Netflix: Business Model Needs To Change

Summary

• Netflix's domestic slow-down and international expansion will take a toll on profitability.
• Negative Free Cash Flow can be turned around, but not enough to justify 300$/share.
• With an expected return near 5%, investors should look elsewhere.

Thesis Summary

Netflix, Inc. (NASDAQ:NFLX) has become the undisputed king of video streaming services. However, recent changes in the market and competition are threatening Netflix's superiority. Giants like The Walt Disney Company (DIS) and Apple Inc. (AAPL) are coming in with a strong competitive advantage. This will lead to lower margins and force Netflix to have to "reinvent" itself.

Along with the impact on earnings, having to supply more content for their revenue will continue to affect the balance sheet. Asset turnover has been falling consistently over the last 10 years, and all this Capex is affecting cash flows and financial strength. Given the facts, it doesn't seem like the trend is going to reverse in the immediate future. Therefore, we are bearish Netflix.

Company Overview

Netflix has been offering VOD streaming services for the last 20 years. Starting as a simple website with a pay-per-rental system for its content, it switched to the now so popular subscription model in 1990. In 2002 the company went public for $15, achieving funding of $82.5 million. One year later, it would reach 1 million subscribers. Finally, in 2005, Netflix launched its streaming video service domestically. During the next 10 years, Netflix would capture most of the U.S. market and expand internationally, putting Netflix at the forefront of the streaming service industry.

Growth and market share

As Netflix has come to dominate the streaming market, the outstanding market share and revenue growth (the company has achieved a 10-year CAGR of 28.11%) in recent years are the main reasons why investors have enjoyed such great returns.

Data Source: Seeking Alpha

Source: CNBC

Product

While Netflix still offers DVD services, it is the streaming service that is the main driver of revenue and growth. The costs associated with the streaming service can be divided into two parts: Licensing, and Production. Although almost two-thirds of content at the moment is licensed, it is clear from recent reports that Netflix is currently having to make a big move towards production, having earmarked 85% of new spending in 2019 for the creation of original content. With Disney and Apple, as well as Amazon.com, Inc. (AMZN), all competing for a slice of the streaming pie, it is becoming increasingly difficult and expensive to obtain licensed content.

Risks and challenges

In the section below we will discuss some of the risks and challenges facing Netflix over the coming years.

US Competition

I won't delve too much into this, as many articles have already been written on this topic since Disney+ and Apple TV were first announced. In this regard, Netflix is indeed facing increased competition, but I see this as a relatively small threat, at least in the short term. People are creatures of habit, and it will take some time for consumers to shift from Netflix to another service. Netflix has a competitive advantage in producing their content, because they have access to the mounds of data on their users, and this advantage should give Netflix an edge for long enough to establish itself as a producer.

This is why I believe that as much as US revenue will take a hit, the "Myspace" fate is an unlikely one for Netflix. Let us say, to err on the side of optimism, that Netflix can retain a US market share of 40% in 2023.

Profitability

The biggest problem Netflix faces, in my opinion, is falling profitability. This is connected with the competition but is a separate problem altogether. By Netflix's data, the most profitable market, the U.S., is already close to saturation. The growth of revenues in the future will hinge on international revenues, as we have said. However, current data shows that the margin for foreign operations is much smaller. Although the international gross margin is improving, we can only reason that it will stabilize at a significantly lower level than in the U.S. as foreign customers simply cannot pay as much as U.S. customers. Data from Statista shows that ARPU (Average Revenue Per User) is about 1/5 worldwide of what it is for the domestic market. Evidence of this can also be seen in the company's own Income statement. As we can see, the Gross Profit Margin is much smaller for foreign operations.

Gross Profit	2010	2011	2012	2013	2014	2015	2016	2017	2018
Domestic	37.45%	38.10%	35.27%	36.24%	38.08%	41.75%	42.79%	44.37%	47.69%
Foreign	-88.36%	-29.73%	-65.39%	-9.81%	11.77%	8.86%	5.24%	14.34%	25.78%

Click to enlarge

Source - 10Q Reports

Free cash flow

Furthermore, even though Netflix certainly produces an Operating profit, FCF/share tells a different story. FCF/share is negative. This is due to the 'content' assets that Netflix purchases/produces every year. With consistently falling asset turnover, Netflix has had to get more and more indebted to finance its revenue growth.

Assets as % of revenue	2009	2010	2011	2012	2013	2014	2015	2016	2017	2018
Total Assets	40.69%	45.41%	95.77%	109.94%	123.73%	127.94%	150.50%	153.86%	162.60%	164.45%

Click to enlarge

Data source: Seeking Alpha

Data source: Seeking Alpha

However, it is reasonable to assume this cannot go on indefinitely and the trend appears to be slowing down. Also, there is hope that the original content will have better economies of scale than the licensed content. Further on we will assume for valuation that this ratio can remain at its current level for the next 4 years.

Valuation

Taking the above into account, we can project the Balance Sheet and Income Statement for Netflix over the next 4 years and reach a target price using discounted cash flows.

We assume the market CAGR (during the 2018-2023 period) of domestic video streaming to be 18.3% domestically and 20.3% internationally, with a gradually falling rate, as you will see below. Revenue and gross margins will be calculated using growth rates which are based on a report by Allied Market Research and with the use of trendline analysis. We will assume that Netflix's market share falls to 40% in the U.S. over this period and remains at 25% internationally.

Domestic market	2019	2020	2021	2022	2023
Netflix Revenue	9,621.1	12,238.0	14,870.4	16,941.6	18,402.1
Market growth%	20.1%	20.0%	15.0%	10.0%	5.0%
Netflix share%	50%	4%	56%	58%	60%
Netflix growth%	20.1%	27.2%	21.5%	13.9%	8.6%

Click to enlarge

International market	2019	2020	2021	2022	2023
Netflix Revenue	10,521.4	17,103.6	23,966.4	30,803.2	36,753.8
Market growth%	35.2%	27%	18%	11%	5%
Netflix share%	25%	32%	38%	44%	50%
Netflix growth%	35.2%	62.6%	40.1%	28.5%	19.3%

Click to enlarge

• Domestic and international operations are evaluated separately based on the company's annual 10-K reports for the years 2010 to 2018. This includes revenues, cost of revenues and marketing expenses. The cost of revenues will fall gradually to 50% in the U.S. 70% abroad, following reasonable interpretation of the trends. Marketing costs will fall gradually to 10% of the revenue.
• Other SG&A costs until 2018 do not follow a particular trend but hover around 4% of revenue, so that is the proportion assumed thereon.
• R&D expenses will remain at 8.32% of revenue, the average of the last 10 years.
• Interest expense will be 4.92% of long-term debt standing at the end of the previous year.
• Income tax expense will be 21% of EBT.
• The company will distribute all free cash flows and issue debt as needed to finance its business while maintaining its December '18 D/E ratio at (1.98) (this is not a prediction of what is going to happen as much as a way of establishing value).
• The rest of the balance sheet will grow with revenue (this will also keep debt and equity growing with revenue). We are assuming here asset turnover cannot keep increasing and it will remain at the current level (around 60%).
• Free cash flows will grow at the expected global inflation rate after 2023 (3.4%, according to Statista)

This results in the following simplified financial statements for 2020-2023:

Income Statement	2019	2020	2021	2022	2023
Revenue Growth	27.53%	20.22%	13.37%	8.45%	2.94%
Revenues	20,142.5	24,214.8	27,451.2	29,769.8	30,644.9
Cost Of Revenues	12,386.0	14,562.8	16,645.4	18,139.9	18,752.5
Selling General & Admin Expenses	3,240.8	3,657.3	3,843.2	4,167.8	4,290.3
R&D Expenses	1,675.9	2,014.7	2,283.9	2,476.9	2,549.7
Net Interest Expenses	-508.7	-648.7	-779.9	-884.1	-958.8
Income Tax Expense	489.6	699.6	818.8	861.3	859.7
Net Income	1,841.6	2,631.7	3,080.1	3,240.0	3,234.1

Click to enlarge

Balance Sheet	2019	2020	2021	2022	2023
Total Assets	33,125	39,822	45,145	48,958	50,397
Long-Term Debt	13,212	15,883	18,006	19,527	20,101
Total Liabilities	26,444	31,791	36,040	39,084	40,233
Total Equity	6,681	8,032	9,105	9,874	10,164

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Free Cashflow	2020	2021	2022	2023
Net income	2,632	3,080	3,240	3,234
Change in WC	827	657	471	178
Capex (Net of Depreciation)	3,195	2,539	1,819	687
Change in debt	2,671	2,123	1,521	574
Levered Free Cash Flow	1,281	2,007	2,471	2,944

Click to enlarge

Source: Author's work

*All figures are expressed in thousands.

If these conditions are met, as you can see, four years appear to be enough for extra cash to pick up sufficiently for a valid analysis. The following table shows the discounted free cash flow valuation for different discount rates. Note that the table shows the present value of the free cash flow forecasted for each year with the 2023 value including an added perpetuity at 3.4% growth.

Discounted Free Cash Flow	EV	2020	2021	2022	2023	Shares (MM)	Price ($)
4.00%	427,195	1,232	1,855	2,197	421,912	451	946.80
4.50%	232,111	1,226	1,838	2,165	226,883	451	514.43
5.00%	158,963	1,220	1,820	2,134	153,789	451	352.31
5.25%	137,219	1,217	1,811	2,119	132,071	452	303.45
5.50%	120,654	1,214	1,803	2,104	115,533	451	267.41
6.00%	97,084	1,209	1,786	2,075	92,015	451	215.17
6.50%	81,121	1,203	1,769	2,046	76,104	451	179.79
7.00%	69,596	1,197	1,753	2,017	64,629	451	154.25
7.50%	60,885	1,192	1,736	1,989	55,968	451	134.94
8.00%	54,070	1,186	1,720	1,961	49,202	451	119.84

Click to enlarge

Source: Author's work

*All figures are expressed in thousands except for Shares and Price.

As we can see, with actual share prices at the moment, just over 300$, you can expect a return of near 5.25% according to this forecast.

Can Netflix turn things around?

As we can see from the analysis, based on fundamentals, Netflix seems to be overvalued. While the business in itself serves millions of people and is poised to keep growing, there are some fundamental problems with the business.

Furthermore, in this regard, while Netflix has the superior market share to its competitors, it is behind on all other fronts. Apple, for example, is in a much better financial position and has the "deepest pockets" of all the players. Disney has a preexisting library of titles since it has been producing TV shows and films.

It will be interesting to see how this plays out. There is a possibility, as some people have pointed out, that the market will become increasingly fragmented, with the content being divided into all the different platforms. This might lead to a decline in streaming, with people reverting to illegal streaming. After all, if you can't have all the content you want conventionally in one or two platforms why bother? More likely, however one of the following two will happen.

1. We will see increasing mergers or collaborations amongst the streaming players.
2. Businesses will deliver a more flexible PPV approach.

To succeed in the future, there are some vital actions that Netflix must take to stay fresh and increase profitability.

M&A

Moving forward, Netflix must use its weight to acquire local production and film studios around the world and integrate them into their network. With the right system, Netflix can achieve synergies necessary to turn profitability around. As mentioned above, Netflix will have to increase its content creation. Mergers and acquisitions will play a fundamental role. Only by leveraging existing local content makers can Netflix hope to maintain its position as a streaming king.

Leveraging Data

The other thing Netflix can do is leverage its data through AI technology to better understand and serve its customers' needs. Already, AI is used day to day to make recommendations. Netflix already features this. But what if it took things further? What if not only did they use the data to recommend but also to produce content? So far, Netflix has denied using customers' data when making creative decisions. But why? It seems to me like this is an underexploited opportunity.

Sports

Finally, it is important to mention the importance that live streaming will have in the future. As we move away from traditional TV, we will see a big increase in sports streaming. I believe Netflix would do well to enter this market. It is in a great position to add this service thanks to its huge customer base. If Netflix did this, the analysis might be a different one. However, Netflix has no plans to start doing this.

Conclusion

While Netflix will keep delivering streaming services for years to come, future growth and earnings seem to be more than factored into today's share price. Many analysts have concluded that Netflix is now "dead money". Although this analysis cannot conclude that the company itself is under threat, it does appear that prices should continue to drop to near 200$.

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.

Comments

[OscarSmith]

one of the few stocks that barely went down, i love netflix but just like gold starting to go down, this could go to 100/150 next week. cuz no dividend and people are scared/ will only go for safe solid profitable dividend stocks like every crisis, second leg of the crash.

[johnfairplay]

NFLX's business model has the stock up over 10 percent YTD, while virtually every other stock is down YTD.

[daschwantz]

I think there are a few things that shareholders need to think about as risks in these down markets.

1) NFLX hasn't moved down nearly as much as the markets have, on the assumption that 'it is a stay-at-home stock that will benefit', however it is not known that this would actually increase new subscriptions in saturated markets with the highest margins, or instead allow people to watch everything left that they care to watch and cancel / churn to a new streamer
2) In a recessionary situation, people will return to illegal formats rather than paying for subscriptions, especially with so many new providers. NFLX is not immune from this, especially when they need to keep raising prices to improve cash flow. They currently have $3USD plans in India...will they really be able to raise these prices AND keep to projected subscription growth rates during a downturn?
2) High yield bond markets are extremely stressed right now, and the low rates NFLX pays on debt is due to ONE thing alone - bondholders know that the equity has value that can be tapped if and when needed. In other words, they are expecting NFLX to do a share offer when necessary to keep bondholders from getting too itchy. in down markets this becomes much more likely, and when it does happen shareholders never have an opportunity to exit their position before the repricing happens (after hours).

[ShermanMcCoy]

1. effect will be neutral to positive, not negative.

2. marginal effect only, irrelevant overall.

3. NFLX bonds are well bid - zero assumption of equity mkt put.

[yellowpage]

That's just naive. 1. Netflix releases multiple new shows every week, you can never watch them all. You may burn through all Disney classics you want to catch up, there's always something new with Netflix. 2. Netflix is the price of a lunch. Most people are willing to pay that for convenience and quality alone. 3. Low interest rate only makes it cheaper to finance new loans, while Netflix is still negative on cash flow.

[granko]

Author stating ARPU value of 1/5 for non-US consumer (vs US) made me stop reading this article - did author make any effort to look at and compare Netflix prices worldwide? I.e. in many European markets Netflix subscription is priced higher than in US... extremely myopic

[yellowpage]

$9 vs $13 today. It may get to 50% overtime, but it will never be 20%.

[ShermanMcCoy]

Projections garbage = valuation garbage = conclusion garbage.

[yellowpage]

OP doesn't know nothing about Netflix, just like bears before him. International markets will have a higher margin than US, because the cost is much lower, competitions are mostly local content providers and they don't have the global scale. Netflix made money heist a global phenomenon, and for non English speakers, who cares it's English or Spanish. Soon Netflix will have 300M users, with 75% or more users and 2/3 revenue from offshore.

[Jackass1]

Joseph McCarthy Censoring what I have to say it’s like living in Russia or Cuba

[nerd_rage]

"Moving forward, Netflix must use its weight to acquire local production and film studios around the world and integrate them into their network."

Why? Netflix can fund original production just fine now. They currently do fund a massive amount of original shows and movies, as any Netflix subscriber can attest. Every day there's something new, and guess what, most of it is disposable junk. I have no particular reason to sample (just checking the new crap today) "The Tiger King," "Freud" or "The Letter to the King." Next week those will be shoved aside for a new pile of shows and movies of no particular appeal (although I might check out "The Platform" just because it sounds so demented).

What Netflix needs: big brands. it doesn't have any and its competitors do. Disney makes one Mandalorian and resells it to the world while Netflix makes ten shows for ten territories at a tenth of the price of The Mandalorian, and they all look a tenth as good.

Result: Netflix is fully stocked with garbage that rarely seems worth sampling, while their competitors can use existing global brands as built-in promotion. And that is the biggest threat facing Netflix: without their own global brands, they can't be efficient enough to keep up.

Netflix does have a way out of this trap. It's not easy but they might as well try: develop their own global brands that play well across multiple territories. Then turn them into franchises. Both Stranger Things and Witcher seem to have this potential. Netflix should keep developing possible franchises even if most flop (remember Bright?)

And forget about sports, Netflix is wise to steer clear. Sports and news have the same problem: they are hard to globalize and they lose value too quickly. When Netflix gets a new subscriber in Chile or Indonesia tomorrow, the whole Netflix library is brand new to that person. House of Cards may be seven years old but those new eyeballs recharge it with value all over again.

Can't do that with a football game from seven years ago, and the guy from Chile or Indonesia has a different idea of what football means anyway, and he wants to see his local teams. I'm not convinced it even makes sense to globalize sports like entertainment.

[Ron Burgundy’s Hair]

What did you think about the hiring of susan rice as an expert on videos?

[S1974]

I agree on sport. On recognized brands, they for sure help: developing themselves is tough, it manageable, like HBO did for many years and Netflix is trying to do now securing deals with creative people. A safer play is to acquire a solid IP holder and develop from that base, like Iger and Disney did phenomenally with Marvel and Star Wars, for example. There, you can get MGM, AMCX or VIAC. Good purchases at today’s prices plus premium.