Netflix: House of Cards?

Ivan Kralj, analyst on James Clunie’s Jupiter Absolute Return Fund, explains why the team has been shorting the stock for more than one year.

Netflix may be creating an army of happy customers, but it does not seem to be creating wealth for its shareholders in the process. That’s why we’ve been shorting the stock for over a year.

In recent years, Netflix, the American video-streaming company, has captured the attention of many households around the world. With unlimited, commercial-free viewing for a low and flat subscription fee, the company has been able to grow its subscriber base at an impressive pace.

Having unashamedly binge-watched several of its series, such as the excellent political drama House of Cards, I can testify to the quality of Netflix’s original content. It’s easy to see why all of this would add up to a great customer experience and a growing industry – and a potential investment opportunity.

However, while Netflix might be creating an army of happy customers, it does not seem to be creating sustainable wealth for its shareholders in the process. Its rather offensive $41bn market cap might suggest otherwise.

The stock trades on 408x P/E and 133x EV/EBITDA.

For such eye-watering valuations, you would expect the company to be operating a highly profitable, wide-moat business with no contenders for the throne. That is not the case, so we are bearish and have been short since mid-2015.

Competition heats up
Reed Hastings, the charismatic founder and CEO, readily admits that the number of players trying to eat Netflix’s lunch is significant.

Amazon, Hulu, Sony, HBO, Apple, YouTube, Yahoo and many others are trying to enter the video-streaming and content-creating space. They are all borrowing a lot of money and writing billions in content checks.

Amazon in particular, with its Prime Video service, is ramping up its content offering and, thanks to an equally attractive price for customers, is growing membership numbers at a significantly faster rate than Netflix.

Danger also lies in the fact that Netflix outsources its distribution technology to Amazon Web Services. It is naive to assume that Amazon is not using this relationship to learn and gain a competitive advantage in its Prime Video business.

But Netflix has not been passive. In order to attract new subscribers, the company recently announced that it wants to increase the content that is created or licenced by the company itself, from the current 10% to 50% of the total content on the portal.

The idea is to own, rather than borrow, truly differentiated content. This is significantly altering the profile of the business, given the riskiness of producing your own content (according to some estimates, 80% of movies and series don’t make any money), as audience tastes are hard to predict.

So far, the success rate has been mixed, with one of the first movies produced, ‘The Ridiculous 6’, holding a very rare 0% rating on Rotten Tomatoes, the popular film review aggregator.

Burning through cash
The need to increase content spending at a time when content costs are growing, combined with an expensive international expansion which also requires tailor-made content, has inevitably affected the company’s finances.

Netflix has spent $4bn on content in the first six months of 2016 alone, and has committed to buying an additional $10bn in the coming years. The company is barely profitable, with wafer-thin margins, and continues to burn cash at an accelerating rate.

To compensate for the cash burn, Netflix has been raising funds via debt and equity issuance and plans to raise additional capital in the high-yield market later this year. Both high margins and high growth therefore seem a mirage for the company.

Hastings will soon have to decide whether to continue focusing on a massive market while eking out miniscule margins, or whether to become a premium platform with higher prices and margins, but a much smaller customer base and, therefore, lower growth.

The last quarter was emblematic of this choice. Netflix tried to raise prices for many longstanding members in order to fund more content creation, but the number of subscriber cancellations unexpectedly spiked. If Netflix’s shares were not so overpriced, it might not be facing such a serious dilemma.

The problem is that the market is discounting a rosy future of both high growth and high margins.

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