Netflix: South Korea Derails Its Business Model
Summary
- A new lawsuit against Netflix would normally be a non-event, however, it comes on the heels of another loss for Netflix in South Korea.
- The deal has the potential to cost Netflix significantly and it comes on the heels of the company's tenuous financial position.
- Overall, Netflix is trading at a lofty valuation and we don't recommend investing at this time.
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Net neutrality is a simple concept, but a fundamental building block of the internet. The idea is that your internet service provider must provide access to all content equally, with no discrimination based on the company supplying that content, user, platform etc. For example, Apple can't pay Comcast to slow down your internet speeds if you're using a Windows laptop.
Under the Trump administration, Ajit Pai, commissioner of the FTC, put significant effort into attempting to please large corporations by repealing net neutrality. Since then, significant effort has been put into bringing back net neutrality. However, with Squid Game on track to become Netflix's (NASDAQ: NASDAQ:NFLX) most popular show of all time, the effects of no net neutrality could be coming home to roost.
The Lawsuit
Netflix's new show Squid Game has the potential to become its most popular show of all time. It's already one of the most popular. In South Korea, which is the original language the show is based in, it's already performing incredibly well. In fact, it's performed so well, a South Korean broadband firm is suing Netflix for the increased traffic.
Normally, we would ignore such a lawsuit. However, South Korea has ruled against Netflix in the past. The result of this lawsuit remains to be seen, and as investors and not lawyers we're not going to attempt to speculate with the details here. However, not just the start of this lawsuit, but the fact that the courts have sided with ISPs in the past implies the lawsuit is not frivolous.
Netflix's New Costs
On the basis of this, we will attempt to quantify Netflix's new costs.
For South Korea, the ISP which stated that Netflix used 1.2 terabits per second in 2020, should have to pay $20+ million across the year. Globally, Netflix consumes 12.6% of downstream bandwidth traffic. Global internet traffic is roughly 235.7 exabytes per month. An exabyte is ~1 million terabytes, so for a rough conversion, in South Korea Netflix uses 388 petabytes.
Globally Netflix uses ~29.7 exabytes, which implies, assuming an equivalent fee rate globally, $1.5 billion is used by ISPs for supporting the distribution of Netflix's content each year. To make life easier we'll assume that those costs stay constant year over year. We also use $1.5 billion to represent the upper limit of annual expenses.
Netflix's Current Profits
At the same time, Netflix's profits aren't anything special.
Netflix Profits - Netflix Press Release
The company's FY 2021 guidance is for $10.55/share. For 2022 it's expected to go to $13.02/share, however, we see that as optimistic. However, the company's share price is $610/share and the dollar value of its profits is ~$4.5 billion/year. It's at a P/E ratio of roughly 60 which shows an expectation for it to grow its profits significantly.
This helps to highlight two things. The first is that the company doesn't have a lot of room to raise expenses. Another $1-2 billion in annual expenses would cut profits almost in half which you can't afford with a P/E of 60. The second is that outside of all expenses, investors are expecting Netflix's profits to grow substantially.
As we'll discuss in the next section, we feel this is a lofty goal.
Netflix's Financial Risk
As a family that recently cancelled our Netflix subscription, we're sharing our opinion on Netflix's financial risk from a perspective as an end-user and from a financial perspective.
Over the past several years, Netflix's competition has gone up dramatically. Hulu has grown, Disney+, Peacock, Apple TV, and HBO Max have all come out recently. More so, with the exception of HBO Max, all have come out at a dramatically lower price point in comparison. At the same time, a growth in piracy has hurt the direct release plan. 
Streaming Prices - Statista
It's much easier to make an illegal copy of a movie that's just come out on a streaming website. Netflix is now at the upper end cost wise versus its peers. That means that the company has minimum room for continuing to occasional price increases that have become a standard part of the company's market offerings.
Additionally, the company is fighting against deep-pocketed players like Disney, AT&T, and Apple. Each of those companies can casually invest $10s of billions in new content. Netflix, with just $4 billion in annual profit it needs to keep growing, can't invest in content in the same way. As popular content leaves Netflix to go back to the original content hosts, it's a noteworthy risk.
It's also worth noting that Netflix is spending much more on content than its financials indicate at first glance. The company amortizes content spending, which means the cash cost is much higher but it's assuming future returns. That's a risk worth paying close attention to.
Overall, Netflix's financial risk is in an environment with increasing competition and costs its valued for strong profit growth. We don't foresee that happening.
Thesis Risk
The risk to our thesis is two-fold. The first is that while we highlight how Netflix's financials don't match its valuation, it's worth noting that Netflix's fixed costs don't scale proportionally by subscribers. As a result the company could continue to grow helping its performance. Second, there's a chance it wins the lawsuit which would revert these risks.
Conclusion
Netflix's new lawsuit in South Korea, on the back of Squid Game's success, represents a significant risk for the company. Globally, the company's content is one of the largest bandwidth consumers. The company has made deals in the past in the US, so there is precedent for this deal potentially expanding globally.
Overall, it represents another potential bill, totaling almost $2 billion/year, for a company already at the upper end of what it charges customers at a lofty valuation. In our opinion, it's another example of how Netflix is overvalued, which is a risk that investors should be focused on paying close attention to before investing.
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This article was written by
The Value Portfolio specializes in building retirement portfolios and utilizes a fact-based research strategy to identify investments. This includes extensive readings of 10Ks, analyst commentary, market reports, and investor presentations. He invests real money in the stocks he recommends.
He is the leader of the investing group The Retirement Forum with features including: model portfolios, macro overviews, in-depth company analysis and retirement planning information. Learn more.Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (41)
It does well for option plays also. Shorter term if there is another modest pullback, I will add a bit more. It’s going to do better than 3 M and my pharma.
* Even if they do, NFLX should be able to pass on the cost, since presumably every other streaming service would face the same cost.
* Even if both of those have the worst possible result for Netflix, SK is one of many countries. Surely this won't play out badly in every country, and possibly might not catch on in any other ones.
* Why would the cost of data stay constant over time? Bandwidth gets bigger over time. There's more competition with home 5g and LEO satellites.Besides that, Netflix bears ignored its growth and pricing power for many years. Here you're just continuing that mistake.
