Market Musings - February 2, 2018
Smiling at me
Nothing but blue skies
Do I see"
--Irving Berlin, "Blue Skies" (1926)
We continue our blog series: Market Musings, Volume 2, Edition 7, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Netflix: Priced For (and Beyond?) Perfection".
Netflix stock (NFLX) has lately gone parabolic, increasing from the $187 level just 2 months ago to $265 as of close of trading on February 1st, or up a massive 42% in just the past 60 days. The rapid rise in the stock price naturally begs the question, "Too much too soon?" We believe the answer is a resounding "yes", based on the analysis set forth below.
MARKET REACTION TO Q4 2017 RESULTS
First, take the actual dollar amount of the increase in NFLX's valuation over the past two months, leading up to and immediately following the release of Q4 2017 results on January 22nd (see earnings PR here). With a $78 rise in the share price and 447 million diluted shares outstanding (per the company's 2017 10-K filing), simple math tells us that approximately $35,000,000,000 has been added to the diluted market capitalization in the past 60 days, or almost $600,000,000 per day during that period. Note below the parabolic move in the stock during this period:
Now $35 billion is a seriously big number, with lots of zeros (nine, in fact). Something must have fundamentally changed with the company to account for such a massive increase in capitalization, correct? Did NFLX just introduce a revolutionary new product? Nope, they have the same products they had two months (streaming Internet TV and DVDs by mail). Did NFLX announce expansion into a huge number of new territories? No, they still operate in the same ~190 countries that they operated in as of a year ago. Did NFLX add a gazillion new customers unexpectedly when they reported Q4 2017 results? Not really. In fact, according to Credit Suisse, domestic paying customer count at 52.8 million was just 700,000 higher than expected and international paying customer count at 57.8 million was also 700,000 higher than expected. So NFLX exited 2017 with 1.4 million customers, or about 1.27%, more paying customers than expected. Should a 1.27% "beat" in terms of paying subs really translate into an extra $35 billion added to the market cap (note that this equates to $25,000 in additional market cap per "unexpectedly added" customer)? No, this surely cannot account for the stock price explosion, as no customer has a net present value to NFLX of anything remotely close to $25,000. What about total sub adds during the quarter? According to a Seeking Alpha news summary, "Total streamings adds were 8.33M for the quarter vs. 6.34M consensus". Yet this number includes free subscriptions, which logically should be less valuable than the 1.4 million extra paying additions (versus expectations) referenced above. Again, can one really believe that two million unanticipated incremental customers in Q4 justifies $35 billion in market cap (or $17,500 per customer)?
Perhaps Q4 2017 financial results were massively more impressive than expected, however. Did NFLX record a huge EPS beat in Q4? Negative; at $0.41/share, NFLX actually just met consensus (source here). What about revenues? Again, no. While clearly impressive at up 33% yoy, NFLX's $3.29 billion in revenue only beat expectations by a mere $10 million (at three-tenths of 1%, a rounding error). Did free cash flow numbers overly impress? Once again, highly unlikely. In Q4, NFLX had negative free cash flow of $524 million, which was actually in line with the average negative free cash flow of the four immediate preceding quarters, so there was no marked improvement in this metric.
Apparently, the recent bullishness of NFLX longs boils down to rampant optimistic speculation regarding "the future". Management's guidance for Q1 2018 net additions of 6.35 million subscribers and revenues of $3.69 billion lit the fuse that resulted in a stock price explosion up to a recent high of $286.81/share. Longs have apparently decided to focus solely on subscriber counts and pay no heed to the fact that free cash flow for 2018 is now expected to sink to a negative $3 to $4 billion (far worse than 2017's negative $2 billion), based on increased content spending. Nor do they seem the least bit concerned with very real risks regarding their investment, such as increased streaming video competition from the likes of behemoths Amazon (AMZN) [see here], Apple (AAPL) [see here] and Disney (DIS) [see here] and the recent repeal of the net neutrality rules by the FTC [see here]. Right now NFLX longs see "nothing but blue skies".
CAN WE OTHERWISE JUSTIFY NFLX INVESTORS' BULLISHNESS?
For the sake of argument, however, let us assume that none of the known risks (or, rather, "known (but ignored)" risks) actually materialize over the short to medium term (say, the next five years through the end of 2022). Let us further assume there are no "known unknown" risks to fret about either during this period (even though these always lurk). In other words, let's just be blindly bullish for the moment. Can we justify NFLX's $118,455,000,000 market valuation, and if so, how? First, we start with the proposition that a company is properly valued today if it trades at a stable earnings yield of 3.85% (which is the inverse of the S&P 500's current 26X P/E ratio--see source here). This means that NFLX would be properly valued at its current market cap if it had produced $4.56 billion in earnings in 2017 ($118.455 billion divided by 26). Obviously, we know that this did not happen, as NFLX only registered $558 million in income last year. But what really matters is free cash flow, because at the end of the day only cold, hard cash can be returned to shareholders. Yet, free cash flow in 2017 was negative $2 billion, far worse than net income. So no help there either.
There is a ray of hope for longs, though. If one desires a 10% return on one's investment, the Rule of 72 tells us that such person's investment must double every 7.2 years; if one desires a 20% return, it must double every 3.6 years, etc. Given the inherent uncertainty in NFLX's business model and the massive stock gains NFLX longs have enjoyed recently, assume for the sake of argument that a NFLX long asks for a meager 15% return annually going forward on his or her investment. NFLX's current market valuation could then be justified if we could conclude that the company trades at a 13X multiple based on earnings and cashflow 4.8 years from now (72/15 = 4.8), or by the end of 2022. In other words, if we believe that at $265/share we are today buying NFLX at 13X its 2022 earnings/cashflow, we can expect a 15% CAGR between now and then, since the market cap should double by YE 2022. So if we could somehow determine that in 2022 earnings and cashflow will reach twice the $4.56 billion amount referenced above (or $9.12 billion), then NFLX's current stock price could make sense from an ROI perspective.
How likely is this? First consider GAAP net income. Analysts currently expect 2018 earnings of $2.69/share, or $1.283 billion based on 477 million diluted shares outstanding (source here). Thus, to get to $9.12 billion in 4.8 years, earnings would need to increase at a 50% clip over that period (assuming no net issuance of shares, which is highly unlikely). However, we must keep in mind that analysts are an extremely optimistic lot and 2018 earnings estimates will probably come down as the year progresses, in which case the required CAGR will be higher than 50% (perhaps substantially higher). Moreover, NFLX is now capitalizing huge amounts of content costs, most of which will be amortized over the next five years. Even if earnings somehow double in 2018, increased content amortization should put a serious drag on earnings growth thereafter (put another way, current GAAP earnings are being flattered by the fact that NFLX has been capitalizing more and more of their recent spending, but the effect of this should reverse as these costs begin to flow through the P&L statement). Maybe NFLX bulls feel comfortable penciling in well over 50% earnings growth for each of the next five years with no further questions asked, but this seems quite optimistic given the foreboding competitive landscape ahead (NFLX bulls should perhaps recall Jeff Bezos's famous dictum, "Your margin is my opportunity"), as well as the amortization dynamic we have just described.
Next let's look at cash flow. Per the Q4 earnings conference call (link here), we already know from management that free cash flow should be in the negative $3 to $4 billion range in 2018. Taking the midpoint of negative $3.5 billion, NFLX will need to either cut spending or increase revenues (or a combination thereof) by an aggregate amount equal to $12.62 billion by YE 2022 ($9.12 billion plus $3.5 billion) in order to justify a reasonable return for NFLX investors over the next five years from today's stock price. Is this achievable? Looking at costs, it seems pretty unlikely given anticipated continued inflation in content costs (demand for streaming content should exceed supply for the foreseeable future, considering all of the deep pockets moving heavily into the streaming game). As far as revenues are concerned, management has previously targeted a mid-single digit CAGR subscriber pricing increases, as per the following exchange from the Q2 2017 earnings call (source here):
Therefore, assuming we trust management's prediction, we can expect that 2017's $11.7 billion in revenues attributable to NFLX's current subscriber base to go up about 5% per year. This supplies $3.1 billion of additional revenue in 2022 ((1.05^4.8)-1 X $11.7 billion), which could go a long way towards closing the current year's $3 to $4 billion negative cashflow runrate. Then there are, of course, net new subscribers. Assuming NFLX can add an average of 15 million new paying customers per year going forward, this would generate a total of 75 million additional paying subs by YE 2022, most of which should be foreign-based. If we further assume that each of these new subs pays the equivalent of $12/month in 2022 (up 27% from the $9.43/month average for all subs and up 39% from the $8.66/month average for all foreign subs in 2017), then the incremental sub base should generate $10.8 billion in revenue for NFLX (75 million X $12 X 12). Even assuming that 50% of this new sub revenue falls straight to the bottom line, this $5.4 billion plus the additional $3.1 billion from pricing increases on existing subs still falls over $4 billion short of our $12.6 billion incremental cash bogey described above. If we bump the 15 million annual sub growth figure up to 20 million, we still fall $2.3 billion short of our $12.6 billion target. And the foregoing further ignores the fact that content costs should continue to rise if NFLX adds another 100 million paying subs.
Thus, the NFLX long, even if using our optimistic assumptions and blindly ignoring clear known and "known unknown" risks, cannot find remotely enough incremental cash flow between now and the end of 2022 to support a 15% CAGR for NFLX shares going forward, boding ill for further share price appreciation in the medium term. Moreover, all of the foregoing assumes that the S&P's historically high 26X multiple does not contract over the next five years due to higher interest rates (yet another risk factor for the long case).
Reed Hastings and his team at NFLX have done an admirable job growing the company's streaming business over the past 10 years and will likely enjoy continued momentum for the foreseeable future. However, most (if not all) of this success is now baked into the company's $118 billion fully-diluted market capitalization. Indeed, according to our calculations and despite using extremely optimistic assumptions (little competition ahead, moderate content cost increases, large continued sub growth, no contraction in general market multiples, no further shareholder dilution despite massively negative near-term cashflow, etc.) we still cannot find enough growth in earnings or cashflow over the next five years to justify underwriting even a 15% CAGR on NFLX shares through the end of 2022. Clearly the easy money has already been banked for NFLX shareholders.
DISCLOSURE: Short NFLX.