Analyst: Anthony Petretti Sector: Consumer Discretionary Valuation: Netflix Inc. Ticker: (NasdaqGS:NFLX) Date: 12/18/2017 Current Price: $190.42 Recommendation: Short Company Description Investment Thesis Netflix Inc. has been one of the hottest stocks over the past several years and it continues to exceed expectations. Despite this, I have given them a Short recommendation. Based on my research, I believe that the stock deserves the short status due to its competitive moat (or lack thereof) and its unsustainable content spending. In addition, I have used a relative valuation model to detail the expensiveness of the stock at this time and to show just how much they have to lose if their multiples revert to the mean. Lack of Sustained Competitive Moat: One of my biggest areas of concern for Netflix is that it lacks a competitive moat in the market. They are a pure-play media company that has no ambitions of entering into any other product lines to diversify their business according to their last earnings call. Although pure-play companies of all sorts have outperformed their conglomerate counterparts significantly over the past several years, this leaves little margin for error if a competitor comes in or consumer trends change unexpectedly. The only real source of competitive moat that Netflix has is its content (Netflix Originals), which is unique to Netflix. Even then I struggle trying to justify content as a moat since everyone has the ability to make their own content. The only way content Netflix Inc. is a video streaming company that has taken the world by storm over the past several years. It is located in the diversified media industry and operates under three segments. These segments are international streaming, domestic streaming, and domestic DVD. The real bread and butter of the business its streaming side of the business which derive According to Factset, in 2016 about 63.6% of revenues are generated domestically with a bigger and bigger piece of the pie becoming international each year as demonstrated by the three year revenue trend for the United States (Exhibit A). The company makes its own content and also shows other third party content for viewers to consume via any internet connected device such as Apple TV, Roku, Tablet, Smart TV, etc. 1
would be moat worthy is if it was a show on the same level of Game of Thrones. Even then, coming up with a Jack-Pot show like Game of Thrones takes some luck at the end of the day. Another potential moat source that people have identified for Netflix has been its data. The argument is that since Netflix has collected data on its consumers viewing habits domestically and internationally then it is in the best position to identify trends and predict consumers wants from a content perspective. The basis of the argument is understandable and they are some truth to it but at the same time this is an insult to the other media giants. Amazon business is pretty much to sell everything to everyone and they are by far in the best position to leverage competitive advantage that involves data. This is because they have similar data to Netflix in regards to viewing habits (HBO), but they also have shopping habits, reading habits (Audible), etc. This gives them a more holistic and complete view on the consumer than anyone else. At the end of the day each company has its own troves of data to pull from and analyze in order to capitalize on potential and current consumer trends. Content Spend: Content can be very rewarding but it is a very expensive thing to produce. This year Netflix is estimated to spend $7.5 billion on content and its originals and it projects to ramp up this spending further to $10 billion heading into 2018 (Exhibit B). All this spending has put a damping on cash flow of the past several years. Given the international and local markets that they compete in, this spending is only going to go up in order to meet local preferences and maintain the premium status. Their moat seems to be closing at the same rate or faster than the rate at which they are digging it. My thought process is that since there is no value add with other products/services attached to the Netflix subscription, it then must have the best content compared to its peers or else people will eventually give up on it and switch more value add services. For example, having the prime membership allows for a cheaper subscription to HBO and free shipping just naming a few examples. Since this is a cyclical stock, if there is a recession then this is one of the first products to be cut out of the family budget since it does not provide any other benefit besides the shows themselves. 2
Relative Valuation Competitors: The competitors I used for the relative valuation and for comparison in my research are as follows: Amazon.com Inc. (AMZN), The Walt Disney Company (DIS), Viacom Inc. (VIAB), and Time Warner Inc. (TWX). Although many of these companies are diverse and have multiple segments of business unrelated to media, I believe that these are closest competitors and most accurately portray the risk of Netflix s business. Amazon Inc. is a close competitor given its ownership in HBO. Viacom Inc. is a global content and entertainment company that operates Paramount and Nickelodeon. Time Warner Inc. and Walt Disney Company are both media giants that own a stake in Hulu. Hulu is another streaming service very similar to Netflix in a lot regards, but is split ownership between Comcast, Disney, Fox, and Time Warner. HBO and Hulu are the closest comparisons and competitors to what Netflix has to offer given the content and way the product is consumed so more weight has been given to Disney, Amazon, and Time Warner. Forward EV/EBITDA: Netflix is currently trading at an EV/EBITDA multiple of 49.99x as of 12/18/2017. I used an NTM EV/EBITDA of 25.00x, which is in line with its competitors. The NTM EBITDA I used for my relative valuation was $1711.28. This gave me an intrinsic share price of $91.60, implying that Netflix is trading at a 51.89% premium in the market. I believe that this multiple will follow the same trajectory as it has year to date and continue to fall back into line with its peers as growth eventually slows (Exhibit C). Forward EV/ NTM Total Revenue: Since it is completely ineffective to compare a P/E multiple of FAANG stock to any other stock, I have opted to use a revenue multiple instead. The current multiple of 6.19x means that Netflix s Enterprise Value is 6.19x its sales which is twice the amount the next highest competitor. I do not believe that this multiple is justified given the risk behind these revenues since they have one income source. Only investing in one source of growth for the long run is not provide justification for the highest revenue multiple. This is why I put Netflix s revenue multiple more in line with the next closest competitors Amazon and Disney (Exhibit D). A 3
revenue multiple of 3x about half the stock price but it is a more fair representation of the firm value on a relative basis. Risks to Thesis: Momentum stock: Not only Netflix, but the rest of FAANG has had considerable momentum to them over the past couple years. Everyone who stood to bet against them got wiped out. It is always difficult making investment decisions on products you interact on a continual basis because there is going to be some inherent bias no matter what. Content Spending: Another risk to my thesis is that Netflix s content spending is actually widening their moat. Although they are pouring considerable amounts of money into production, they still have executed year after year in all of their markets. In addition, being a pure-play allows them to focus all their capital and resources on what makes them number one. Net Neutrality: Earlier this month the FCC voted to repeal net neutrality, which granted unrestricted data flow for all companies. This repeal is a wildcard since it to early to tell what affect with will have on the internet. This can be a positive or negative depending on how you look at it. This could make Netflix much more expensive since they will have to pay more for the higher data usage. It could also be positive if this provides higher barriers to entry for smaller competitors, thus giving Netflix a moat. Reasons to Short: Lack of Sustained Moat Content Spending Trading at Huge Premium Relative to Competitors Conclusion In conclusion, I am recommending a short on Netflix s stock given the lack of clear longterm moat, unsustainable content spending creating a constant cash flow burn, and extreme relative valuations. I am aware that this a period of time in the stock market where valuations are at all-time highs and business is booming, but given the long-term fundamentals of the company a short position makes the most sense while the company is at a peak. 4
Appendix Exhibit A: Netflix Inc. Revenue Exposure by Country (Source: Factset). 5
Exhibit B: 2017 and 2018 estimated and projected content and originals spending Exhibit C: Netflix TEV/FWD EBITDA Daily Multiple YTD. 6
NTM EV/EBITDA Current Multiple 49.99 Target Multiple 25.00 NTM EBITDA $1,711.28 Enterprise Value $42,782.00 Less Debt $4,889.00 Less Minority Interest $- Plus Cash and Equivalents $1,746.00 Equity Value $39,639.00 Shares Outstanding 433 Implied Price Per Share $91.60 Current Price Per Share $190.42 Premium (Discount) -51.89% Overvalued Exhibit D: Netflix TEV/ FWD NTM Total Revenue Daily Multiple YTD. NTM EV/Total Revenues Current Multiple 6.19 Target Multiple 3.00 NTM Total Revenue $13,819.54 Enterprise Value $41,458.63 Less Debt $4,889.00 Less Minority Interest $- Plus Cash and Equivalents $1,746.00 Equity Value $38,315.63 Shares Outstanding 433 Implied Price Per Share $88.54 Current Price Per Share $190.42 Premium (Discount) -53.50% Overvalued 7
8 Netflix Inc. (NasdaqGS:NFLX)