Netflix Inc. NFLX reported its third-quarter earnings last week, beating subscriber growth expectations. The company added 5.3 million subscribers during the quarter compared to the consensus of 4.5 million. While Wall Street is fixated on the subscriber growth, the latest earnings report sheds light on several concerns.
First, Netflix is evolving into a content company. This puts pressure on the financing needs as well as margins. Second, entering digital distribution is not very difficult, which is paving the way for new streaming players. This will result in content being offered though several platforms, pressurizing Netflix's distribution moat.
The company acknowledges this as CEO Reed Hastings emphasized on content creation in the latest letter to shareholders. The fragmentation of content also questions Netflix’s ability to be the undisputed entertainment hub of the future.
In short, content creation is the way forward for Netflix, which requires regular investments in original programming. From an investment perspective, this changing business orientation means the stock is a risky bet.
Netflix is evolving into a content provider
The company is considered an entertainment hub, a platform that will aggregate quality content over time. It is often argued Netflix will act as an intermediary between subscribers and quality content markers, creating a network effect like Facebook FB or other two-sided platforms. According to some sources, digital distribution is the company's economic moat. If that is actually the case, then Netflix is a good growth-oriented investment. Regardless, bullish presumptions seem faulty.
For instance, there is a real chance Netflix will not be the aggregator of content in the future as various content creators will distribute their content using their own streaming services. Disney DIS recently decided to pull its content from Netflix in 2019. AMC Networks AMCX, with the help of several other networks, is planning to launch a streaming service. CBS Corp. CBS recently launched its All Access streaming with flexible pricing, $5.99 for basic and $9.99 for ad-free streaming. CBS’ show, "Star Trek: Discovery", led to record registrations with the streaming service. Then there is Time Warner's TWX HBO, which is leading the content war. With all these streaming services, one can only wonder how the streaming landscape will turn out.
It is clear networks and content creators are not settling for a single, dominating streaming player in the industry, which is why Netflix cannot be the undisputed distributor of content.
What about the distribution moat?
Distribution is the moat, or key competitive advantage, of Netflix’s streaming domination. However, evolution in technology has disrupted the oligopoly in the space. Netflix benefited from this disruption, but nothing is stopping networks and content creators from benefiting from low barriers to entry as well.
Put simply, building an online distribution channel is not cumbersome for deep-pocketed networks. With a little help from Amazon Web Services and artificial intelligence engines, Netflix’s streaming model can be replicated.
Some would argue Netflix has an AI-powered recommendation algorithm that helps the company retain its subscribers, and its distribution is a vital competitive advantage for that reason.
In addition, its recommendation system helps retain subscribers, but the impact is not material enough. Netflix claims it saves $1 billion each year with its recommendation algorithm, making up around 10% of revenue. What is important to note, though, is the remaining 90% of revenue comes from investing in quality content.
Moreover, Amazon AMZN and Alphabet's Google GOOG have their own recommendation algorithms. Amazon is using a recommendation algorithm for TV shows and movies in its Prime service. There are companies that tout audio and video search discoverability as their competitive advantage; streaming players can outsource if they lack expertise in the area.
While the recommendation algorithm compliments Netflix’s platform, it is not a sustainable competitive advantage. To review, there is room for more than one streaming player in the market as distribution is not a critical competitive advantage.Â
If distribution is not the moat, what is?
The answer is quality content. The premiere of the seventh season of "Game of Thrones"Â resulted in more than half a million downloads of HBO’s streaming app. During the first week, revenue was up three times. As mentioned previously, CBS All Access experienced record subscriber growth amid the launch of "Star Trek: Discovery." Netflix also blew past analysts' expectations in the quarters following the launch of successful shows like "House of Cards." In addition, following the release of "Stranger Things," the company added 3.2 million subscribers, surpassing estimates of 2.3 million subscribers.Â
Content is the main attraction for streaming services, so quality content is what determines a company's moat, not distribution.
Netflix sees that, investors will!
Due to the changing landscape, Netflix sees itself competing as a content creator. Hastings was unequivocal in pointing out the company's future lies in original content:
"The long-term trends are clear. Our future largely lies in exclusive original content that drives both excitement around Netflix and enormous viewing satisfaction for our global membership and its wide variety of taste.”
The company is planning to spend $7 billion to $8 billion on content in 2018, outstripping all other major providers. Amazon is a close second as it spent $4.5 billion. HBO spent $2 billion.
The point is it all comes down to the quality of content, and Netflix is planning to compete on that.
Here’s the problem – quality is expensive
Being a quality content provider requires a lot of money. It is one thing to be an entertainment hub and another to be a quality content creator. Netflix is more of a content creator now. Margins are low for content creators as the need for quality content does not go away.
Netflix charges nominal subscription fees, which leads to negative cash flow and aggressive cashburn. The company supported an operating margin of a mere 6.8% during the trailing 12 months. HBO’s operating margin was around 33%, while Warner Bros. and CBS had an operating margin of 17% in 2016.
Financing, margin and valuation
Netflix is choosing to spend aggressively going forward, but this will have financing and bottom-line implications. The company has to finance its content creation regularly. It is not generating any cash flow for investment in content. Netflix has been cash flow negative during each of the last four quarters. Consequently, it has to look toward capital markets. Just recently, Netflix announced a $1.6 billion debt offering to finance its content obligations.
As Netflix is planning to aggressively spend on content, it will not be able to surpass the current margins of major content providers. This puts the company in a difficult situation from a valuation perspective. To justify its current valuation, the company has to grow its revenue at 26% p.a. for the next five years at an operating margin of 10%. Currently, the operating expense is around 7%. Given aggressive planned spending on content in 2018, it is unlikely the company will achieve this target in the next five years. All in all, Netflix's valuation does not look good. See the table below:
Focus Equity Estimates
Takeaway
Netflix is an impressive entertainment company that benefited from its distribution model. As other companies see digital as the new distribution norm, they will focus on creating in-house streaming services. Creating an online distribution platform is no longer a barrier to entry given improvements in technology. Therefore, Netflix cannot rely on its distribution network alone. The company is focusing more on content as it can lose its distribution domination. High content costs will put pressure on Netflix’s financing needs as well as on its margins. Since the valuation is already high, the bottom line is Netflix should be viewed as a content creator with independent distribution, rather than a streaming player with a distribution moat. Investors should embrace the changing dynamic and stay on the sidelines for now.
Disclosure: I have no positions in any stocks mentioned and have no plans to initiate any positions within the next 72 hours.
