Growth Stocks: Netflix

Warren Buffett's words did not sit well with Netflix before its results

Last week Warren Buffett recently mentioned from Tokyo that the streaming business is not a very good business, and Netflix's (NFLX.US) operating history may be a prime example of why the reputable investor made such statements. The company's growth story is fantastic on an EPS GAAP basis, but when looked at from a cash flow perspective, returns to shareholders have been poor. Even using optimistic assumptions for FCF growth, the models suggest that NFLX has a notional value of $250 per share, which is a current overvaluation of more than 26% at last Friday's closing price. Key factor to consider: Increase free cash flow given the competition and capital intensive nature of the industry.

Considerations

On a GAAP basis, Netflix (NFLX.US) looks like a story of EPS growth and subscriber growth over the past 10 years. When we turn to free cash flow, the story gets a bit more complicated, and recent gains don't make up for longer-term losses. In fact, the company has steadily diluted shareholders and paid no dividends since it went public in 2002. Adding fuel to the fire, Buffett recently took a jab at the entire streaming industry, calling it a poor business with competitors pocket-size. As Netflix is a pioneer in the industry, it is the best example to analyze why exactly it could be considered a bad business.

Buffett on Streaming

Recently, during a CNBC interview, Warren Buffett was asked about his investment in Paramount (PARA). He responded with the following:

“Streaming that, you know, is not really a very good business. And, you know, it's the entertainment people that make a lot of money, the shareholders haven't really done that well over time."

Paramount (PARA.US) has recently aggressively expanded into the streaming business, rebranding its CBS All Access to Paramount Plus in 2021 and aggressive spending on content and advertising to attract new subscribers. The reward for this so far has been a huge increase in the number of subscribers. On the other hand, free cash flow has turned negative in 2022, for a historically cash flow positive company. With PARA and many other companies eager to dive deeper into the streaming business and steal market share from NFLX, we'd think NFLX would be a free cash flow machine. This does not appear to be the case, which brings us to the next point of analysis.

A questionable growth story

The growth story is staggering for Netflix, if we measure it from EPS. In fact, from 2013 to 2022, the company has been able to grow earnings per share from a meager $0.26 to $9.95, which is roughly a 50% CAGR. But if we look at free cash flow per share instead, a different story emerges. The company continued to lose money in free cash flow between 2013 and 2019, with a peak loss of around $3 billion in 2019, or around $6.5 per share. It has not been until the last 3 years that the company has been able to generate free cash, of $1.59 per share generated in 2022. This is showed below:

Source: Data from Netflix earnings report

Netflix is a pretty simple business compared to other media companies in that it basically operates in one segment. The company charge a subscription fee for the content of its license, produce, or purchase. For NFLX, the main difference between free cash flow and EPS is the amortization of content over time in the latter.

Content spending recently jumped to just under 18.000$ millions 2021 and 17.000$ millions in 2022. There are some fluctuations looking back at the data, but the long-term trend is clear, with spending steadily increasing of cash content that far exceeds amortization expense. If this trend continues, and the company has no plans to fundamentally change its business model, GAAP EPS may be considered misleading, as it is not representative of the cash that can be withdrawn from the business and paid to shareholders. These values in the last 5 years are presented below:

Source: Data from Netflix earnings report

For a long time, NFLX had some advantages. Subscriber growth was immense, it was an industry first, and investor enthusiasm drove its share price well beyond free cash flow generation capabilities. As growth slowed in 2022 with a meager 4% year-over-year increase in subscribers, investor enthusiasm waned and stocks plunged nearly 75% from peak to trough. With ever-growing stock-based compensation ($575 million in 2022) and a historically negative free cash flow business, any stock price weakness will affect the growth story as funding through equity it will be more dilutive. Add intense industry competition to the mix and it's easy to see how equity investors could struggle to get paid over the long term.

Assessment

Let's make an effort to consider an extremely optimistic scenario for analysis. Assuming the company was able to grow free cash flow per share at a CAGR (Compound Annual Growth Rate) of 40% through 2032 by reducing content spend and continuing to grow subscribers. The company could then monetize its content as a long-term asset for years to come and grow at the rate of global GDP of 4% per year. Using a discount rate of 10% since the company is minimally capitalized with debt, and estimating that this is probably the minimum rate of return that equity investors will demand. Even with these lofty assumptions, the model in the table indicates a fair value of around $250/share, which is demonstrated below.

DCF Netflix

Technical analysis

Netflix NFLX.US) stock follows a bullish channel pattern from its lows at $162 per share. From an earnings perspective, the company should stick to this course and it is the one that investors are primarily looking at. However, from our discounted cash flow analysis, the valuation could break even at $250 per share (red line).

source: xStation5

Investment thesis

New sources of income

Although Netflix operates exclusively as a streaming service, they could find other sources of revenue, such as licensing small parts of their vast media library to competitors. This is unlikely, as company executives have recently stated that this is not on the table.

Crackdown on Account Sharing

Netflix has been in the news recently for initiating policies to reduce account sharing capabilities and limit one subscription per household. This makes business sense, as not having restrictions on who can view unlimited content seems like bad practice. In theory, this policy will increase the number of subscribers. However, questions arise here: If competitors don't follow suit, will consumers who share accounts move to other platforms with more flexible policies? Will subscribers cancel if they feel like Netflix is looking down on them? Only time will give us the answer.

Spending on content can decrease

Netflix can find a way to reduce spending on content without compromising quality. One idea is the potential use of AI to help write scripts to increase production. However, this idea is unproven and speculative in nature, and any productivity improvements could also be used by competitors. It is cautious to be skeptical that the company can significantly reduce costs, considering the long-term trend of content spending and the immense competition in the field.

Competition could decrease

In theory, other companies with more profitable segments can see the futility of trying to compete in streaming and reduce spending in the segment if it is not profitable. This seems unlikely, given the continued efforts by big tech companies and legacy media to maintain market share.

Conclusion

At XTB we believe that Netflix is a great business that offers a fantastic product at a good price, but offers questionable returns to its capital investors. With the model presented indicating a 26% drop from current market prices, or a fair value of $250 per share, it seems a sale might be warranted. However, a short position is not the solution either considering that we are looking at a growing profitable company with a high degree of investor enthusiasm. Keynes' phrase is maximal here when he said that "markets can remain irrational longer than we can remain solvent."

For the NFLX to continue to increase FCF per share, it will likely need to aggressively grow subscriber count and reduce content spending to a more reasonable level. Content spending has skyrocketed in recent years and has risen steadily over time, and industry competition is intense. Therefore, a large growth in FCF will be difficult. This analysis on Netflix is thus a global warning to the industry and to those in the industry who hope to profit by emulating the NFLX model. The industry is capital intensive, competition is fierce, and shareholder returns are questionable.