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

For several years, Netflix, (NASDAQ: NFLX  ) CEO Reed Hastings has pegged Time Warner (NYSE: 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.

Who will really own the future of television?
You know cable isn't the future of TV. But do you know how to profit from this coming shift? Luckily for you, the Motley Fool's top analysts have identified three companies are poised to benefit when cable falters. Click here for their names. (Hint: They're not Netflix, Google, and Apple!)


Read/Post Comments (5) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 15, 2014, at 8:21 PM, Fo45 wrote:

    I do not call those buying Netflix investors but momentum surfers. with Netflix dreaming to become the next HBO it is valued almost twice as much as HBO.There is no logic. let's compare the two:

    HBO Netflix

    Original content +++ +

    Own content +++ N/A

    Delivery of content +++ +

    membership +++ +++

    revenue +++ +++

    profit +++ +

    So, I really do not get Netflix' s valuation compared to HBO. HBO has everything that Netflix wants original content , offered by cable companies, no fear off net neutrality ruling, no fear of content cost and large international market penetration.

  • Report this Comment On February 16, 2014, at 1:41 AM, AceInMySleeve wrote:

    Adam half of HBOS fee gets taken by cable.

  • Report this Comment On February 16, 2014, at 9:11 AM, TMFGemHunter wrote:

    @Ace: that's not really true. If you order just HBO a-la-carte from the cable company, then it might be something like 50% going to the cable company. On the other hand, when the cable company offers you 6 months of free HBO as an enticement to sign up, HBO is still getting paid (although it might cover part of the cost of the promotion). On top of that, the cable companies often have discounted HBO as part of a larger bundle. In those cases, they are taking way less than half of the revenue. (But they get extra revenue from your higher-tier package, obviously!)

    However you slice it, the fact remains that Netflix has a bigger domestic subscriber base than HBO now, yet it earns a fraction of the profit. The business model is simply not nearly as profitable, so Netflix needs a lot more volume just to match HBO's earnings.

    Adam

  • Report this Comment On February 18, 2014, at 2:52 AM, AceInMySleeve wrote:

    Adam I don't think you are looking hard enough at explaining the profit diff. HBO has no fundamental advantage. They spend in anticipation of years of growth and protecting their share until the market matures.

  • Report this Comment On February 18, 2014, at 9:12 AM, TMFGemHunter wrote:

    I'm not sure what you mean by "fundamental advantage". If you mean that Netflix could potentially replicate HBO's business model over the next 10 years or so by starting to produce content and gradually building a large library of popular wholly-owned/paid-for content, then I agree. There's no fundamental advantage in that sense.

    But to say that HBO has no fundamental advantage over Netflix is to say that in 10 years, Netflix could be earning as much as HBO. If HBO is worth $18 billion today, that would probably put Netflix's value around $12 billion or $13 billion, or about half the recent trading price.

    Netflix bulls are going well beyond saying that HBO has no competitive advantage. In fact, to be bullish on Netflix, you have to believe that in a decade it will be making at least 2 or 3 times as much money as HBO. That's where I have to part ways with the bull camp.

    Adam

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2841180, ~/Articles/ArticleHandler.aspx, 10/31/2014 2:20:18 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement