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John Engle
John Engle
Articles (529) 

Netflix: Too Much Enthusiasm Ahead of Earnings

Investors seem to be banking on major subscriber growth amidst coronavirus lockdown

April 17, 2020 | About:

Netflix Inc. (NASDAQ:NFLX) has been on a tear recently. While the novel coronavirus epidemic has thrown many businesses into turmoil, investors evidently believe the near-total lockdown will serve as a tailwind for the streaming media giant. On April 14, the company’s stock actually surpassed its pre-crash price level.

The streaming giant is being driven by forward-looking enthusiasm bordering on irrational exuberance. Yet, before the Covid-19 outbreak, the company was already beginning to suffer from the collision of sky-high market expectations and a much more pedestrian reality. When the company reports earnings next week, those lofty expectations will be put to the test.

Subscriber growth has stalled

Netflix has committed to a strategy of achieving “scale at all costs” in order to secure market leadership in the streaming content space. It has undoubtedly achieved this goal, as evidenced by its massive paid subscriber base. However, the seemingly endless subscriber growth trajectory has begun to stall. Netflix’s domestic subscriber count barely budged in 2019, rising from 60,229 in the first quarter to 61,043 in the fourth quarter – a mere 1.4% increase.

Facing moribund domestic subscriber growth, Netflix has turned to international markets for salvation. The bull narrative has latched onto this story as it has developed and, thus far, it has not disappointed. Netflix boasted more than 106,000 paid subscribers at the end of 2019, more than double what it had in the fourth quarter of 2017. While international growth has been impressive, signs of saturation have begun to show themselves. Indeed, Netflix warned investors in January to expect a paid subscriber slowdown in the first quarter.

Investors seem to be banking on the idea that Netflix will be a major beneficiary of the Covid-19 lockdown. The logic is reasonable given that the entertainment alternatives have been severely constrained. The hope is that Netflix will enjoy a near-term subscriber boost, perhaps giving new legs to the international market growth story.

Cash burn has persisted

For years Netflix has promised a gradual path to profitability. The company’s fourth-quarter earnings was the latest to reiterate this intention, stating that the “plan is to continually improve FCF each year and to move slowly toward FCF positive.” But economic sustainability has thus far remained out of Netflix’s reach. Indeed, as technology analyst Beth Kindig pointed out in her Jan. 22 analysis of Netflix’s earnings report, cash burn in 2019 was staggering:

“Netflix’s numbers put a price tag on global domination: Free cash flow (FCF) was an astonishing negative $3.3 billion for 2019. The company forecasts negative free cash flow of $2.5 billion for this year. It’s expensive to produce high-quality local originals for many geographic regions.”

Despite the monumental price tag of content development and promotion in 2019, Netflix continues to insist that it is on a clear path to sustainable cash generation.

Scale has not solved

Scale might help solve Netflix’s profitability issues, in theory. That has been a big part of the bull thesis since its early days. Yet, in practice, the promised cash-generative benefits of scale have failed to materialize. For example, as GuruFocus legend The Science of Hitting observed on April 15, operating costs have failed to decline on a per-subscriber basis:

“From 2014 - 2019, they more than tripled their avg paid subscriber base - yet OpEx per sub increased. Forget about marketing (I can understand that one). How about tech & development / G&A. What am I missing here?”

This simply does not make sense if Netflix is indeed able to reap the benefits of scale. With operating expenses remaining persistently high, the case for “market domination through scale” looks increasingly tenuous.

Assessment

High cash burn, slowing subscriber growth and ephemeral economies of scale all serve to challenge the Netflix bull thesis, yet the stock has continued to price in continued massive growth and profitability expectations. Sky-high earnings expectations in 2020 seem doomed to disappoint, even if the disruption from Covid-19 has served as a short-term tailwind to Netflix’s business.

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As market saturation continues without sign of imminent profitability, I expect the now-widespread optimism to grow increasingly muted. At the same time, reasons for skepticism, if not outright pessimism, will likely proliferate throughout 2020.

I recommend steering clear of this name. It is priced for growth that will likely never happen.

Disclosure: Author is 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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