Netflix Is In Trouble

When I woke up and turned on the news on Wednesday morning, the main headlines on CNBC were Powell’s hearings on the Hill, Virginia being named CNBC’s best state for business in 2019, and Friends leaving Netflix in the near future. These days, anytime the Fed Chairman speaks, the market listens. But honestly, I think the market pays too much attention to the Fedspeak and should be focused more on the fundamentals of high quality companies as long-term investments than the short-term sentiment of the men and women running central banks. As a Virginian, born and raised, I was obviously happy to see the CNBC best states for business decision. Though, this news has little to do with my investing portfolio (though I suppose that Virginia maintaining such high status on this list could help my property value appreciate in some way). Oddly enough, I think the most impactful news of the morning when it comes to my DGI portfolio over the long-term was actually the last bit regarding Friends. This might seem a little silly, but hear me out.

For awhile now I’ve been bearish on Netflix (NFLX). It’s the only F.A.N.G. name that I’ve never owned. I’ve had no desire to buy shares because of the enormous premium associated with them and my long-held belief that this premium is irrational because the company doesn’t have a competitive moat. But, my belief hasn’t stopped the cord cutting phenomenon from crushing the valuations of several other old media DGI plays that I do own.

Obviously, the market has disagreed with me for some time now. NFLX has soared alongside the rest of its F.A.N.G. brethren. Had I bought NFLX at just about any point during my investing career, I’d be much wealthier today because of it. I’m happy to eat a bit of crow here and say congratulations to all of the long-time NFLX believers and investors. However, I will say that it’s starting to look like the market is changing its tune. Sometimes stocks stay overvalued for incredibly long periods of time. Could the chickens finally be coming home to roost?

Right now, there are a handful of very powerful companies attempting to carve out market share in the new digital media/entertainment landscape. It’s fairly clear that the old ways of doing business with ad supported cable are dying. Big tech has stepped into the media space and really disrupted things. For awhile, the valuation of traditional media names suffered in response to these high powered competitors entering the fray. Yet, all along, their cash flows have remained strong. Heck, for years, Netflix contributed to these strong cash flows as the big media names licensed their content to the alpha dog in the streaming space. But, now times are changing. Old media multiples are already rising and I wonder if sentiment is finally changing in their favor?

Recently, it was announced that NBC Universal would be pulling The Office from Netflix and exclusively offering it on its own streaming service. The Office is the number 1 watched show on Netflix, so this was a big blow for the streaming pioneer. Friends is the number 2 watched show on Netflix and now that content is leaving the platform as well. Prior to these two big announcements, Disney (DIS) has said that it is pulling its content from Netflix in favor of its own Disney+ streaming app. For years, these big media names were content to share their IP with Netflix, for a price. But now, they appear to be playing hard ball. These big name shows certainly won’t be the only content leaving Netflix. I don’t know about you, but the vast majority of the shows/movies I watch on Netflix are licensed from elsewhere. I can’t help but wonder if this content exodus will lead to outsized churn when it comes to NFLX’s huge subscriber base.

Netflix is investing heavily into original content to combat this trend. It appears that NFLX will be spending ~$15b on original content in 2019 alone. This spending dwarfs that of any competitor. NFLX adding 1000’s of hours to its library annually; however, franchises like The Office and Friends are extremely unique and I think it’s unlikely that Netflix will be able to generate top-notch content like this on a regular basis, no matter how much money it spends.

To me, it appears that the current Netflix strategy is akin to throwing spaghetti at the wall and seeing what sticks. Every now and then I come across Netflix original content that is very well done, but more often than not, the shows/movies they produce seem second rate. Obviously personal narrative is not the best method of due diligence. The broader data speaks for itself and it is worth noting that even though I’ve been rarely impressed, Netflix broke HBO’s 17-year streak of most Emmy nominations in 2018 with 112 total for the year (I don’t want readers to think that I’m being biased here).

HBO’s top heavy content still led the way with Game of Thrones and Westworld coming in first and second place in terms of nominations per show, yet NFLX’s broad scale approach allowed them to dethrone the king overall. Moving forward, it will be interesting to see how the award show nominations and viewership data plays out with more and more competitors investing heavily in the original content space. If Netflix can continue to win the overall medal count, then eventually I may have to eat some crow here as well. But, at the end of the day, it’s not awards, or even eyeballs that matter most, but instead, cash flows.

The bull argument that I hear most often when it comes to NFLX shares is that the company has a major first mover advantage and its huge subscriber base represent a moat that its peers cannot compete with. Because of the strength of its subscriber base, the market has forgiven Netflix for its lack of profits, giving it the benefit out of the doubt. However, even today, after all of NFLX’s success, I don’t think the company has secured a defensible moat. Switching costs are essentially non-existent in this market and while Netflix is a well known brand name, it’s the shows themselves that carry the real value, not the distribution platform itself. Sure, the company has a huge subscriber base, but this still hasn’t translated into large cash flows. On the contrary, NFLX’s cash flows are still negative to this day.

During the trailing twelve months, Netflix has generated free cash flow of -$2.8b. During its recent quarter, NFLX management guided for 2019 free cash flow to be -$3.5b. In short, while bullish analysts like to focus on subscriber growth and the success of hits like Bird Box, Murder Mystery, or Stranger Things, this success isn’t trickling down to the bottom-line. Margins are just too low and the company’s spending is too high.

On the other hand, NFLX’s major competitors all have highly profitable, diversified revenue streams that allow them to funnel capex into original content while still maintaining an attractive balance sheet and profit oriented fundamental metrics.

During the trailing twelve months, Comcast (CMCSA) has generated free cash flows of more than $14b. Disney’s free cash flow during this same period of time is roughly $9.5b. And, AT&T’s (T) free cash flow during the prior year is $25.7b. It’s not as if these huge companies aren’t investing in their businesses as well. They’re all building out streaming technology. Disney just made a mega-acquisition and built two major theme park additions. Comcast has also invested heavily in its global content production and IP while maintaining leadership in distribution via internet and cable assets. And it’s not just the traditional media names who’re highly profitable. Facebook (FB), Amazon (AMZN), and Alphabet (GOOGL) all generate massive free cash flows themselves, coming in at $15.8b, $20.7b, and $25.5b, respectively. These big tech names are also competing in the media space, meaning that it appears that Netflix is highly outgunned when it comes to the ability to sustainably invest heavily in their business over time.

For years now, I’ve heard estimates of large EPS figures coming down the pipe for NFLX. People have said that NFLX will be earning $10.00/share+ by 2020, making the current valuation seem sensible. However, as the content wars rage, capex for this company will only increase. This is going to put a damper on NFLX’s bottom line. Furthermore, I have a hard time believing that the recent trend that we’ve seen with higher subscription prices on NFLX services can hold steady. This has been a major part of the bullish thesis for Netflix: pricing power. There was a time when it appeared that NFLX could raise its prices all it wanted because consumers were locked in without other options. Well, now with Disney+ at $6.99 (and the likely option to combine this service with Hulu and/or ESPN+ for a bargain), AT&T’s HBO Max with the Time Warner content speculated to be priced in the $15-$18 range, and the NBC Universal OTT platform which is expected to cost ~$10/share for cord cutters, and other options likely coming from Alphabet’s (GOOGL) YouTube, Amazon (AMZN) Video, and Apple TV (AAPL), there are going to be no shortages of attractively priced platforms for consumers to choose from.

If Netflix can’t continue to raise prices because it is losing some of its best content to these competitors, the platforms themselves will prove to be commoditized. This brings us back full circle, to a place where content matters most, not platforms. Netflix currently trades for ~134x ttm earnings. I simply cannot justify that sort of premium for a commodity business.

This is why I’ve been happy to invest in the old media names. Sure, they may not be as glamorous as Netflix, but their balance sheets are certainly more attractive. Their valuations can be justified and they don’t require a high degree of speculation. Do I think NFLX is going to go the way of the dodo now that the old media names have gotten their act together and entered into the OTT competition? No. There is certainly room for several companies in most consumer’s streaming budgets. But, do I think that NFLX ownership is dangerous for investors? Yes, I do. At the end of the day, content is still king. Netflix has first mover advantage in the OTT distribution race, but in terms of content IP, names like Disney, NBC Universal, and Time Warner all had major head starts. And, I think it’s going to be easier/cheaper for them to build out distribution than it will be for Netflix to build out a valuable content library.

This article was previously published for members of The Dividend Growth Club.

Disclosure: I am/we are long AAPL, CMCSA, DIS, T, GOOGL. 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.