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Soid Ahmad
Soid Ahmad
Articles (164)  | Author's Website |

Analysts Back Netflix, Overlook Content Costs

Although subscriber growth is in the cards, it comes with high-cost baggage and risk to the bottom line

April 15, 2018 | About:

Analysts have started to cheer Netflix Inc. (NASDAQ:NFLX) as earnings approach. Morgan Stanley and JPMorgan have raised their price targets to $350 and $328 respectively. Goldman Sachs is even more upbeat with a revised price target of $360, an upside of 18% over Friday’s closing price.

Netflix is rallying with the stock up 7% during the week; in contrast, the S&P 500 registered a growth of approximately 1%. The streaming service is expected to report its results of first-quarter 2018 after the closing bell on Monday.

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Morgan Stanley cites international exposure as a reason for its bullish price target on Netflix.

"We believe Netflix is still in the early stages of global adoption," Morgan Stanley analyst Benjamin Swinburne wrote in a note to clients.

He further argued that Netflix has a massive growth opportunity as the company has only 120 million subscribers in a market of 600 million global subscribers, a penetration of merely 20% globally.

JPMorgan analyst Doug Anmuth thinks the company will post strong first-quarter results amid global growth. In the long run, he argues, the company will benefit from the decline of linear TV, insulation from regulators when compared to other internet companies like Facebook (NASDAQ:FB) and Alphabet (GOOG) and a library of high-quality content.

Goldman Sachs also cites global subscriber growth and Netflix's content library as catalysts for stock price growth going forward.

“Beyond the quarter, we continue to believe long-term subscriber growth and profitability will exceed current consensus expectations as Netflix realizes the global scale benefits that come from its subscriber base, distribution network and content library," Goldman said.

The common theme around Netflix’s potential success is global growth. Although, the company continues to register growth, high content costs, potential competition and a skyrocketing valuation put a dent in the bull thesis.

Netflix just can’t stop spending on content

Cost of sales ate into 66% of Netflix’s revenue during fiscal 2017.

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The company spent around $6 billion on content over the last year; content-related expenditures are expected to reach $7.5 billion to $8 billion by the end of 2018. By  increasing content costs and the quality on content, it will lead to subscriber growth.

The only problem is – content costs are expected to stay high and, consequently, subscriber growth might not translate to bottom line. For starters, the company doesn’t indefinitely own licensed content. In the management’s own words, the content is for “fixed fee and specific windows of availability.”

Although original content is perpetual and will attract new subscribers, it can’t protect against churn (users leaving the platform). In short, the company must consistently spend on original content and licensed content simultaneously. It is worth mentioning that content amortization costs continue to stay high for Netflix.

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Depreciation and amortization stands at $6.3 billion, with content amortization making up more than 98% of the total. The point is, Netflix’s content is expiring at a rate similar to its actual content spend, so the company should spend consistently to maintain its library.

As content costs are expected to remain high, the bull thesis that Netflix will achieve escape velocity in terms of bottom line after a certain number of subscribers might not hold true.

Content costs are not the only problem

Netflix will potentially face stiff competition in the space going forward from deep-pocketed content providers like Disney (NYSE:DIS) and Time Warner’s (NYSE:TWX) HBO. Disney has already stated to pull its content off Netflix. HBO, on the other hand, offers original content through its own streaming services. While Netflix is throwing money at content creation, seasoned players like HBO are spending much less to produce high-quality content. For example,HBO spent $2 billion in 2016 while Netflix spent $6 billion in 2017. Overall, high octane competition will certainly contribute to Netflix’s margin woes going forward.

Then, there’s valuation

Netflix trades at a very rich valuation amid anticipated international growth. In fact, the company is trading at a multiple of 72 times 2019 earnings.

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And, it’s not just the bottom line. The stock is also expensive on a growth basis compared to Amazon (NASDAQ:AMZN) and Facebook.

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Even with bullish assumption of the sell side, the stock is priced for perfection. For instance, if Netflix reaches 350 million subscribers by 2023, it should be priced at $307, according to the economic valued added approach to valuation.

EVA valuation

Assumptions:

Netflix will reach approximately 96 million U.S. subscribers and about 279 million international subscribers by the end of 2023. The company will generate annual average revenue of approximately $116 per U.S subscriber and $88 per international subscriber. The company is expected to spend at least $6 billion on content each year, so 1% growth is assumed in perpetuity. Cost of capital is assumed at 8%.

Projections

   

2018

2019

2020

2021

2022

Perpetuity

   

Notes

         

Dollars in million

Net Income

   

2539.3

4076.1

5994.7

8401.3

11433.0

15267.4

 

Cost of capital

r*capital invested

286.6

466.8

755.5

1174.7

1752.8

2527.2

Economic Value Added

   

2252.7

3609.3

5239.2

7226.6

9680.2

12740.1

Discount factor

   

0.93

0.86

0.79

0.74

0.68

8.51

Discounted EVA

   

2085.8

3094.4

4159.0

5311.8

6588.2

108384.1

Period

   

1.0

2.0

3.0

4.0

5.0

6.0

                 
       

Market value added

129623.4

       

Invested Capital

3582.0

       

Value of the equity

133205.4

Perpetual Growth in Residual Earnings

0.1

Price Target

$307.0

The EVA valuation reveals no upside even after allowing for high subscriber growth; the stock is priced for perfection.

Bottom line

Analysts are focusing on subscriber growth with rosy price targets. This growth, however, comes with baggage that includes high content costs. Prospective competition isn’t going to help keep costs down either. Moreover, the stock is already priced for serious subscriber growth. As far as investments go, Netflix is a risky proposition.

Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.

About the author:

Soid Ahmad
Soid Ahmad is affiliated with the Association of Chartered Certified Accountants. He graduated from Oxford Brookes University. He also holds a Master's degree in Economics and Finance from HSRW Germany. He has been working as a technology analyst for several years and has an eye for mispriced technology stocks. He is also affiliated with Focus Equity, an independent equity research firm.

Visit Soid Ahmad's Website


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