On Tuesday afternoon, Carl Icahn's Icahn Enterprises (NASDAQ: IEP ) released a somewhat bizarre press release, noting that it had sold more than half of its Netflix (NASDAQ: NFLX ) stock -- nearly 3 million shares in total. The release noted that the decision to sell had been made by Carl Icahn himself, rather than by the portfolio managers, David Schechter and Brett Icahn.
In fact, the release contains a long statement by Schechter and Brett Icahn in which they affirm their investment thesis and claim that Netflix is still significantly undervalued, despite having more than quintupled since they bought the stock. Moreover, Carl Icahn stated that he mostly agreed with their analysis.
In other words, the decision to sell Netflix had nothing to do with the possibility that Netflix's amazing run has taken it into "overvalued" territory. Icahn sold half of his stock simply "to take some of the chips off the table." Yet Carl Icahn's decision to radically scale back his Netflix stake was smarter than he knew, because the investment thesis laid out by Schechter and Brett Icahn is deeply flawed.
I'd like to focus on the "domestic" side of the bull case from Schechter and Icahn. They also believe international markets represent a huge opportunity for Netflix, but if they're overestimating the domestic opportunity, it also seems likely that they're overestimating the international opportunity.
In the U.S., Schechter and Icahn expect Netflix to increase domestic streaming revenue by $4.3 billion over the next five years. That would put domestic streaming revenue just over $7 billion by 2018! Part of the revenue gain would be driven by price increases, as Icahn and Schechter believe Netflix could charge $9.99 a month by 2018.
Still, Netflix would need to grow its domestic subscriber base to around 60 million (which is the low end of CEO Reed Hastings' long-term addressable market estimate) to meet this target. While this may occur eventually, the rapid-growth scenario Schechter and Brett Icahn envision seems extremely far-fetched.
First, as Netflix grows in the U.S., it will start to saturate the market. There are only 88 million broadband households in the U.S. today. Moreover, some of them may not be interested in an Internet video service (or may be very slow to adopt it), and some may choose competing services such as Hulu or Amazon.com's (NASDAQ: AMZN ) Prime Instant Video.
Netflix is already projecting that subscriber growth will slow modestly year over year in the current quarter. As Netflix becomes larger, it will only get harder to produce big year-over-year subscriber gains. Yet Schechter and Icahn project average gains of 5.4 million domestic subscribers annually for the next five years -- just slightly slower than this year's growth rate.
Second, any price increase is bound to upset the subscriber growth trajectory, just as it did two years ago. Analysts at Wedbush recently completed a survey, which found that 79% of domestic streaming subscribers would oppose a price increase.
Obviously, these surveys should be taken with a grain of salt; it's very unlikely that 79% of Netflix subscribers would cancel if prices went up. However, a price increase would probably increase the churn rate (the percentage of subscribers canceling each month). The larger Netflix grows, the more damage an uptick in churn would do to growth.
For example, let's assume that Netflix adds 5.5 million domestic subscribers per year for the next two years, ending 2015 with 44 million domestic subscribers. Suppose that Netflix then raises the price to $9.99 for 2016, causing a 1% increase in churn that lasts through 2016. That would mean an additional 440,000 cancellations per month, or 5.3 million incremental cancellations over the course of 2016 -- completely wiping out subscriber growth.
It would be very challenging to reach 60 million domestic subscribers by the end of 2018 even with no price increases, as saturation will start to pressure growth in the next year or two. Including a price increase, it seems fanciful to expect 60 million domestic Netflix subscribers by 2018. Netflix will probably show strong domestic streaming revenue growth over the next five years, perhaps doubling revenue to $5.5 billion. However, that would still leave a $1.5 billion shortfall relative to Schechter and Icahn's forecast.
Unrealistic cost containment
While David Schechter and Brett Icahn expect rapid subscriber growth despite an eventual price increase, they think content cost growth will dramatically slow going forward. Year-to-date, domestic streaming "cost of revenue" is up 19% year over year. Yet Schechter and Icahn think domestic content costs might increase by only $1 billion over the next five years -- a 9% compound annual growth rate.
This forecast is just as unrealistic as the subscriber growth projection. Content costs are rising rapidly in the U.S. streaming industry because of a surge in competition, particularly from Amazon and Hulu. Moreover, Netflix needs to invest heavily in original and exclusive content to keep pulling in new subscribers (presumably there's a reason today's non-subscribers aren't Netflix members yet).
However, these exclusive deals are very expensive. For instance, last year the company signed a big exclusive deal for Disney movies that goes into effect in 2016. The expected cost? Upwards of $350 million per year! That one deal would represent 19% of Netflix's U.S. streaming content costs for 2013.
As Netflix's favorable content deals expire over the next three years and the company increases the percentage of its budget devoted to original and/or exclusive content, Netflix will have to pay significantly more than it does today just to maintain the same offering. Improving the overall content offering will add even more expenses.
At the recent growth rate, domestic streaming "cost of revenues" would rise to $4.4 billion by 2018. Even assuming some slowdown in the cost inflation rate, domestic content costs still seem likely to reach $3.5 billion to $4 billion by 2018, as opposed to the less than $3 billion figure Schechter and Brett Icahn propose.
Not such a no-brainer
David Schechter and Brett Icahn envision a scenario wherein Netflix could grow its domestic streaming contribution profit from a little over $600 million this year to nearly $4 billion per year by 2018. This assumes that Netflix's content cost growth will slow dramatically. while subscriber growth stays near 2013 rates (in spite of an eventual price increase).
However, their scenario vastly overstates the potential for "operational leverage" at Netflix. In a realistic scenario, revenue growth will fall short of their target by more than $1 billion while content cost growth could exceed their target by just as much. This creates a shortfall of more than $2 billion to the 2018 profit estimates Schechter and Brett Icahn use.
Even if Netflix grows domestic streaming contribution profit by only $1 billion over the next five years, the stock still could grow into its valuation if Netflix's international expansion succeeds. However, Netflix is hardly undervalued at its current market cap of $20 billion.
If Carl Icahn really believes in Netflix's profit growth potential as much as David Schechter and Brett Icahn do, he's vastly overestimating the company's prospects. His decision to sell 3 million shares anyway was therefore even smarter than he thought it was.
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