Netflix Isn't Cheap, But Here's Why Barron's Prediction of a 50% Drop Is Flawed
Right now, Netflix Inc. (NFLX) - Get Netflix Inc. Report is valued at about $735 for each of the 104 million streaming subscribers it had at the end of Q2. Given that the company is typically collecting around $10 per month from those subs and is still bleeding cash, it becomes understandable why -- in spite of the phenomenal growth the company has been posting -- some are queasy about the streaming giant's valuation following a 38% run-up so far in 2017.
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Still, in the absence of a market crash, arguing that Netflix could fall 50% or more, as Barron's did in a weekend piece that's weighing a little on Netflix's shares (the stock was down about 0.7% on Monday afternoon), feels questionable. Especially when two of the arguments made for being bearish -- a rising debt load and aggressive accounting for cancelled shows -- are pretty well-understood and arguably overblown.
Barron's Jack Hough asserts that Netflix's long-term debt balance -- currently at $4.8 billion -- is reason for concern, given that the company expects to burn through another $2 billion to $2.5 billion in cash this year due to heavy spending on content, and will likely bleed more cash over the next few years. However, Netflix's net debt balance, which backs out cash on hand, is only $2.7 billion. That's equal to just a fraction of the $11.7 billion in revenue Netflix is expected on average by analysts to see this year, and more importantly pales relative to a $73.4 billion market cap.
This healthy market cap means that Netflix could easily choose to raise needed funds via equity offerings without badly damaging its stock price. If the company decided to launch a $3 billion stock offering tomorrow, its shares might drop 2% or 3% due to the share dilution and increased supply the offering would bring -- this, of course, would be partly offset by the fact that $3 billion would be added to Netflix's balance sheet -- but no massive drop would happen.
Hough calls the attitude among Netflix lenders that the company is a low-risk borrower since its market cap is so high "a dangerous piece of circular logic," since Netflix is only worth that much because of its debt-financed growth. However, if the company had never raised a cent of debt and instead just relied on equity financing, its shares would have still blasted off. The gains would have just been a little smaller due to the dilution caused by the stock offerings.
Then why is Netflix choosing to take on billions in debt? Because it's confident it can afford to, given the company's growth rates and the moderate amounts of cash it's set to burn. With the qualifier that cash burn estimates are tough to make and could be off in one direction or another depending on how Netflix chooses to spend, analysts see Netflix going through another $5.3 billion in cash between now and 2021 before turning cash-flow positive.
After accounting for existing cash, such cash burn might serve to grow Netflix's debt load to around $9 billion -- a pretty reasonable number when one considers annual revenue is expected to top $22 billion in 2021. And as noted before, if Netflix starts getting squeamish about its debt load, equity raises can get the job done and do limited damage to the stock as long as investors remain confident in Netflix's long-term growth and cash-generating potential. Considering how Netflix's shares have performed over the last few years, opting to raise debt rather than dilute stockholders has certainly been a smart move thus far.
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Hough also suggests Netflix is inflating its quarterly earnings by not fully writing off the remaining costs for cancelled shows such as Bloodline, on the grounds that finished seasons of such shows are still available for streaming. He contrasts Netflix's accounting with that of Time Warner Inc. (TWX) , which has taken write-downs for cancelled HBO shows even as they remain available on HBO's streaming services.
While one can argue Netflix should take Time Warner's accounting approach, it's worth keeping in mind that doing so would have no impact on accounting for popular non-cancelled shows, which make up a big portion of Netflix's $6 billion-plus content budget. More importantly, it wouldn't change Netflix's cash-flow profile for better or worse.
As is often the case for telecom carriers, whose business models have a few things in common with Netflix's, Netflix's quarterly EPS numbers tend to have little impact on how its stock moves following an earnings report. Markets have been focused on subscriber growth, and to some degree, the company's cash flow and streaming content obligations. In July, the company slightly missed Q2 EPS estimates, but shares blasted off thanks to much better-than-expected subscriber adds and decent guidance.
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Also mentioned as a concern by Barron's: New competition from The Walt Disney Co. (DIS) - Get The Walt Disney Company Report , which plans to launch a kids-focused streaming service and pull much of its content off Netflix, and Facebook Inc. (FB) - Get Meta Platforms Inc. Report , which just unveiled a professional video platform called Watch.
But it's worth keeping in mind that Disney's moves won't happen for another two years or so, which gives Netflix ample time to use the money it won't be paying Disney to invest in kids-friendly original and licensed content. And although Disney and Pixar-branded content will definitely be leaving Netflix, Reed Hastings' company is still talking with Disney about holding onto Star Wars and Marvel content -- since such content appeals to both adults and kids, it might be in Disney's interests to non-exclusively license it to Netflix, while also offering it on its streaming service.
Also: A recent Piper Jaffray survey found that only about 20% of U.S. Netflix subs spent over 10% of their viewing time on Disney content, and that only 5% spent over 40% of their time on it. The firm thus sees only a "minimal impact" from Disney's move on Netflix's subscriber count.
As for Facebook, the social media giant has repeatedly stressed that it's pursuing a YouTube-like ad-supported business model for professional video, and has no interest over the long run in either paying for content or selling it on a subscription basis.
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Meanwhile, the Barron's column doesn't pay much attention to Netflix's core competitive advantages. Namely, how the company's unmatched scale and viewing data allow it to obtain superior returns on its content investments.
With the company possessing 100 million-plus subs and tons of data to both inform content investments and personalize what's recommended to a viewer, Netflix can often find it easier to produce a positive return on, say, an $80 million movie or a show with a $30 million annual budget than peers can (at least without having to partly rely on alternative forms of distribution -- for example, exclusively showing a movie in theaters for a few months -- that lower the value of its streaming service).
Not even Amazon.com Inc.'s (AMZN) - Get Amazon.com Inc. Report Prime Video can fully match Netflix here: Jeff Bezos' company's 2016 "retail subscription services" revenue (primarily Prime membership fees, plus some separate content subscriptions) was 28% lower than Netflix's 2016 revenue, and is of course used to support a lot more than just Prime Video. Moreover, there's a decent amount of data suggesting that average weekly Prime Video viewing per subscriber is markedly lower than per-subscriber Netflix viewing.
None of this is to say that Netflix doesn't face some real challenges. Both directly and indirectly, Amazon is undercutting Netflix's pricing, and that could help its cause in more cost-sensitive foreign markets. And complaints have been growing about Netflix's shrinking library of licensed content, particularly for older movies. If unaddressed, that might give Amazon and HBO a way to differentiate themselves.
But for now, such challenges are doing little to dent subscriber growth thanks to the popularity of originals and Netflix's data-driven approach to investing in and recommending them. And this growth, along with the long-term pricing power Netflix is building up as its original show and movie launches keep swelling, has left markets comfortable with the reasonable amounts of debt raised to help make all of this possible.
One can certainly question Netflix's valuation at current levels. But questioning the health of its business is much harder to do at this point.
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