The valuation is too high when you consider the risks to the investment case
Thursday 19 Sep 2019 Author: Steven Frazer

US streaming TV giant Netflix is one of those stock market ‘marmite’ stories; investors tend to either love or hate it.

Even at a glance the bear argument is easy to grasp. Subscriber growth is slowing, competition is intensifying and large amounts of cash are needed to keep content fresh, while it already has enormous debts to service, forecast to top $10bn by the end of 2019.

For many, to say this situation leaves the firm’s $295.27 share price and $126.5bn market value looking stretched would be an understatement of epic proportion.

This implies a 2020 EV/EBITDA (enterprise value-to-earnings before interest, tax, depreciation and amortisation) multiple of nearly 30-times (mid-teens is typically considered racy) and a price-to-earnings (PE) multiple of over 50.

The Netflix fans’ view can be summarised like this. Competition isn’t that fierce, cash burn is set to dramatically reverse over the next year or two, most of its $8.4bn net debt is long-dated while the company has only scratched the surface of its global growth opportunity so far.

ARE THE RAPID GROWTH DAYS OVER?

From its origins as a DVD rental by mail service, Netflix has morphed into a pioneer in subscription video-on-demand and the largest online TV and film provider in the US, where it has more than 60m subscribers. Today it has more overseas customers than in its US backyard, about 10m in the UK and 151.56m worldwide.

According to Sandvine’s 2018 Global Internet Phenomena Report, Netflix accounted for 26% of all global video streaming traffic, beating YouTube at 21% and Amazon at 6%. The average Netflix user worldwide now watches more than 90 minutes of video per day.

Subscriber growth disappointed in Netflix’s second quarter to 30 June 2019 with only 2.7m new customers added. This was one of the few times the subscriber count has missed the company’s own target, with 4.7m anticipated in the period (5m was forecast by analysts).

Netflix argued this was a blip, fuelled by subscription price increases and some top shows being pulled from the roster by rights owners (such as re-runs of Friends and The Office) ahead of the launch of new rival streaming services.

The company believes it will add 7m new subscribers in the third quarter. The big question is whether it has reached saturation point. Netflix’s 60m US subscribers figure is set against an estimated target market of 128m homes, so a 47% penetration rate. Cable TV subscriptions peaked at 87% of all US households with access to cable as recently as 2012 – thus implying Netflix still has a lot of room to grow.

Worldwide the opportunity is much larger with estimated 1.4bn potential homes to target leaving its global penetration rate below 11%.

NEW STREAMING COMPETITION

Netflix has used its scale to construct a large data set that tracks every customer interaction, then leverages this data to better purchase content as well as finance and produce original material, such as hit series like Stranger Things, Orange Is the New Black and House of Cards. Netflix has also been building out its foreign language library.

Original content has become increasingly important to Netflix and it will remain so with competition intensifying. Amazon Prime Video has been around for a while and the November launch by Disney of its new Disney+ streaming service (including all those Disney animated favourites plus Star Wars and Marvel franchises) will be the latest Netflix rival. AT&T’s Time Warner is also lining up its own streaming service.

Netflix losing some valuable content from its former partners and emerging streaming rivals may well have an impact on subscriber growth in the short term. However, it is quite feasible that people end up subscribing to more than one streaming service in the long run.

Monthly pricing is relatively incidental – for example, Netflix’s £8.99 is effectively the same price as a cheap cinema ticket or a pie and a pint. Many may feel that spending an extra £7 to £9 a month is worth it for the extra choice, if they watch a fair bit of TV.

FINANCIAL PRESSURES

The balance sheet and cash flow remain the elephants in the room. Netflix pays for and develops content as a fixed cost, so the more subscribers it has, the lower the costs relative to revenue and the higher its profit and cash flow, which explains why Netflix’s profit continues to surge.

The company is forecast to report $1.47bn of net income this year to 31 December, up 21% on 2018 and that’s including the weak second quarter. Analysts estimate net income of more than $2.6bn in 2020; the same year free cash outflow is set to reverse after years of cash burn.

Analyst predict $3.3bn outflow this year (below the company’s own $3.5bn guidance), falling to $2.4m in 2020 and below $1bn by 2021. That’s as far out as forecasts go right now but presumably free cash flow should turn positive thereafter.


SHARES SAYS: The ongoing investment in content required to continue powering user growth and fight emerging competition could cap long-term profitability, and the risk is too great to invest at these levels. Avoid.

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