By: Steve Smith
Last week, Disney not only announced it is preparing to launch a streaming service that will be priced significantly lower than Netflix, but also revealed it is in talks with Twenty First Century Fox to acquire most of its stations and library. The combination of having one of the largest collections of content, much of which is tied to recognizable, trusted and timeless titles, at a lower price point might finally present a sufficiently formidable threat in terms of both growth and the Netflix stock price.
Up until now, investors have been willing to hold Netflix stock because they bought into the company’s transition. The company has moved from an entity that buys/licenses third party content and acts simply as a streaming delivery service into one that produces its own original content on the belief that exclusivity is what brings in new and keeps old subscribers.
The fact that it was able to increase the basic membership fee seemed to confirm peoples’ willingness to pay for the award winning content and the “stickiness” of the business model and benefit of being the market share leader.
But in addition to a possible price war with Disney and growing competition from the likes of Amazon, there may be a larger problem lurking. Behind the creation of hit shows and movies Netflix has produced is a giant debt bomb that might bring the final curtain down on its share price.
Over the past 3 years the company more than doubled its spending on original content to an expected $8 billion in 2018. And the rate is expected to continue for the foreseeable future.
While subscriptions for the streaming service has nearly quadrupled in five years to 104 million people, so has the company’s debt.
Netflix has amassed $20.45 billion in long-term debt and obligations in recent years.
For instance, the company has $4.8 billion in long-term debt and $15.7 billion in other obligations as of 2017. This stands in contrast to just $7 billion revenues and a mere $800 million in profit.
And the debt levels had already been accelerating; just four years ago, when it had a mere $500,000 (half a million dollars) in long-term debt and a little more than $5 billion in other obligations.
And to keep those subscription numbers up, Netflix’s CEO, Reed Hastings, acknowledged that he will need to keep spending. It just recently announced a fresh issuance of $1.6 billion in new debt to help pay for projects such as $100 million on a Martin Scorsese project and $90 million on a Will Smith movie.
These debt figures don’t even include overseas expansion, in which Netflix’s global long-term debt levels has doubled to $4.84 billion in the last year.
A River of Red Runs Through It
The profitability metrics during the most recent quarter all took a significant hit. Gross margins narrowed from 33.48% to 30.04% compared to the same period last year, and operating (EBITDA) margins dropped to 56.39% from 58.15%. The operating cash flow declined 79.45% compared to same period last year is and there was no significant movement in accruals or reserves. All of this means that revenue per subscriber is declining.
If this trend continues, the quarterly linear trends would predict a 16% net profit margin in the future five-year time horizon. Slowing top-line growth and shrinking margins would should ultimately lead to a more normalized P/E at in the low 20s compared to its current 339. Even this number is misleading, since the company really runs at best breakeven on a GAAP basis.
And that may soon turn into losses. Netflix’s cumulative free cash flow burn over $3 billion over the past decade. And the burn has been accelerating in recent years.
If they have not been able to make money so far, what makes investors believe they will make more money in the future in an increasingly competitive market? For how long will the market tolerate these losses in the face of slower growth and more competition?
Competition seems to be multiplying faster than sequels to Fast & the Furious at the multiplex. Not only are internet behemoths such as Amazon, Apple and Google muscling into people’s living rooms but there is also a aforementioned Disney with it’s new aggressive push into going over the top streaming. There are also new all digital firms such as Hulu and Crackle and other delivery devices like Roku and Sling and Outerwall’s Red Box and of course satellite services such as DishNetwork.
As a pure video streaming play, Time Warner, with HBO as its crown jewel, is probably the best comparison. HBO has nearly 150 million subscribers compared to Netflix’s current 110 million.
So even assuming Netflix could add another 60 million subs over the next five years, a 75% increase which far exceeds even its own estimates, that would still only imply an 15% annualized growth rate.
The Incredible Shrinking Library
In past years, Netflix had one significant advantage over its streaming competitors: its massive library of movies and TV shows. One of the reasons Netflix has pushed more and more into original content recently is it can no longer afford that massive catalog of licensed content, as costs rose relative to its revenue.
Since Jan. 2014, the number of titles available on Netflix in the US has shrunk by 31.7%. This was particularly pronounced in movies, where Netflix’s selection had gone down by over 2,000 titles. Amazon Prime Video now has a library of movies and TV shows nearly 3 times size of Netflix.
I actually still get DVD’s in the mail in those red envelopes because hardly any independent or foreign films are available for streaming. And for newer, special effects-laden movies I like the quality of Bluetooth. I may not be the typical customer, but I think this speaks to the fact people will go where the content is; and in this regard Netflix is simply one of many platforms with no real competitive moat.
All told, the picture looks bleak. I want to establish a long term bearish position. I’m buying some a LEAP put options. Specifically;
-Buy the Jan. 2019 puts with an 180 strike for $7.00 per contract.
My expectation is for shares to be below $150 within the next 18 months. This would give the puts a minimum value of $30 for a $23 or 320% gain.
Fade to black.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
January 3, 2019
December 4, 2017