Our tour of the FANG stocks continues this week with Netflix (NASDAQ: NFLX).
As a business story, Netflix ranks among my all-time favorites. As a stock, it continues to make me standoffish despite its ongoing meteoric rise in share price.
The Netflix story is one of persistence and unrelenting vision. In its early days, Netflix was resuscitated several times by its investors. If I recall correctly, it lost money for at least five years straight, but time and again CEO-cofounder Reed Hastings convinced investors to hang tight and keep cutting checks. (I cannot for the life of me locate the source for this story, so you will have to trust my memory.)
More Studio Than Streaming Service
Investors a lot smarter than I am probably look at Netflix and see a twenty-first-century equivalent of what Metro-Goldwyn-Mayer was in the 1920s and ’30s: destined to be a leading studio that produces a slew of original content, much of it sure to be syndicated, rediscovered, remade, and resold ad infinitum.
If you have not heard, Netflix in 2017 is much more of a studio than a streaming service, and that DVD- by-mail thing became yesterday’s news quite a few yesterdays ago. Don’t listen to me, though; instead pay attention to Netflix’s planned content spend in 2018: eight billion dollars. That’s more than Disney will spend on original content (7B), more than HBO (2.5B), and definitely more than rival streamer Amazon Video (4.5B).
Netflix took the initiative about five years ago when it released its first original television series, House of Cards. This tense political drama, starring Kevin Spacey, was ultimately a gambit. If Netflix could attract and retain viewers with their own original content, as opposed to licensing content from outsiders, then the lifetime profitability of each original show would dwarf that of the licensed content.
The numbers haven’t really borne out that expectation as of yet, at least not in terms of profitability. Investors, however, have totally bought in to the idea of Netflix as the long-term content king, and they are willing to overlook the stock’s astonishingly high price-to-earnings ratio (247.17) in the name of perceived future growth.
A Cash Furnace
I think the story here may be a lot more complicated than Netflix as the indomitable content-producing powerhouse that “got there first” and therefore cannot be supplanted.
In order to finance its upcoming eight-billion-dollar content blitz, Netflix will have to look to debt capital markets for a new cash supply. The company is a notorious cash burner, and this will be apparent by the end of 2017; the company is expected to report a negative free cash flow (and this not the first time either). The balance sheet is already fairly debt-heavy and the new debt is sure to put even more pressure on the company to maintain its lead.
In my humble opinion, the main mistake currently being made by investors is confusing Netflix’s lead as a content/streamer with a stranglehold in the space. It’s like we’ve forgotten what prompted Netflix to pursue original content in the first place. It was not Reed Hastings’s boyhood dreams of being a big-time studio executive.
Instead, it was a play of necessity.
Even prior to House of Cards, many legacy media companies had already begun to view Netflix as a competitor rather than as a useful content distribution partner. Hulu (now with its own Emmy-award-winning original content) was, and remains, a joint venture between big media conglomerates: Disney (NYSE: DIS), Time Warner Inc. (NYSE: TWX), and Comcast (NASDAQ: CMCSA)—all of whom arrived on the scene armed to the teeth with their own original content and ready to stream it free or cheap.
This is the same content that they naturally refused to license to Netflix, preferring their own traditional broadcast television networks, along with Hulu of course. Netflix had no choice but to try to make a go of it as a content creator.
To get a sense of the tenuousness of Netflix’s position, imagine what might have happened had House of Cards been a major flop. With an alliance of media giants at the doorstep, it is not beyond the realm of possibility that Netflix may have collapsed like, well, a house of cards.
What makes me skeptical of Netflix’s current booming valuation is the apparent inability of the market to distinguish the battle from the war. Netflix has a rising subscriber count (a trend that will likely continue), newly raised prices (that consumers are happy to pay), and is making headway on international expansions after a surge at the beginning of 2017.
The company has also now enjoyed nearly five years of noteworthy success with its original programming. To be clear, I’m not saying its plan to double down on original content is a bad move. The results of the battle are clear, a decisive win for Netflix.
I just don’t see the fight as being over yet, not by a long shot.
There are definitely flops in Netflix’s current original lineup as there surely will be in the offerings to come. Meanwhile, Apple Inc. (NASDAQ: AAPL) is signing deals with Steven Spielberg. It’s still too early to say what this new development entails, but it is yet another pain point that will become apparent down the line.
While some of Netflix competitors, to use Jim Kramer’s word, may be “capitulating” right now, we shouldn’t assume that they will perpetually acquiesce to Netflix’s number one slot in this space. If Netflix is caught slipping on any given front while holding an unscrupulous amount of debt, we could easily see a significant sell off that sends Netflix’s stock price into free fall.
DISCLOSURE: I do not own shares of Netflix.
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This article is a part of our ongoing series that explores a different stock or fund each week. The information contained herein should not be construed as ‘financial advice’ and is presented as the opinion of the author.
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