband TV news
The US is responsible for more than 50% of total pay tv revenues in the world. Even customers in rich countries in Western Europe are not used to that much for content. Cord cutting is primarily a US phenomenon because broadband is simply much cheaper abroad, which means Netflix is relatively more expensive. In addition, Netflix might find that governments in some countries are likely to protect domestic companies while other countries spend significant amounts of money on the production of content funded by public funds.
Given the diversity of these markets, lower spending per capita, and government interference, it might take at least an additional 5 years to reach the $5B annual rate of profitability that the US is expected to reach.
Content library
Netflix is investing in content to attract more customers but still relies heavily on third party content. The downside of third party content is that it is only available for a limited time and at a significant fee. This fee directly cuts into the margins of Netflix and this is why Netflix is investing in its own content. While Netflix has spend $6.3B last year on content, competitors spend even more. Disney, for example, spends $7.8B on non-sports related content. Netflix is increasing its budget to $8B in 2018, which is in line with Disney, but given the historical differences in spending, the content library of Netflix is still a lot smaller due to previous investments in content by Disney. Another important question is who can spend its budget more efficiently. While Netflix might have the advantage in data analysis, I think Disney is actually better equipped due to their strong brands and first class studios. People really like movies from Marvel Studios and Star Wars while kids love movies like Frozen from Walt Disney Animation Studios. In addition, Disney can use their historical content to create new content and since the amount of historical content is huge is becomes much like a recurring high margin revenue stream. This means that while Netflix has a very strong platform and might have some data advantages, competitors benefit from stronger brands, established studios, and a larger historic content library.
Synergies
Netflix produces its own content to get more bargaining power with third parties and to enhance their product. Exclusive content is important in attracting more subscribers but Netflix does not really have a competitive advantage in content production, except from possible superior customer preference knowledge. It does not have the ability to use it content in synergistic ways. Disney, on the contrary, does have significant synergies since it can use its created content in its parks and on merchandise. While Media Networks is the primary source of revenue and income for Disney, its Park and Merchandise businesses combined contribute 42% to revenues and 37% to operating income. While other competitors like Amazon and Apple (AAPL) do think that content is complementary to their existing businesses, profitability in content is not the main driver of company success.
Cash flow & content
While profitability is an important metric in most situations, cash is still king. Due to all the investments in content, Netflix's cash flow statement does look a lot less attractive than its income statement. While the jury is still out on the returns on these investments in content, they pose a real risk to investors. An important problem for investor returns is that the increased demand for content leads to higher production costs and all the new content might also decrease the value of the current content more rapidly than previously thought. The exact lifetime value of all this new content is unclear and while certainly valuable, it could be that content decreases in value more rapidly due to increased creation of new content. What is clear though is that since these additional investments in content are not financed with cash flow from operations, Netflix is relying on the capital markets for funding. While the share count has increased from 433,809 in the first quarter of 2015 to 448,142 this increase of 3.3% over this time frame is to be expected. What might be more worrisome is the debt load that increased from $3.4B to $6.5B in a year. Debt is still low compared to market value but given the lack of tangible assets this is not an important metric. Netflix is not very profitable yet and is not generating any cash which means that relying on debt might not be the most prudent thing to do especially given the elevated share price.
Valuation
Given the projections for both the domestic and international business Netflix is likely to generate an annual net income of $10B in 10 years. This might seem reasonable given that the current market is $122B which results in a p/e of roughly 12. The problem though is that you have to wait 10 years to reach this valuation. Which means that even when Netflix achieves rapid growth in revenues, customers and profitability, the returns to shareholders would be average. Reaching $10B in profitability in only 10 years might be an amazing achievement but would not necessarily lead to outstanding shareholder returns.
Conclusion
Using a p/e multiple of current earnings on a fast growing company does not make much sense if you want to value a company. What is important is to estimate the size and profitability of the company when it reaches a more mature state. Given that Netflix is already penetrating 42% of all US households, it might find that growth is actually less endless than previously thought. Netflix might still be able to grow rapidly for another five years but after that, growth is likely to slow considerably while no cash is returned to shareholders in the meantime. Given that the international markets have very different spending levels on content and are likely to favor domestic producers to a certain extent. It is difficult to see Netflix getting more than 50% of profits from overseas ever. An annual profit of $10B in 10 years look like an amazing achievement from an operational point of view but might actually leave investors fairly disappointed in the meantime.
The original idea for this article came when news came out about value investors starting to invest in Netflix. This is something which got me slightly worried. While I have great respect for Bill Nygren, I think that it is a sign of market mania that value investors feel the need to invest in a growth stock like Netflix. When value investors already have a position in Netflix, who are left to keep buying the stock? Nobody, which is probably why the stock has declined since then.
This article was written by
Analyst’s 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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Comments (39)
Since when is tech a durable competitive advantage?
1: People are sharing accounts
2: Netflix does not have a monopoly on streaming services. It is not the case that all broadband or TV cable subscriptions are delivered by the same company.My assumption on international is that it will reach the same profitability as Netflix reaches in its domestic market. This again is rather aggressive given the following facts:
1: Foreign governments spending on content
2: Foreign countries favoring domestic companies
3: Foreign countries having very different tastes
4: Foreign individuals spend significantly less on contentCable TV companies had a monopoly in their specific region. This is and will not be the case for Netflix. This means competition would limit price increases and profitability.
I think the end game is that people in the US will start to pay less for content since they are better able to choose which services provide value to them.
