Published Date: 2021-07-22 | Source: INCE|Community | Author: The Finance Ghost
Those who have followed me since last year on thefinanceghost.com
or especially by reading Ghost Mail
will hopefully have seen my various pieces on Netflix. When the pandemic struck and the share price went crazy, I had a proper look at this company to figure out if the rally could be sustained.
What I got wrong was that Netflix still had more steam in it, so I lost out on trading profits. What I got right is that the company has some fundamental issues that make it an unattractive investment for me.
The core problem comes down to the drum that I constantly beat: valuation.
Netflix is a film company masquerading as a tech company. The company may operate a platform, but I don't see the network benefits that are enjoyed by the likes of Facebook. I don't have a better experience with Netflix just because my neighbour is also a subscriber.
Netflix is a software-as-a-service (SaaS) company at best and a media company at worst. At one point, Netflix traded at a 10x Price / Sales multiple. It's now trading at 8.5x, which is still much higher than the likes of Disney (5.5x), Comcast (2.5x), Discovery (1.3x) and Fox (1.6x).
Last year, people were giving far too much credit to Netflix's moat, which I believe is weak. People want content and Netflix is constantly on a treadmill, trying to catch up to the content catalogue enjoyed by the likes of Disney.
I have Netflix at home. The family loves it and we get our money's worth. However, the content does get pretty marginal once you dig beyond the top shows and most of the movies are dicey. I'm not sure I would keep Netflix if the price was hiked closer to what DSTV charges.
It's not just me who feels this way. Membership growth in Q2'21 was only 8.4% year-on-year. That certainly doesn't justify a 8.5x Price / Sales multiple. Revenue was up 19.4% which is better, but still not enough for that demanding valuation.
Operating margin expanded to 25.2%, which helped operating income grow by 36%. That all sounds fantastic, except free cash flow once again turned negative. The only reason it was positive last year is because loads of new subscribers came onto the platform and Covid restrictions meant that creating new content was very difficult.
Free cash flow (or lack thereof) is why Netflix's share price has displayed a sideways trend for months, although it's been really volatile along the way. Free cash flow is a measure of the cash available to shareholders after capital investments and other drains on cash in the business.
In Netflix, the capital requirement is to constantly invest in content. This is different to other SaaS companies, which usually invest heavily in marketing rather than ongoing product development.
As competition increases from the likes of Disney+, Netflix's life won't get any easier.
However, at the right valuation, Netflix is worth a look. Operating margin has increased substantially since 2016 and having 209 million subscribers is impressive by any measure.
The business has incredible data on consumer preferences, which could help it disrupt the traditional cinema model and appeal to studios looking to release new films. There's also the opportunity to keep producing new content in languages other than English, which is less of a competitive bloodbath and allows Netflix to dominate specific regions.
The big news, however, is that Netflix is expanding into games. The gaming industry is enormously profitable, especially on mobile which is where Netflix will initially focus.
The opportunity for streaming is clear: only 27% of US TV screen time is spent on streaming platforms. Netflix is only 7% of total screen time, which implies a quarter share of the streaming market. There's a lot of runway for streaming as a whole and Netflix will participate in that.
However, shareholders need to ask themselves what the cost of this competition will be and whether Netflix will consistently generate free cash flows. If not, the valuation is still too rich.