Netflix Investors Need Some Perspective

In the battle between Netflix (NASDAQ: NFLX  ) bulls and bears, hyperbole often overshadows the truth. Advocates on both sides like to make grandiose claims about Netflix's fate. Bulls think Netflix is destined to become ubiquitous and extremely profitable, while bears think it's a house of cards.

In all likelihood, the reality is somewhere in between. The true story of Netflix is not about the its dominance or implosion. Instead, Netflix's worth comes down to a rather pedestrian race between revenue growth and content cost inflation. Today, revenue growth is outpacing cost growth, but not by very much. To justify its sky-high valuation, Netflix will need to better leverage its existing content spending in the future.

A view from the bear side
Despite Netflix's strong rebound since the "Qwikster" fiasco in 2011, a surprisingly large number of investors think its business model is unsustainable. For example, TheStreet's Rocco Pendola has repeatedly argued that Netflix is all "smoke and mirrors." Pendola believes that big media companies such as Time Warner (NYSE: TWX  ) and Disney (NYSE: DIS  ) control the whole industry, and that Netflix can survive only as long as these competitors tolerate it.

However, while Netflix does buy content from big media companies (which rely on the pay-TV industry for most of the revenue), there's no real danger that these companies will cut Netflix off. There's too much money to be made by selling content to services like Netflix. Moreover, there are enough content owners out there that Netflix will always be able to find a few that are willing to play ball.

In short, Netflix's fate is in its own hands. If investors are overrating its prospects, it's not because Time Warner is going to "punkslap" Netflix -- as Pendola has colorfully put it on occasion. It's simply because Netflix won't be able to grow profit rapidly forever.

Bullish beyond belief
At the other end of the spectrum sit uber-bulls such as portfolio managers David Schechter and Brett Icahn of Icahn Enterprises (NASDAQ: IEP  ) . While company Chairman Carl Icahn (Brett's father) decided to sell a large portion of the company's Netflix holdings in October, Schechter and Brett Icahn think Netflix is still massively undervalued.

The crux of Schechter and Icahn's argument is that Netflix is a superb bargain for consumers at $7.99 a month, and should eventually grow to serve 60 million to 90 million households. They also believe that the business model has massive operational leverage -- i.e., Netflix can grow revenue rapidly without adding much in the way of costs.

This scenario is just as far-fetched as Pendola's bearish one. First of all, while Schechter and Icahn say they "find it difficult to understand why a household would not subscribe to the service," the fact remains that most households do not subscribe to Netflix. Speaking from my own experience as a non-subscriber, I'd say Netflix would have to add a lot of content before it would be worth the price for me.

More broadly, the fact that tens of millions of U.S. households don't use Netflix today suggests that it isn't a "bargain" for them. Pretty much everybody in the U.S. knows what Netflix is -- even my 90-year-old grandmother, who doesn't use the Internet! -- so it's not as if lots of consumers have yet to discover Netflix. The only way Netflix will attract these holdouts (and get existing customers to pay more) is by adding more high-quality content to the service.

The real issue
What will really determine the scope of Netflix's success over the next five to 10 years is how fast content costs rise in relation to revenue. In the press release announcing Icahn Enterprises' sale of Netflix stock, Schechter and Icahn suggest that Netflix could boost domestic streaming revenue by $4.3 billion annually over the next five years. They believe Netflix can drive this growth while adding just $1 billion in content expense!

For some context, let's look at Netflix's revenue and cost growth this year. Through the first nine months of 2013, domestic streaming revenue grew 26% year over year. However, streaming content expense grew almost as quickly, increasing 19% year over year.

For Netflix to add $4.3 billion of domestic streaming revenue in the next five years, it would need to grow at a compound annual rate of 21%. Netflix would have to keep adding subscribers at its recent pace of 5 million to 6 million annually while also raising prices, with no sign of market saturation. At the same time, content cost growth would have to abruptly slow to 9% annually.

Instead, while revenue growth and content cost growth will both moderate on a percentage basis in the next few years, the two growth rates are more likely to converge than diverge. Revenue growth primarily depends upon subscriber growth, and sooner or later Netflix will start to saturate the market. Meanwhile, cost growth is unavoidable: even established slow-growth distributors such as Comcast (NASDAQ: CMCSA  ) are contending with rapidly rising content costs.

Foolish bottom line
Netflix bulls and bears like to argue from extremes. Bears argue that Netflix is a house of cards with no control over its destiny, doomed to crumble because of skyrocketing content costs. Bulls view the situation through rose-colored glasses and expect revenue to grow rapidly without much of a content cost investment by Netflix.

Neither of these scenarios is likely. Revenue growth is modestly outpacing content cost growth today, leading to margin growth and earnings growth at Netflix today. However, today's revenue growth rate (at least domestically) is clearly unsustainable in the long run. The real question investors need to answer is whether Netflix can pull back on content cost growth fast enough to keep margins growing. Otherwise, earnings growth will never live up to bulls' expectations.

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  • Report this Comment On December 03, 2013, at 6:47 PM, AceInMySleeve wrote:

    "The only way Netflix will attract these holdouts (and get existing customers to pay more) is by adding more high-quality content to the service."

    Consider their DVD service which continued to add subscribers for years despite having essentially the same content quality the entire time.

  • Report this Comment On December 03, 2013, at 7:02 PM, duuude1 wrote:

    And I think almost everyone, including apparently you Adam, misunderstands one of the key elements of control that Reed and NFLX has: a critical understanding of the true value of any piece of content.

    Based on NFLX's collection of every click and pause and rewind and rating of everything we watch, they know what people like, and what they hate. They know what content attracts views, and what content does not. And they can predict what new content, therefore, will attract new subs.

    Therefore when numbnuts like Chris Albrecht (http://www.nytimes.com/2007/05/10/technology/10iht-hbo.1.564... at Starz demands too much for their content, NFLX can just walk away.

    Who owns the power in a negotiation - the party who doesn't know the true value of their product when they demand a certain price for it - or the party who knows exactly how much revenue that product can bring in and knows when to walk away from an unreasonable demand?

    NFLX is the one in control in all of these negotiations.

    Content spend is a controlled percentage of their revenues. Key point here duuudes. Reed calls the shots on what percent of revenues they will spend on content.

    Content spend will NOT exceed revenues unless they decide to do so.

    NFLX is in the driver's seat here folks.

    Stay long, stay strong. Pray for another Qwikster fiasco so we can pick up more shares cheap - did anyone else buy back in late 2012? :)

    Feels good now huh? (it didn't feel good for a while - but just keep buying, just keep buying...)

    Duuude1

  • Report this Comment On December 03, 2013, at 7:29 PM, duuude1 wrote:

    I'm pleased to see that Pendola doesn't get much respect in most of the posts and comments here on TMF. In direct contrast to his punkslapping cable buddies, here's a small piece of news from last week that I was surprised did not find its way to some Foolish commentary:

    http://gigaom.com/2013/11/20/hbos-no-cable-experiment-goes-n...

    This is essentially a direct head-to-head competition between NFLX and TWC/HBO in a small market with approximately the same launch timing and with similar products - and we can see who is punkslapping whom.

    And now the goliath TWC has swooned over the therapist's couch and is asking for a suitor to come and rescue them? Who's doing the punkslapping again, Pendola?

    In addition to the fine example of humanity we have in Chris Albrecht of Starz (see above link), we have the fine example of prescient business vision from TWC Chairman Jeffery Bewkes who made this fine call a couple years ago:

    http://www.nytimes.com/2010/12/13/business/media/13bewkes.ht...

    Who's doing the punkslapping again?

    Sell cable.

    Buy NFLX.

    Duuude1

    (ummm, by the way, I'm a bit long NFLX)

  • Report this Comment On December 03, 2013, at 8:01 PM, duuude1 wrote:

    Last thing Adam, I notice your profile at the bottom of the article states:

    "Fool contributor Adam Levine-Weinberg owns shares of Apple, is short shares of Netflix"

    Smart on AAPL.

    But short NFLX? Really?

    Don't you want to kind of cover your shorts and come over the the sunny long side here?

    Don't you remember a certain very smart, very successful hedge fund manager, a very Foolish investor in general, Whitney Tilson, losing his shirt by shorting NFLX, and eventually capitulating:

    http://www.bloomberg.com/news/2011-10-25/whitney-tilson-form...

    Don't you want to learn from the pain of other smart professionals who've been burned badly before you?

    C'mon duuude, stanch the pain and cover!

    :)

    Duuude1

    (at least you are disclosing and we can judge how that influences your articles - thanks for that)

  • Report this Comment On December 03, 2013, at 10:25 PM, 24penny wrote:

    Nice balanced article for a fellow short. I'm also eyeballing those obligations. You should figure out a way to weight its growth in.

  • Report this Comment On December 03, 2013, at 10:54 PM, TMFGemHunter wrote:

    @Duuuude1: Thanks for the comments. I stand by my Netflix short; while I don't think Netflix will get "punkslapped" (whatever that means) anytime soon, I do not see any likely path to the level of profitability Netflix would need to justify its current valuation.

    To be honest, I think the "data" argument carries a lot less weight than you (and other Netflix bulls) assume. Netflix can certainly save money by analyzing viewer data to decide which content to dump -- or when to exit the bidding for content renewals. However, competitors like Amazon have just as much or even more data: because Amazon also has physical DVD sales and pay-per-view data as well as Prime data.

    There's a much simpler explanation for why Netflix doesn't renew content: it can't afford to. SVOD costs are rising at an astronomical rate. Netflix's desire to get exclusive rights to most content also raises the price. For example, Netflix didn't drop Downton Abbey because it wanted to. Downton Abbey is a current, hugely popular serialized drama... i.e. exactly the kind of show Netflix wants. (In fact, Netflix just bought the rights to Downton Abbey for Canada!)

    I suspect that winning the U.S. bidding for Downton Abbey (and other shows removed from Netflix this year) would have pushed Netflix's content spending WAY past the budget for 2013. Netflix's 19% content cost growth in 2013 has come despite removing highly viewed content from the service like Downton Abbey, Spongebob, etc.

    At some point, the constant loss of content will weigh on subscriber growth. Or Netflix will have to start growing content expense even faster in order to keep its subscriber base happy. Anyway, that's one man's opinion.

    Adam

  • Report this Comment On December 04, 2013, at 6:51 AM, duuude1 wrote:

    Hey Adam,

    All right, duuude. We'll agree to disagree. Just don't get hurt. We're all in this for the same thing, ultimately - to learn and grow.

    I own AAPL, AMZN, and NFLX among the potential content competitors, and of the three, I believe that NFLX is lightyears ahead becasue of their all-you-can-eat subscription model. Most of AAPL and AMZN's revenues come from ala carte purchases, right? So the motivation for either AAPL or AMZN to carefully refine their content valuation is lower - they just need some marketing duuude to look at box-office receipts and give a thumbs up or down on whether buy a piece of content. It's just not a big worry, especially for cash-flush companies like them.

    For NFLX, this online video business is all they've got. They're small, less well funded, and they're protecting the only crumb in their possession. For AAPL and AMZN, if this video stuff doesn't work, oh well, no big deal, it was only a fraction of their cake, they've got plenty left over if that one crumb was a bit stale or inedible. I think we all know that no one in this market is so blase about success or failure, but neither are any of the competitors as focussed as NFLX. And there, if anything, is the crux of the risk in investing with them - it's all-or-nothing. There's no basket, just the eggs, and Reed and Co had better watch them eggs carefully. And valuing content is one of the core competencies necessary for their business to thrive.

    You are absolutely right in that the market for content has gone bubblicious. It's like the housing market - everyone is raising prices just because, well, everyone else is. It is NOT because everyone knows the fundamental value of their content is higher. No way. It is merely because the Joneses next door got a higher offer from Amazon, so why can't I get more for mine?

    But when the prices of existing homes goes nuts and is beyond reasonable valuations, what do you do? Build your own. Thus NFLX's recent push into original content.

    The price dynamics in this market are definitely a problem - but they're a problem for everyone in the market. I hate the excessive price increases in content just as much as I hate the increases in the housing market. It's unreasonable and unsustainable, and everyone will suffer, as we recently saw. Luckily there are other options in both cases, like Orange is the New Black for NFLX and renting for me :)

    Duuude1

  • Report this Comment On December 04, 2013, at 9:40 AM, dinopontino1 wrote:

    Everyone I know religiously watches Netflix every night. They have instant, they have HBOGO yet they still watch Netflix. I can't explain it but it's a reality. IMHO HBO has better content and Amazon is cheaper (has the Good Wife and Downton Abbey, 2 serials that should attract binge viewers) but that myspace -> facebook transition hasn't happened yet.

    When someone casually mentions to me that they downloaded the Amazon instant/HBO Go app, I will short this stock. Until then, let the bull run b/c they are the market leader, regardless of valuation.

  • Report this Comment On December 04, 2013, at 10:24 AM, TMFGemHunter wrote:

    @Duuude1: Best of luck! But remember that original content tends to be even pricier than licensed stuff. Also, you can't really compare Apple and Amazon a la carte offerings to Netflix/Prime/Hulu. Those a la carte offerings are typically set up as a revenue sharing arrangement, so Apple/Amazon don't have to "buy" the content at all. They put it up for sale on the site, and the content owner gets a big cut of the rental revenue.

    @dinopontino1: It's really dangerous to rely on personal experience and anecdotes for investing, although everybody does it to some extent. It's a fact that around 32 million households currently subscribe to Netflix. That's something like 30% off the country. So if everyone (or even most people) you know use Netflix religiously, your circle of friends is far from the norm.

    Adam

  • Report this Comment On December 04, 2013, at 5:32 PM, TOM48 wrote:

    I bought 600 shares 10/1/2004 for $9.64. Still have 100 shares, but sold 500 to pay off my house & bought 2 new cars. Not bad for a $5784 investment and I still have 100 shares worth $35647 today. So short or long it doesn't matter to me. Netflix has been very very good to me. But you have to have huge ones to go short right now when you are going to have people giving or getting Netflix for the holidays.

  • Report this Comment On December 04, 2013, at 6:11 PM, cmalek wrote:

    @TMFGemHunter:

    "It's really dangerous to rely on personal experience and anecdotes for investing"

    Peter Lynch did not do too bad doing that. "Buy what you know"

  • Report this Comment On December 05, 2013, at 9:11 AM, leokno wrote:

    Speaking as a soon to be past customer, Netflix content in not up to the standards of other services and more importantly Netflix is the only service I have/had that constantly interupts programs with slow downloads.

    Wouldn't own it, won't suscribe

  • Report this Comment On December 06, 2013, at 2:23 PM, BentMike wrote:

    "I do not see any likely path to the level of profitability Netflix would need to justify its current valuation."

    This is a fair and wise statement - but in practice. valuation can limit your investing away from really good companies - where there are intangibles, and a very long story.

    Just how does on value the potential of international expansion? It is unwise to disregard it. But it is tricky to estimate the value of it.

    That expansion and proprietary content are the main reasons for the weird PE, if that simplistic metric is considered to be the valuation.

    We can all agree to disagree on what these mean.

    I also like the almost all the right moves bit that NFLX seems to be following.

    I hope you have a long stake as well as the short, both could play out.

  • Report this Comment On December 06, 2013, at 2:28 PM, BentMike wrote:

    cmalek,

    Lynch also did solid research into the companies that did well. That wasn't based on anecdotes and impressions at all. The "what you know" was just a jumping off point.

    The personal experience thing always cracks me up with NFLX - people who don't care for the content and think most everyone holds the same opinion of it. Probably the one who knows the most about that is NFLX, they have the numbers to crunch.

  • Report this Comment On December 06, 2013, at 10:21 PM, TMFGemHunter wrote:

    @BentMike: Just to clarify, by valuation, I did not mean P/E ratio. I meant that quite literally as the market value of Netflix: about $22 billion on a fully diluted basis. I agree that the P/E ratio is not a good metric for understanding whether to invest in a growth company.

    To justify that valuation, Netflix will need to eventually be earning billions of dollars in pretax profit annually. I don't see how that can happen, barring some very aggressive assumptions about long-term revenue growth and/or margin expansion.

    Adam

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