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.
We believe seven years of cheap money and its disruptive effects could be to blame for the amount of capital being thrown into the production of content.
The American financial writer James Grant describes ultra-low interest rates as an opiate that clouds the judgement of imprudent lenders and soothes the anxiety of encumbered borrowers.
The company would never have grown so much were it not for the unique monetary environment we are now in, and it needs its cost of capital to remain low in order to remain on this hamster wheel of debt issuance and content creation.
Waiting for a change in the narrative
Storytelling is usually the main reason for an extreme valuation, so it is reasonable to believe that any news that breaks a story in investors’ minds will bring a company’s valuation down to earth. It is always difficult to identify the precise catalyst in advance.
With many expensive, high-growth, ‘glamour’ stocks, it is a slowdown in growth (of subscribers, in Netflix’s case).
In its two most recent earnings announcements, Netflix has indeed first downgraded guidance on international membership numbers, and then disappointed on the number of subscribers added in the US, admitting that “we are growing, but not as fast as we would like to have been.”
On such announcements, the stock has generally declined and then recovered, proving extremely resilient to bad news.
What will be the potential catalyst for a share price correction? The sociologist Mark Granovetter and his threshold model of collective behaviour come to mind.
The theory goes that people with a zero-threshold are not afraid to look stupid and do not seek other people’s approval, and so will be the first to throw a stone and begin a riot, or to come up with innovative ideas.
People with a threshold of one will join the crowd if there is one person already throwing stones, and then people with a threshold of two will join, and so on, until the riot starts.
According to Granovetter, people do not throw individual judgement out of the window during a riot. Instead, he talks about a domino effect and external peer pressure, as the main drivers of this social behaviour.
When trying to understand why more investors haven’t decided to question their Netflix assumptions yet, one might borrow Granovetter’s concept and view the early short sellers as “threshold zero” market participants, with higher-threshold investors gradually joining in. Everyone has different thresholds.
In Netflix’s case, there seem to be a lot investors who are not yet prepared to question their assumptions. Once these high-threshold players finally turn, Netflix’s sky-high valuation may well prove to have been nothing more than a house of cards.