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2019-10-22 07:08:18

I’ve made my bearish stance when it comes to Netflix (NFLX) clear throughout the years. It’s the only FANG name that I’ve never owned. Looking at NFLX’s tremendous gains over the last decade or so, it’s obvious that the market has been right, and I’ve been wrong on this one. However, I maintain my viewpoint that the stock has little to no defensible moat to speak of, and therefore, I cannot justify the sky-high valuation.

I simply can’t understand why investors have been willing to pay such high premiums for a name that doesn’t generate free cash flow and, in my opinion, can be easily disrupted. For years now, I’ve thought that it was only a matter of time before NFLX’s disruption of the traditional linear television model caused the major media names to venture into the digital space, giving the company a bit of its own medicine. When this happened, I imagined that the company’s pricing power would diminish and sub growth would slow due to rising competition (for years, NFLX was essentially the only show in town). Now, we’re starting to see this process play itself out.

In recent quarters, we’ve seen NFLX miss on subscriber adds, and the recent Q3 report/Q4 guidance point towards this trend continuing. For years, this is the metric that the market has based the share price off of (because without any earnings to speak of and negative free cash flows, bullish investors have had little else to hang their hopes on). NFLX trades with a near-triple digit earnings multiple, and I suspect we’ll see significant multiple contraction in the near future as subscriber growth prospects wane. This doesn’t bode well for the shares, which is how we arrived at the title of this piece: “Netflix Is Still In Trouble”.

The title says “still” because this piece is a follow-up to a bearish article that I published prior to the company’s last quarter, titled “Netflix Is In Trouble”. This piece was originally published for subscribers on July 11th. NFLX was trading for $381 at the time. In that piece, I highlighted my valuation concerns brought up in the introduction here, as well as the news that several hit shows were leaving the service, which to me stood out as the beginning of a much larger trend regarding a content exodus as major content producers/media brands began to attempt to claw back some of the digital market share that they’d conceded to Netflix over the years.

As it turns out, the timing of that piece was pretty auspicious, because shares have fallen more than $100 since. My original “Netflix Is In Trouble” piece was one of my most read/engaged with pieces that I’ve published here on Seeking Alpha. It’s obvious that Netflix has a large following, and in recent weeks/months, it appears as though this has become a sort of battleground stock. For years, the bulls who believed that the company’s growth potential trumped any traditional valuation metrics won out, though could the Q2 results (combined with the onslaught of new competitors entering the streaming market) have been the straw that broke that camel’s back?

I’ve never been able to drink the Kool-Aid and ignore NFLX’s underlying fundamentals in favor of subscriber numbers. I know that bulls have said that the company's business model is all about reaching a critical mass, after which it will be vastly profitable. In a competitive vacuum, this might have been true. But that theory ignored the fact that others can (and eventually would) enter the streaming space.

To me, a distribution platform is easy to replicate. I’ve never seen much value in the Netflix brand itself. This is why I’ve also never been interested in jumping onto the Roku (ROKU) train, as that stock has popped in recent years. To me, content has been, and always will be, king in the media space. We’re seeing an all-out war right now between major players with deep pockets who are creating their own original content to grab subscriber eyeballs. We’re also seeing the price for highly sought-after content increase, as producers re-value their wares when offering them to the major distribution channels. Most recently in this regard, there were reports that bids for South Park’s streaming rights may reach the $500 million market. These two trends have caused Netflix’s content spend to spike, and there doesn’t appear to be any end in sight.

Given that NFLX doesn’t have other revenue streams that generate strong cash flows to fund this content spend, this company is forced to raise debt to fund its growth effort in the streaming wars. This is a dangerous practice, in my opinion. The company’s long-term debt pile has ballooned in recent years, from only $900 million 5 years ago to nearly $12.5 billion today. Its recent quarterly report shows that long-term debt rose by more than $2 billion since December 31st, 2018. Granted, rates are low. Usually, I don’t blame management teams for raising debt in low rate environments like this to make investments, because it’s not terribly difficult to generate returns on that debt higher than the interest rates due. However, I also typically follow companies with strong free cash flows, which gives me confidence that the repaying the debt won’t become a major issue in the future.

NFLX, on the other hand, doesn’t generate positive free cash flow. The company generated negative $551 million of FCF in Q3, and management said that it expects full-year FCF to be in the negative $3.5 billion range. I know that NFLX bulls will figure out a way to justify this rising debt and negative free cash flows, focusing on some other metrics that are more attractive. Sure, operating margins are rising, and they’re expected to be even higher next year. And yes, NFLX just posted record operating profits, but at the end of the day, we’re still talking about a company likely to generate roughly $3.50 of earnings per share in 2019 (and that’s generously accounting for another beat in Q4), which translates to an ~80x multiple at today’s $275.00 price tag. Furthermore, as revenue growth slows and content growth speeds up, I have major concerns regarding the strength on the company’s balance sheet. Maybe I’m just old-fashioned, but at the end of the day, rising debt and negative cash flows raise major red flags for me, and I can’t help but wonder if the current operational situation at NFLX isn’t sustainable.

I’m not here to say that NFLX is going bankrupt or the way of the dodo anytime soon. If I had to guess, I’d say that this company will ultimately be one of the winners of the streaming war. The head start it has in this space is real. Disney’s (DIS) content portfolio will allow it to immediately compete, in my opinion, but other services, like Apple TV+ (AAPL) are essentially starting from scratch. Apple has a massive cash pile and strong cash flows to dip into to fund its content spend that NFLX doesn’t, though with only something like 10 shows on its service at launch, I think it’s going to be a while before we can honestly view AAPL as a major competitor to NFLX. I’m fairly certain that NFLX will be around in a decade; yet, what I think AAPL and DIS did with their low-cost services was put the final nail in the coffin on NFLX’s pricing power argument.

Without the ability to raise prices, I suspect it will be quite some time before we see the massive FCF and/or earnings per share gains that many investors and analysts were calling for in the recent past. It wasn’t long ago that I saw many NFLX bulls calling for ~$10.00 EPS in 2020. This is how they previously justified the high share price/multiples. Well, it’s fairly clear now that this isn’t going to happen. It’s my belief that various price increases were built into prior valuation models, and now that those appear to be unlikely, we’ve seen the stock sell off. To me, it appears that the U.S. market for this company is maturing at a rapid rate, and while there is still room for international sub growth, we circle back to the idea behind a previous article that I’ve written on NFLX where I came to the conclusion that not all subscribers are created equally for this name.

The Q3 data continues to show that international subs produce significantly lower margins. The margins that the international subs generate has been increasing nicely in recent years, though I suspect that the company is going to run into the same issues with regard to limited pricing power and increased content and advertisement spend in these markets that it is facing in the domestic space. The company’s guide for Q4 international contributing margins was one of the more daunting bits of data released in the Q3 report, in my opinion. Q4 guidance highlights a break in the recent trend of rising margins in the international area as the company is forced to focus on lower-priced subs in various growth markets. NFLX’s international sub growth continues to be strong, but it is slowing down as well, making it increasing difficult to justify the current multiples on the stock.

I’m certainly not the first one to make this argument, but I’m happy to parrot this sentiment because I fear for investors who ignore it: valuation matters.

Because of NFLX’s large growth potential, I agree with the market that it should receive a premium above its media peers. No other media name is likely to post such strong double-digit EPS growth in the coming years. That’s great if you’re a NFLX bull, right? Well, sure... except for the fact that I’m of the belief that this company should be valued as a media play (albeit, a fast-growing one) and not a revolutionary tech company.

To me, those revolutionary disruption days are behind NFLX. At this point in time, the company isn’t attempting to disrupt the delivery of content anymore, but instead, is trying to compete in the content creation business in an attempt to maintain market share. The digital media pie is still growing, but at this point in time, there are many mouths to feed. To a certain extent, I think the rising tide here will lift all boats. But investors will only benefit from this if the stocks they own are being priced reasonably. Otherwise, the rising tides will not account for multiple contraction.

When you look at the other top dogs in the media space, you simply won’t see multiples anything like those being applied to NFLX. Simply put, this multiple needs to contract much further before I’d say that the stock is trading near fair value.

When growth stocks slow down and have to be-rate rated, the ensuing multiple contraction that they experience can be very scary and painful for investors involved. As I said earlier, NFLX trades for roughly 80x 2019 full-year estimates. Analysts currently expect the company to post very solid EPS growth in 2020 and 2021, though personally, I have my doubts as to whether or not the company can hit 50%+ bottom line growth in the face of rising competition. Regardless, I’ll stick with the current 2020 consensus number of $5.47 for this exercise.

Disney, which is probably NFLX’s most fierce competitor at this point in time, has a forward P/E ratio of 23.4x.Comcast (CMCSA), another strong player in the media space, has a forward P/E ratio of 13.5x.Discovery Communications (DISCA) trades for just 7x its 2020 consensus EPS estimate.Fox Corporation (FOX) trades for 13.9x its 2020 consensus estimate.Viacom (VIA) is probably the cheapest media play, trading for just 6x its 2020 EPS estimate.AT&T (T), which isn’t exactly a pure-play media name but does have strong media/streaming assets, trades for just 10.5x forward estimates.Alphabet (GOOGL), which also isn’t a pure-play media name but does own YouTube, which is a major player in the digital content space, trades for 22.8x forward estimates.Sticking to the FANG space, we’ll move on to Amazon (AMZN), which isn’t really a media name but has made an effort to increase its streaming IP and content rights in recent years to augment the services that it offers to Prime customers, trades for 53.3x its 2020 EPS estimates.And Apple (AAPL), which I don’t view as a media name, but since Apple TV+ is all the rage these days I’ll include it anyway, is trading for 18.2x its 2020 consensus EPS estimate.

I don’t think it’s fair to compare NFLX to the other technology names, because all of those companies offer investors more diverse revenue streams. Amazon has retail and cloud which generate strong cash flows, Alphabet is one of the most profitable companies in the world due to its Google assets, and needless to say, AAPL is more profitable now with its hardware sales and service offerings than NFLX (or really any company, for that matter) could ever hope to be.

As you can see, none of these companies boast a P/E ratio as high as NFLX’s. And in the primary entertainment/media space, which I believe NFLX operates in, we see that Disney’s multiple is the highest at ~23x. NFLX’s growth rate is much faster than Disney’s, so I believe it should be awarded a higher multiple (even though Disney is much, much more profitable).

To me, I think a ~30x multiple makes sense for NFLX. This is weighing the higher growth prospects against the lack of free cash flow and the rising debt on the balance sheet. That still represents a significant premium compared to its peers. Heck, it puts the stock’s valuation in line with some of the best growth companies in the market today. In other words, I’m not here to bash the company and its operations. I agree with the bulls that Netflix is a wonderful company. But I don’t believe that the stock is being rationally valued, and this created a lot of downside risk for those who’re long at these elevated valuations.

If NFLX were to trade for 30x 2020 EPS, we’d be talking about a $165 price target. NFLX is already down some 28% from its 52-week high and for the stock to reach my fair value target, shares would have to fall another 40% from here. I imagine that to many, this outcome doesn’t seem likely. Stocks don’t make negative moves like that very often, but then again, stocks facing such strong growth headwinds also don’t typically trade with such high valuations. The maturation process of high-growth stocks can be a difficult one to bear for investors, and I think this is the situation that we’re going to see play out when it comes to NFLX in the coming years.

Personally, I’m not going to hold my breath while I wait for such steep declines to happen. And I certainly wouldn’t short this stock because of its darling status as a growth name in today’s market. NFLX has traded with irrationally high valuations for quite some time now, and I know well and good that the market can stay irrational for very long periods of time. Yet, as NFLX’s growth continues to slow, I think the market will have no other option but to reduce the premium that it is willing to put on these shares.

NFLX bounced nearly 10% on the recent Q3 data because of a bottom line beat and an upbeat call by management, but I think the reality of the maturation process is already starting to settle in. In terms of rampant growth, I think this company’s best growth days are behind it. It appears that the market is also coming around to this realization. The stock has already given up its post-earnings gains and appears to be back on the downtrend that it was on prior to the Q3 report.

Q3 was essentially the company’s last reporting period without major competition in the market. Disney+ will release in Q4, and then I think the Q1 2020 numbers will paint an interesting picture of subscriber trends (especially in the domestic market). NFLX can’t afford to slow down or miss expectations when it comes to subscriber numbers because of its speculative premium. Yet, I think this is the likely outcome, and with that in mind, I’m content to avoid the stock until it is much cheaper.

I wish all NFLX longs the very best of luck (regardless of my bearish stance, I don’t wish financial woes upon anyone). I also caution those thinking about buying this dip to pay close attention to the underlying valuation because the vast majority of the stocks in the market trade on these figures, and although NFLX hasn’t done so in the past, I think that’s likely to change as the company matures.

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Disclosure: I am/we are long T, DIS, AMZN, CMCSA, GOOGL, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. @
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