Jan 10 2020 - Netflix: There Are Greater Concerns, Beyond New Competition

Summary

Netflix has offered life-changing shareholder returns to those who invested in the stock many years ago.

However, the company is now facing a headwind, namely the entrance of new competitors in its business.

Moreover, Netflix has been posting negative free cash flows. Even worse, it has not provided guidance regarding the year it expects to become cash flow positive.

As a result, the company will continue to rely on the high-yield market to fund its debt obligations.

Netflix (NFLX) has offered life-changing shareholder returns to those who invested in the stock many years ago. However, the stock has remained ESSENTIALLY FLAT since early 2018 and many investors fear that the new competitors in the streaming business will exert pressure on Netflix. While the heating competition is a concern, I am more concerned about the high debt load of the company and its deep negative free cash flows, which are not likely to become positive anytime soon. In this article, I will analyze why the stock is not attractive around its current level.

Growth

Netflix has grown its subscriber base and its revenue at a tremendous pace for several years in a row. In the third quarter, the company grew its revenue 31% over the prior year and more than doubled its operating income, from 1 million in prior year's quarter to 0 million. The strong performance was driven by a 22% increase in the number of paid memberships in the last 12 months.

While it would be natural to expect the paid net additions to decelerate, the performance of Netflix has been outstanding. Its paid memberships grew by about 25% on an annual basis between Q3-2018 and Q1-2019 and have only mildly slowed down, to about 21%, in the last two quarters. On the other hand, the price hikes in the U.S. last year caused a significant customer churn, which has not returned to normal levels yet. As a result, paid net additions in the U.S. were only 2.1 million in the first nine months of 2019, much fewer than the 4.1 million reported in the first nine months of 2018.

New competition

Many investors are worried about the heating competition in the streaming business due to the entrance of new competitors, such as Disney+, Apple TV+, HBO Max and Peacock. Indeed, all these competitors are likely to gain a meaningful share of the streaming market and thus somewhat affect the growth trajectory of Netflix.

However, it is important to note that the streaming business is still too small compared to linear TV. In addition, Netflix has much more diverse and higher-quality original content than each of its competitors. Consequently, although Netflix is more expensive than most of its competitors, it is not likely to be severely affected by them, particularly given that most consumers can easily afford its offerings. In other words, the membership losses of Netflix to its streaming competitors are likely to remain much smaller than the shift of consumers from linear TV to Netflix for the foreseeable future.

For instance, the growth pattern of Netflix in Canada, where Hulu is not present, is very similar to its growth pattern in the U.S., where Hulu is very popular, with approximately 30 million members.

Netflix growth in US and Canada

Source: Investor Presentation

Overall, the entrance of new competitors in the market is certainly a headwind, mostly due to the pressure it will exert on prices. Netflix will not be able to hike its prices uninhibited anymore. In addition, the offerings of Netflix will inevitably be harmed by the new competitors. To provide a perspective, WarnerMedia (T) recently outbid Netflix, to the tune of 0-0 million, for the rights to the unparalleled series "Friends". Nevertheless, the new competitors are not likely to derail Netflix from its high-growth trajectory in the near future, as we are still in the early phases of the secular shift from linear TV to streaming.

Negative cash flows

Netflix has been unable to generate positive free cash flows in every single year since its IPO, in 2002. In the third quarter, the company posted free cash flows of -1 million, which were better than the -9 million in prior year's quarter but remained in deep negative territory. Moreover, management expects free cash flows around -.5 billion for the full year 2019. Furthermore, not only does Netflix post negative free cash flows, but it also posts negative operating cash flows.

It is also important to note that management has not informed investors when it expects to generate positive free cash flows. It has only provided a vague guidance for improving the free cash flows from next year. However, the inability of Netflix to improve its free cash flows amid tremendous revenue growth indicates that it is extremely hard for this business to generate positive cash flows.

The company spends an increasing amount to create original content year after year. Given the heating competition in the streaming business, the pressure for more original content will increase in the upcoming years. Consequently, as there is a finite number of studios, the cost of producing original content will remain on the rise and hence it will make it even more difficult for Netflix to improve its free cash flows.

Debt

As Netflix has been posting negative free cash flows year after year, it is only natural that the company has accumulated an excessive amount of debt. Its current liabilities (due within the next 12 months) exceed its current assets by a wide margin (.3 billion vs. .3 billion) and hence Netflix will need to use most of next year's earnings to fund its near-term obligations.

Moreover, its net debt (as per Buffett, net debt = total liabilities - cash - receivables) stands at .8 billion. As this amount is approximately 14 times the annual earnings of the company, it is certainly high. Even worse, as Netflix is burning cash at a fast clip (due to its negative free cash flows), it will increase its debt load even further for many more years. The company recently confirmed this, as it stated that it will finance its investment needs by resorting to the high-yield market.

To cut a long story short, Netflix is not likely to have problem servicing its debt for the foreseeable future. On the other hand, its debt pile will continue burdening its bottom line via high interest expense while the company will be highly vulnerable in the event of an unforeseen headwind, such as a significant deceleration in its membership growth due to a potential recession or an aggressive strategic move of a competitor.

Valuation

Given the expected earnings per share of .36 for the full year 2019, Netflix is currently trading at a price-to-earnings ratio of 101.1. As this earnings multiple is excessive, it is hard to draw conclusions on the valuation of the stock merely from this multiple.

If Netflix does not decelerate due to the new competitors in its business and continues growing according to the analysts' consensus, it is expected to earn .25 per share by 2026. In such a case, its current stock price will correspond to a price-to-earnings ratio of 12.9 in 2026. In other words, if Netflix continues growing at a fast pace for seven more years, its valuation will become reasonable at the end of 2026.

However, there are many risks to this thesis. The new competitors may exert greater pressure on the market share and the margins of Netflix than the analyst community currently anticipates. In addition, if a deep U.S. or global recession shows up over the next seven years, it will exert great pressure on Netflix, particularly given the high debt load and the negative free cash flows of the company. In such a case, the company will not be able to keep borrowing funds at decent interest rates. Overall, if everything goes according to the business plan of Netflix, its valuation is likely to prove reasonable or even cheap in seven years from now. On the other hand, investors should realize that a 7-year period involves a great amount of risk for a cash-burning company with a high amount of debt.

Final thoughts

Netflix is offering the most diverse content in the streaming business and hence it continues growing its paid membership base at an enviable rate. The company is undeniably the leader in its business and will maintain this position for many more years. However, the stock is valued to perfection right now. Due to its inability to generate positive free cash flows and its strong dependence on the high-yield market to fund its obligations, Netflix involves a significant amount of risk, particularly given its high debt load and its sky high valuation right now.

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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