In the past month, Netflix's (NFLX) shares have fallen by roughly 10%. I wonder whether investors are now asking the tough question of whether there is a price when an investment in Netflix no longer makes sense and whether Netflix has not only crossed this price, but it is now overdue for a price correction.
Netflix delivered yet another outstanding quarter in Q4 2017. And to make it even sweeter, its outlook of nearly 40% YoY revenue growth in Q1 2018 certainly delighted the market just after the announcement.
Furthermore, while CEO Reed Hastings continues to measure Netflix's success not by Netflix's ability to generate cash, but by the number of hours consumers spend watching content and 'customer satisfaction', creditors have been all too happy to go along and support Hastings' ambitious vision.
On the one hand, Netflix's revenue has rocketed by approx. 270% in the past 5 years (FY 2013-FY 2017), while at the same time, its balance sheet has gone from a net cash position of roughly $700 million to a net debt position of $3.7 billion. In other words, while revenue is up a remarkable 270% in five years, its total debt has outpaced revenue and has grown 1,300%. But why shouldn't Netflix be using this prolonged bull market to the fullest?
Netflix has a once-in-a-lifetime opportunity to not only capture consumers' interest, but become the go-to provider for online streaming. Given that shareholders have been willing to turn a blind eye to the fact that Netflix continues to consume $2 billion of free cash flow in its most recent year and yet, at the same time, are willing to pay nearly $130 billion market cap to participate in this once-in-a-lifetime opportunity speaks highly of our bullish stock market.
Moreover, Netflix highlights in bold terms the fact that the competition is not only highly ambitious, it is also highly financially resourceful, for example, Amazon (AMZN). While many readers of this post are the target demographic of Netflix's consumers, it may not dawn on some readers that paying up $130 billion market cap for Netflix means that opportunity has now been fully uncovered and that the risk-reward of investing at such a large valuation is simply too dangerous.
Incidentally, Netflix is not shy about the fact that in 2018 it will consume a mid-point of $3.5 billion of cash. The corporate spin being that Netflix needs to consume cash to produce great self-produced content and that shareholders need not worry about its persistent use of cash, because in time, this persistent cash consumption will turn to further revenue growth and, later on, to increased profitability.
Profit Margin Target
This section of this article will come across as slightly technical. Here, I will highlight Netflix's accounting depreciation schedule. Now, please bear with me while I try to simplify this as much as possible.
An accounting depreciation is simply the reconciliation between what the company recognizes as costs compared to what it expects to bring in cash over time. Essentially, in businesses which are highly-capital intensive, such as Netflix, it is used to help investors get a sense of how much cash the business is likely to generate over time. Said in other words, the longer an item on the P&L statement is depreciated, the higher the company’s profit margin will be. For example, if Bright (which, by the way, according to Rotten Tomatoes is poorly rated at 26%) is depreciated in line with Netflix's cash spend (say, over 2 years), then Netflix's P&L statement would now be showing huge profit losses. On the other hand, if Netflix was to depreciate a title, such as Bright, over a longer period of time, such as six years, then its profit margin would look healthier. Now, if Netflix was to depreciate Bright over longer periods of time of more than 6 years, its P&L statement would look even more attractive - although its ability to generate free cash flow from revenue would be the same.
Now, finally, before leaving this section altogether, allow me to highlight one more interesting aspect to Netflix's depreciation schedule. Back in July 2017, Netflix stated:
Content assets are amortized over the shorter of the title’s window of availability or maximum useful life (amortization period is 6 months to 5 years on average and never more than 10 years)
Fast forward a few months to January 2018, Netflix's accounting has now changed ever-so-slightly, and it now states:
Content assets are amortized over the shorter of the title’s window of availability or estimated period of use or 10 years
Although the difference is indeed subtle, it nevertheless highlights how Netflix can continue to delight the stock market and how, on the other hand, it continues to consume billions of free cash flow yet it can confidently state that:
High yield [market] has rarely seen an equity cushion so thick.
When, all the while, its equity cushion is simply derived from its delayed cost-accounting (non-current content assets on its balance sheet).
Readers could argue that this does not matter, that they and everyone the readers know uses Netflix. Which, as I have already highlighted, is most likely true; however, hopefully, readers might now become slightly more cautious and price sensitive when it comes to investing in Netflix.
Disclaimer: Please do your own due diligence to reach your own conclusions.
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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.