Netflix, the streaming-video juggernaut, is growing with astonishing speed. And if you ignore the fact that it borrows billions to finance that growth, the company is a classic success story.
Its ability to expand its global audience is truly impressive. The latest numbers show that Netflix gained more than 6 million paid subscribers around the world in the three months through September. That’s about 66,000 more paid subscribers every day, bringing its total to more than 130 million.
Netflix’s extraordinary growth has disrupted the media landscape and entranced the stock market. As my colleague, Edmund Lee, has written, Netflix’s challenge has helped to motivate, if not entirely provoke, a series of mergers, acquisitions and realignments among giant companies. Disney and Fox, AT&T and Time Warner, Comcast, Amazon, Apple, Google and more: All have had to respond, many by increasing their own spending on TV and video.
Wall Street has embraced Netflix as one of the so-called FAANGs – short for Facebook, Amazon, Apple, Netflix and Google (which trades as Alphabet). The technology titans propelled investors to enormous profits for much of this year.
With Netflix’s resounding success in forging – and, so far, dominating – the global market for streaming video, it may seem churlish to harbour any misgivings.
Yet Netflix poses a difficult problem for investors. All of those movies and TV shows are expensive, and in order to fuel its explosive expansion, the company has been spending faster than it has been taking in cash – and expects to keep doing so for years. Netflix has built its business on a mountain of junk-rated debt.
Despite this, the Wall Street consensus is bullish. The company predicts that, within a few years, costs will start to grow more slowly than revenues. In a conference call this month, David Wells, the company’s chief financial officer, projected “material improvements” in 2020. “We still think it’s going to be a few years toward break-even,” he said. Wall Street has largely accepted that forecast, expecting that at some point, Netflix won’t need to borrow to pay its bills and profits will grow.
Not everyone is convinced, however.
“Netflix’s fundamental business model seems unsustainable,” said Aswath Damodaran, a New York University finance professor, who has examined the company’s numbers closely. “I don’t see how it is going to work out.”
With increased competition looming in streaming video, he said, Netflix must keep spending enormous sums on content and marketing. If it cuts spending, he said, it is likely to lose much of its precious audience.
“Sure, the company is growing rapidly now,” he said. “It has an amazing number of new movies and TV shows. For a consumer, that’s great. But for an investor, it’s a different story: The more Netflix grows, the more its costs grow and the more money it burns. I’m not sure how it’s ever going to turn that around.”
Prof. Damodaran posted a valuation model for Netflix on his blog, as an instruction tool. His model is based on a straightforward, well-established method – the discounted-cash-flow approach used by investment analysts around the world. At my request, he plugged the company’s latest numbers into that model to figure out what Netflix’s shares appear to be really worth. The results were startling.
The company’s shares, in his estimation, are worth buying as a serious investment only at about US$177. But Netflix has been trading around US$310 a share lately, after surpassing US$400 earlier this year.
In a nutshell, the problem is the disparity between money in and money out – and Prof. Damodaran’s presumption that Netflix’s costs must remain high, if it is to keep growing.
Netflix’s cash-flow statement indicates that in the 12 months through September, it spent US$11.7-billion on new content. But its income statement indicates that total revenues were US$14.9-billion, leaving it only about US$3.2-billion to pay for marketing and the rest of its operations. That wasn’t enough to run the business, so the company has borrowed money.
On Monday, Netflix announced that it intended to borrow more, by selling US$2-billion worth of bonds, which rating agencies say is below investment-grade. That comes on top of US$8.3-billion in speculative-grade debt already on its balance sheet. The borrowing is likely to continue to grow as long as the company burns cash faster than its millions of subscribers send in money.
Prof. Damodaran is not the only Netflix skeptic. In a note to investors on Oct. 17, Michael Nathanson, a senior analyst with MoffettNathanson, said that the company’s stock price was baffling, and he estimated that a more realistic level was about US$210.
In a similar vein, Michael Pachter, managing director of equity research for Wedbush Securities and a long-time critic, said he expected Netflix to continue to have difficulty matching costs and cash flow, given increasing competition in streaming video – and the likely loss of movies and TV shows controlled by its competitors.
Disney and Time Warner (which owns HBO) are revamping their offerings. And Hulu (owned collectively by Disney and Comcast), Apple, Amazon and Google (which owns YouTube) are now all serious adversaries, he said. In his estimation, Netflix stock is worth only about US$150 a share.
If Netflix were to fall anywhere near that level – losing a gut-wrenching half of its market value – its corporate competitors would presumably be powering ahead with their own streaming offerings. Yet it would not be surprising if some of them – the recently merged AT&T-Time Warner entity, for example – wondered whether their own marriages made much sense without Netflix’s unbidden influence.
How worried should the stock market be about Netflix? It has shrugged off such concerns most of this year: From Jan. 1 through July 9, Netflix’s shares returned a staggering 118 per cent.
Since July 9, however, tech stocks have fallen and Netflix has been pummelled. Despite brief surges, its share price has dropped more than 25 per cent since that peak.
Netflix executives say they are building their business for the long run. Last year, Reed Hastings, co-founder and chief executive of the company, said traditional competition didn’t worry him. Netflix was so compelling, he said, that its main adversary was sleep.
“You get a show or a movie you’re really dying to watch, and you end up staying up late at night, so we actually compete with sleep,” he said. “And we’re winning!”
In the latest earnings call, he said that deep-pocketed companies, such as Disney, AT&T and Google, were real competitors. “Some day there will have to be competition for wallet share; we’re not naive about that,” he said. “But it seems very far off from everything we’ve seen.”
Netflix, he said, needs to continue to be “focusing on our fundamentals” – supplying viewers with compelling entertainment and delivering it in innovative ways.
But that will cost the company a lot of money. For consumers, that may not be a problem at all. Netflix has already made video entertainment far more abundant and diverse than it was just a few years ago, and as other companies join the fray, the cornucopia of choices is likely to become even deeper.
But does that make Netflix a great stock? You may want to look closely at the numbers.