Netflix, Inc. Investors Should Hope They Don't Own the Next HBO

For several years, Netflix, (NFLX -3.92%) CEO Reed Hastings has pegged Time Warner (TWX) subsidiary HBO as his biggest competition. Both Netflix and HBO make their money on subscription fees in an ad-dominated TV marketplace. Furthermore, both focus on movies and high-quality TV shows (particularly serialized dramas).

Chief Content Officer Ted Sarandos has explained Netflix's strategy as follows: "The goal is to become HBO faster than HBO can become us." This explains Netflix's aggressive investment in original content.

Netflix wants to quickly match HBO's success.

However, Netflix investors should be careful what they wish for. While HBO is very profitable relative to Netflix, it's not very profitable compared to Netflix's valuation. Unless Netflix manages to become vastly more profitable than HBO over time, the stock is likely to underperform the market over the next decade.

Becoming HBO?
HBO is a worthy model for Netflix. Indeed, when Netflix first began making the comparison to HBO, many critics dismissed it as wishful thinking. After all, Netflix was reeling from the failed "Qwikster" spin-off of its DVD business in late 2011, and hadn't launched any original series at that point (although House of Cards was already in the works). By contrast, HBO recently won the most Primetime Emmy awards of any network for the 12th consecutive year!

Today, Netflix has the beginnings of several successful original series, which makes the goal of "becoming HBO" seem a lot more achievable. Netflix has also passed HBO in terms of its domestic subscriber base size, although it still lags significantly outside the U.S.

HBO earnings come out
Historically, HBO's earnings have been lumped into a "Networks" segment at Time Warner. This also included several major cable networks like TNT, TBS, CNN, and Cartoon Network. However, Time Warner recently changed its reporting in order to separate HBO (and sister network Cinemax) from Time Warner's basic cable networks.

HBO earned about $1.7 billion last year.

This separation revealed that HBO's adjusted operating income was an impressive $1.7 billion in 2013, on revenue of $4.9 billion. By contrast, Netflix's operating income was just $228 million last year -- including its DVD-by-mail business -- although revenue reached $4.37 billion.

Valuing HBO
The problem for Netflix investors is that even if the company can eventually grow its earnings to an HBO-like level, that still won't be enough to support its current stock price.

Time Warner's adjusted operating income reached $7 billion this year, excluding corporate expenses. HBO provided 24% of that total. It therefore seems reasonable to attribute 24% of Time Warner's value to HBO. (HBO's revenue and earnings growth rates were both within 1 percentage point of the company average, so there's no good reason to assign it a different multiple.)

Based on Time Warner's enterprise value of $76 billion, this would put the value of HBO a little over $18 billion. By contrast, Netflix's enterprise value has already reached $25 billion! In other words, investors don't just think Netflix will eventually become as valuable as HBO; they think it's already more valuable than HBO!

Is Netflix better than HBO?
This naturally leads to the question of whether Netflix is a better business than HBO. The main point in Netflix's favor is that its domestic subscriber base has already exceeded that of HBO, despite being much newer to the market. Netflix is also growing much faster than HBO.

However, while Netflix will probably overtake HBO in terms of global subscriber totals over time, it will likely do so at a much lower profit margin. The two key features that make Netflix more appealing are its low cost ($7.99 a month, versus $15-$20 a month for ordering HBO a la carte) and its large content library. With lower revenue per subscriber and higher content costs, Netflix needs a significantly larger subscriber base to match HBO's earnings potential.

In addition to having more content than HBO, Netflix's content costs are likely to be higher for a second reason: its lack of owned programming. HBO has a huge stable of proven hit TV shows (past and present) in addition to its pipeline of new original series. HBO can air or stream reruns of The Sopranos or The Wire whenever it wants to, for no additional cost: it already owns the content.

If Netflix wants to keep House of Cards long-term, it needs to keep paying!

By contrast, while Netflix has the exclusive rights to shows like House of Cards, it does not own the content. Its rights typically last for four years. If Netflix renews the show for another season, that extends its rights for prior seasons by a year. Still, Netflix must pay another $50 million or so for each new season just to keep the old seasons available. Several years after the last new season debuts, Netflix will lose the rights to House of Cards. It would have to negotiate a new licensing deal if it wants to keep the series beyond then.

Good company, bad stock to own
Netflix has set its sights on becoming the next HBO, and it's looking increasingly likely that it will eventually succeed. However, investors have bid Netflix shares up to a level that doesn't seem to line up with the company's long-term prospects. Netflix is valued at a 30%-40% premium to HBO today, even though its current earnings power is much lower.

Thus, from a valuation perspective, if Netflix "becomes HBO" in the next five years, investors will be in for a very disappointing stock performance! Netflix investors must think that the service will ultimately become much more profitable than HBO. However, while Netflix should be able to attract more subscribers, it will do so at a much lower profit margin. As a result, I expect Netflix shares to trend lower in the coming years, despite the company's rapid growth.