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John Engle
John Engle
Articles (529) 

Netflix Sets the Stage for a Bleak 2020

Weak first-quarter guidance will continue to weigh on the streaming giant’s bulging valuation

January 23, 2020 | About:

Netflix Inc. (NASDAQ:NFLX) reported earnings for the fourth quarter of 2019 after the market closed on Jan. 21. While the company delivered a few bombshells, it continued to show worrying signs of weakness. Slowing subscriber counts, weak first-quarter guidance and fears of encroaching competition all served to weigh on the results.

2020 is shaping up to be a tough year for the content streaming leader.

Slowing subscriber counts

One relative bright spot for Netflix in the fourth quarter was global subscription growth. Netflix added 8.8 million net paid subscribers during the quarter, well above the 7.6 million targeted in prior guidance. Management attempted to highlight this beat in its investor update letter as well as on its earnings call. A look beneath the surface, however, reveals a more worrying story.

The most glaring warning sign was an evident slowdown in subscriber growth in the U.S. and Canada. During the fourth quarter, Netflix added adding just 0.55 million net paid subscribers in the region (0.42 million in the U.S. and 0.13 million in Canada), well below the 1.75 million added during the prior-year period. After reviewing these numbers, Andrew Freedman, lead communications industry analyst at Hedgeye, opined that this was a sign of real market saturation, undermining a key tenet of the bull thesis:

“U.S. sub growth hit a wall in 2019 while linear TV sub losses accelerated to the downside. Runs counter to the bull thesis around cord cutting freeing up wallet share and incremental subs.”

Netflix enjoys a generous market capitalization and a huge valuation multiple based on investors’ belief in a hyper-growth narrative. With subscription growth in the U.S., its most established market, apparently gassing out, this narrative looks increasingly shaky.

Weakening guidance

Even more troubling than the signs of saturation in its established markets was Netflix’s guidance for the first quarter. The company now forecasts significantly weaker subscriber growth compared to prior market expectations.

As Hedgeye’s Freedman observed in the wake of the earnings release, the latest management guidance implies a severe slowdown in subscriber growth, especially in the U.S. market:

“NFLX internal forecasts have always called for higher Q1 compared to Q4. If you believe the guide, even if they beat by 1M subs, it implies a significant drop in YoY subs. If 'The Witcher' and other content was so strong in Q4, then it SHOULD have filled the top of the funnel (incl. free trials) for higher paid conversion in Q1. They really shouldn't be posting such a large 2nd derivative slowdown QoQ. Which begs the question... What is management seeing for them to guide to such a big slowdown? Either UCAN is going to be negative subs in 1Q20 or international rolls over again. Maybe that is why they are only guiding to global paid subs now.”

The prospect of subscriber numbers actually falling in its core market is extremely troubling for Netflix’s growth narrative. With subscriber numbers in the U.S. hovering around 60 million, saturation is occurring far sooner than bulls anticipated. Many had expected 100 million to be the upper bound. That now appears to have been far too optimistic.

Darkening outlook

Netflix has guided for $2.5 billion in free cash flow burn in 2020, reflecting its continued commitment to spending big on original content in an effort to make up for popular series and films leaving the platform over the next several years. Yet, as I said in December, Netflix’s content strategy is likely financially unsustainable.

Now, with its growth narrative under threat, the streaming content leader’s ability to raise huge amounts of capital through debt and equity sales to fund its multibillion-dollar content expenditure will become increasingly constrained. According to renowned short seller Jim Chanos (Trades, Portfolio), the growth slowdown may soon look even worse:

“NFLX will probably grow total paid subs 15% in 2020, vs 20% in 2019. FCF will still be negative $2.5B in 2020. I think the scenario of 5% sub growth with no FCF may be coming into focus soon.”

If subscriber growth continues to taper off, as the data suggests is already happening, Netflix’s content strategy may soon be wholly untenable. Moreover, the rising threat of competition from the likes of the Walt Disney Co. (NYSE:DIS) will only add to Netflix’s troubles. Indeed, in the U.S. market at least, it now looks very much like Netflix is entering into an ugly zero-sum game with the competition.

Verdict

Netflix is still priced for perfection, even as cracks in its growth narrative continue to grow in number and severity. The stock continues to benefit from the frothy bull market, which has been powered by ebullient expectations of a bright future and widespread buy-in to the idea that companies like Netflix can not merely disrupt, but outright conquer, whole industries.

Yet, no amount of enthusiasm can stave off economic reality forever. Netflix has enjoyed the boons of its eye-watering market cap and the bull market’s loosened lending standards. Unfortunately, these have failed to translate into material economic benefits for the company.

As the projected subscriber slowdown becomes a reality over the coming months, Netflix’s share price will find it increasingly difficult to defy gravity.

Disclosure: Author is long Disney and short Netflix.

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About the author:

John Engle
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.

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