Netflix Is Overvalued But Not Just Because Of The Subscriber Growth Miss

Summary

• Netflix missed subscriber growth estimates in Q2 but investors have many other bigger problems to focus on.
• The subscriber growth miss reveals the tip of the iceberg.
• Competition is not the only negative development for Netflix. There are both internal and external developments that are poised to make life difficult for Netflix in the future.

Over the last couple of weeks, the talk of the town has been how and why Netflix (NASDAQ:NFLX) missed its subscriber growth estimates for Q2. Investors are accustomed to Netflix beating its own estimates for subscriber growth consistently, which sent shockwaves through the market when Netflix missed its subscriber growth estimates by a staggering 2.3 million for Q2.

(Source - Earnings call slides)

In my last take on Netflix in March, I urged investors to take a back seat and be fearful of Netflix when others are greedy. Since then, the stock price shot up to new highs as investors continued to be greedy, fueled by hopes of continued earnings beats for many years to come. Investors certainly received a reality check when Netflix missed its subscriber growth estimates, which is evident by the more than 10% drop of NFLX after releasing Q2 earnings results. Even though the subscriber growth miss confirms my thesis that NFLX is overvalued, I believe investors should not focus entirely on subscriber growth misses or beats to determine whether NFLX is truly overvalued or not. Basing the investment decision on NFLX on subscriber growth misses and beats is a dangerous move, but NFLX continues to remain overvalued.

Don't just worry about the subscriber growth miss

In investing, it's essential to focus on the things that matter and the things that make a true impact on valuation estimates. If you are an investor bullish on Netflix, there's little reason to worry about the subscriber growth miss in Q2. While subscriber growth misses do not sound promising, this is not the first time Netflix failed to meet their expectations.

Netflix had a record-breaking Q1 in which they added 9.6 million subscribers worldwide, which easily surpassed their estimates for the corresponding quarter. The management believes the subscriber growth miss is a temporary phenomenon and that it would recover by the next quarter when Netflix comes up with content that attracts new subscribers from around the world.

The slowdown in subscriber growth was across all of our regions. So you talk about our kind of top of funnel or gross adds, we saw that slowdown across the board, which indicates to us some level of seasonality and kind of overall, as we say, the kind of timing of the content slate"

- Spencer Neumann, CFO

As we can see from what the CFO had to say, Netflix management expects subscriber growth to fall back on track from the next quarter onwards. When this happens, every investor that was quick to dispose of their Netflix shares would want to get back in once again, and this would lead to another rally in NFLX.

However, focusing solely on subscriber growth is ill-advised, for several reasons.

It's not the competition for now. But for how long?

Competition in the content streaming industry is heating as many renowned names in the entertainment industry are planning a strategic entry into this billion-dollar industry. Disney is a classic example of this. It's not that Netflix management does not pay attention to or unaware of the impending risk of being swooped away by the rising competition in the industry. At the same time, Netflix management went the extra mile to comfort investors by confirming that the subscriber miss is not a direct result of the rising competition.

Excerpt from the earnings slides

We don't believe competition was a factor since there wasn't a material change in the competitive landscape during Q2, and competitive intensity and our penetration is varied across regions. (Source)

While this might be soothing to a Netflix bull's ears, the "competitive landscape" will not remain the same forever. The competitive landscape is dynamically changing. Investors need to factor in the increasing competition in the over-the-top (OTT) content streaming industry. More importantly, the competition for Netflix is coming from well-established players in the entertainment industry.

For the last decade, Netflix was successfully able to negate competition from industry players including Amazon Prime (AMZN) and Hulu. However, Netflix's future competitors are poised to be billion-dollar companies that have access to data related to consumer interests, such as Apple (AAPL), Disney (DIS), Google (GOOG) (GOOGL), and Facebook (FB).

Balance sheet worries persist

Throughout history, investors have continued to justify the significant amount of debt on Netflix's balance sheet by focusing on numbers on the income statement. However, it's time for investors to focus on the quality of Netflix's balance sheet as well. Historical evidence suggests that companies with strong balance sheets have been able to thrive when the competition in an industry heats up.

NFLX has brushed off fundamentally driven concerns over the last many years and provided a stellar return to investors who kept faith in the growth story of the company. However, the time has finally arrived for investors to pay close attention to the balance sheet position of Netflix.

Long-term debt has accumulated at a steady rate over the years and the debt to equity ratio has continued to deteriorate over the last 5 years, both of which are not positive signs to be seen in a company that will soon be met with fierce competition.

Debt to equity

(Source - Koyfin)

Despite deteriorating debt to equity ratios and the ever-increasing debt pile, Netflix would not be able to take a step back and spend less than planned for on original content production. As competition heats up, the quality of original content would be a decisive factor in determining who stays on top of this billion-dollar industry.

Netflix's quarterly cash expenditure on streaming content

(Source - Statista)

Netflix has continued to spend billions of dollars per annum over the last 5 years to create original content, which has been instrumental to the massive success of Netflix over the last decade. Considering the billions of dollars that the company plans to burn on creating best-in-class content, and the ever-increasing debt pile, Netflix is certainly headed in the wrong direction from a balance sheet perspective. However, it's imperative for Netflix to continue to spend on creating original content as there's no looking back now amidst increasing competition in the industry.

Cash flows tell the same story as the balance sheet

Many growth companies are associated with negative free cash flows and it has become increasingly popular for investors to justify high-growth companies not being able to generate positive free cash flows. As long as earnings are continuing to beat analyst estimates and competition is not fierce, negative free cash flows will go unnoticed. However, considering that Netflix is already knee-deep in debt but is forced to spend staggering amounts on creating original content, Netflix's negative cash flows raise a concern.

(Source - Author prepared based on data from company filings)

Price-based competition is not what Netflix wants

Disney+ will be launched later this year with a price tag of $6.99 per month, which is considerably lower than the most popular plan of Netflix that charges $12.99 per month. Earlier this year, Netflix hiked their price plans by a whopping 18%, which marked the biggest price increase ever by Netflix. Along with this price hike, NFLX share price gained traction as investors and analysts believe that the customer base of Netflix will continue to stick to Netflix and the price hike would end up providing a boost to the top line and profit margins of the company.

While Netflix relies on its customers to continue paying for their services despite the price hike, Netflix's competitors are keen on competing with Netflix on price. Many potential competitors of Netflix including Disney, Apple, Hulu, and Amazon are poised to keep their prices much lower than that of Netflix, which might eventually prompt Netflix to lower their prices to provide better value for money. In every sense, the content slate of Netflix is far superior to that of its competitors, which warrants Netflix to price their service a notch higher than the rest of the crowd. However, at the same time, a significant disparity between the prices might prompt a set of customers to look for alternative streaming service providers.

Netflix introduced a $3 per month plan in India, exclusive for mobile handset customers. The mobile-only plan that is priced at approximately $3 is expected to help Netflix gain traction in one of its highly focused target markets. Even though this mobile-only plan is promising to help Netflix establish in India as one of the leading content streaming services along with Hot Star and Amazon Prime, Netflix would still have to spend money on creating original content in local languages to gain traction in the Indian market. Understandably, spending millions of dollars on creating original content in local languages and pricing their mobile-only product at a very low price will not support profit margin expansion of the company.

As a company that still tries to expand beyond borders, price-based competition is not what Netflix wants at this point. However, Netflix is forced to lower their prices outside the U.S. On the other hand, Netflix's competitors are focused on providing better value for money than Netflix, which is a negative development for Netflix in the long run as Netflix would not be in a position to hike their subscription prices without losing customers in the future, unlike in the past.

Content-related costs are on the rise

Content is key to Netflix's success. However, it's important for Netflix to formulate a plan as to how cash would be spent on acquiring licenses and creating original content. Many investors have entirely focused on the billions of dollars that Netflix spends on acquiring and creating content and jumped to the conclusion that such spending on acquiring or creating high-quality content would eventually lead to more profits, which is not true. Incremental revenue has been growing by almost 50% slower than incremental expenditures. The strategy of spending staggering amounts on creating high-quality content is just not delivering the goods for Netflix.

(Source - Forbes)

As Netflix fails to gain the expected number of new subscribers on a global basis, the cost per new subscriber keeps on skyrocketing.

(Source - Forbes)

Another obstacle for Netflix about securing quality content is the increasing competition. Soon, many of Netflix's competitors would be bidding for the same licenses as Netflix, which will eventually lead to a secular uptrend in licensing costs. This is an early indication of Netflix not being able to expand its profit margins in the future and would most likely be restrained for cash in the long term.

Ad-based content streaming is on the rise

The content streaming industry is dynamically changing. On top of the subscription-based model that was adopted by Netflix, Hulu, and Amazon Prime, there's a new breed of content streaming services that are opting for advertisement-based services rather than subscription-based services. Because Netflix is looking for growth outside the U.S., ad-based content streaming services will pose a major threat to the success of Netflix in the future.

Facebook Watch has already made progress in bringing live sports to viewers through an ad-based service and YouTube is increasingly releasing movies and TV shows on a free-to-air basis. Sony Crackle is another service that is thriving with an advertisement-based model. All these service providers are poised to make life difficult for Netflix in the future, especially outside the U.S. Regions such as India are highly sensitive to price hikes and viewers are used to advertisement-based content streaming services. The target markets for Netflix outside developed countries are intrinsically different from what they are used to catering to, which provides another challenge for the company to secure long-term growth. It's no question that Netflix will have to look for growth opportunities outside the U.S. to achieve growth objectives.

I believe that ad-based streaming services would be the new normal in few years and Netflix will find it difficult to compete with such services, especially outside the U.S.

Takeaway for investors

As a subscriber of Netflix, I have kept a close eye on how the company is evolving. Earlier in the year, I discussed my belief that Netflix will be met with fierce competition in the future and that the future does not look promising for Netflix.

The subscriber growth miss in Q2 is not the elephant in the room. The miss is indicative of a bigger problem that Netflix is facing. While there's no doubt that Netflix will remain a key player of the global content streaming industry, NFLX is still overvalued and investors are continuing to leave behind important developments.

The competitive landscape is changing, cost per new subscriber is rising, the cost of producing original content and acquiring third-party content is rising and on top of these, ad-based content streaming services are gaining traction. The very core of Netflix's business strategy will be challenged in the near future, which makes me avoid investing in NFLX at current market prices.

NFLX will gain some lost momentum if subscriber growth meets or exceeds expectations in Q3, but investors should remain focused on the big story. NFLX is a sell.

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.