By: Steve Smith
Netflix (NFLX) shares have been on a tear, up an eye-popping 72% in just the first three months of the year. Its market cap now stands at $142 billion, now just $10 billion shy of Disney (DIS). Today’s investing advice will try to explain why the company has so confounded its numerous critics.
Because this isn’t the first time Netflix shares have staged a huge run and confounded both the bears and critics, who not only deem the stock overvalued, but its growth as completely unsustainable. The shorts continue to get burned.
I took a stab at making the bearish case back in November when shares were around $200. The crux of my investing advice at the time was that deep-pocketed competitors such as Disney, Apple and Amazon would ultimately force Netflix to spend its way into an insurmountable mountain of debt.
Today the Financial Times took a shot the bearish case in a piece called This is Nuts, When will Netflix Crash?
Friday’s 5 percent jump took Netflix shares to a fresh all-time high, to value the much-loved streaming company at $144 billion, two-thirds more than at the start of the year.
The people proved wrong are the doubters, those who like Barrons thought its valuation was ridiculous all the way back in August, about $160 ago.
Today, the numbers represent boundless optimism: a dozen times the $12 billion of revenues reported last year, 120 times the profits it is expected to generate in this one. Fast forward, and estimates from analysts prepared to put a finger in the air for 2021 average out to forecast revenues of $27 billion.
Are they, and the market, wrong?
Maybe it would be easier to share that confidence if Reed Hastings submitted to the sort of quarterly conference call suffered by less exalted chief executives, where questions from the crowd are allowed. The company prefers to pre-record polite conversation with chosen analysts.
It might be easier to believe in the growth story if 48 million American households weren’t already signed up for the delights of Stranger Things, and marketing spending wasn’t growing faster than sales. It will jump to $2 billion this year, from $1.3 billion in 2017, which suggests winning customers is getting harder even if, like Netflix, we believe 700 million households around the world are potential customers.
Buying into the dream would be easier if the company weren’t also competing with Amazon, HBO and, in the not-too-distant future, Disney.
Spending of $8 billion on content is planned for 2018. It would be easier to believe such costs were sustainable if the group wasn’t funding itself through an accumulation of debt. That borrowing may be the part the market has overlooked, or even got wrong, but it makes Netflix the epitome of the boom we now enjoy.
The company has been burning cash for years, whether we judge it on operating cash flow or free cash flow. Netflix had to find $0.5 billion every quarter last year, on the latter basis.
It borrows in the bond market to fund such spending, accumulating $6.5 billion in debt, and likes to talk up a ratio of debt-to-market capitalization as if it measures financial health rather than the weight of fairy dust sprinkled on the stock.
The debt is rated junk, four notches below investment grade. Were credit markets to close, as they periodically do to weaker borrowers in moments of strife, Nextflix would be shut out.
It has $2.8 billion of cash on hand, and another $0.5 billion credit line, so it could wait out any reluctance by investors to lend. Maturities are evenly spread into the future.
There’s a circularity to the confidence game though. On the way up free spending on TV stars, writers, and producers is treated like investment. Stock market fans buy into the story of conquest, while debt investors and rating agencies tell themselves subscriber growth will eventually take care of the lack of cash.
A broader market upset could break that spell. Forced to preserve cash, prompting a slowdown in the pace of growth, and investors might focus more on the burn rate and the company’s substantial content liabilities. The group has $7.5 billion of these on the balance sheet, and another $10 billion of such commitments off it.
In all, contractual commitments come to $28 billion, according to this table in the recent
On top of that are another $3 billion to $5 billion of estimated commitments for unknown titles in the next three years, for instance “traditional film output deals, or certain TV series license agreements where the number of seasons to be aired is unknown”. Those costs are largely expected to fall due in 2019 and 2020.
Of course, much of these obligations will come under operating costs, and Netflix can reasonably point to large content obligations elsewhere. At the end of last year Disney listed $48 billion of commitments, almost all sports related for ESPN, out of $92 billion of total commitments.
Set against their respective valuations, Netflix’s obligations don’t look so bad. With net debt it has an enterprise value of $147 billion, to Disney’s $182 billion.
Traditionalists, however, might prefer some harder numbers. The Mouse empire took in $55 billion in sales last year, and produced $9 billion of free cash flow.
Focus on the Disney valuation, however, because it gets at the question of what Netflix investors are playing for.
Imagine in a decade Netflix has grown such that it has $55 billion in revenues. Also imagine it can grow subscription fees as if they were for a college education, even though it will compete against Amazon, iTunes, Spotify and whatever else comes along for entertainment spend. If the average household were to pay $15 per month, up from $9.43 today, Netflix will need 305 million paying households to get there.
It could, sure. We can also argue about details of business structures, predictability of subscriptions and whether Netflix will still be growing.
Yet, if it does everything right from here, what is the upside for enthusiastic shareholders?
A decade of incredible growth would take Netflix to something like the size, heft and cultural influence of Disney today, which the market thinks is only about a quarter more valuable than the TV-streaming trailblazer.
Those feel like the wrong odds.