NetFlix Inc

NASDAQ:NFLX  
665.20
+6.91 (+1.05%)
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Netflix Stock Fades as a New, Abrupt Risk Appears


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##Symbol##NFLX

Netflix (NFLX) is now down more than 25% from its highs, which puts it well into "official" bear market territory. The stock is tending to stay down, even on abrupt market rallies. There is a serious threat, yet again, from a new competitor. But this time, that new competitor is the largest company in the world. Apple (AAPL) has stepped into the fray with Apple TV. Barron's reported on Global Equities Research's Trip Chowdhry when he said that the Apple TV platform "provides strong indication" that Apple TV will come with its own software development kit and its own app store, i.e. its own Apple TV ecosystem. And there's the problem for Netflix, he argues, since in this ecosystem Netflix would be just another app, or a "second-class citizen." (Source: New Apple TV Platform Is Bad News For Netflix: Global Equities)

Another risk we must must also recognize is that Netflix is now relying more on original (exclusive) content than it used to as it has been dropping a substantial amount of other content. In fact, Netflix just announced that thousands of movies will be removed from the US platform after not renewing a deal with distributor Epix. While NFLX points to the fact that so many other platforms already have the content so its not a competitive advantage (or need), oddly Hulu said "our subscribers have been asking us for more, and more recent, big movies" (Source: BBC News). "Today about ten percent of the content available on Netflix is either licensed or created by the company. It plans to increase that number to fifty percent" (Source: https://www.scottfearon.com/). Keep in mind, content creation is a very different business than a technology company. This is a huge risk and does fall outside of the purview of Netflix's core competency. Even though NFLX has crushed this new competency as well, we are left to ask if the company's story is as compelling if it's an original content creator, rather than a technology disruptor through distribution.

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For years I wrote about Netflix and several times existential risks appeared to be around the corner. There were calls that the company would turn into a commodity and become easily replaceable. Those calls were dead wrong. Netflix established its strength by saving TV shows that would otherwise have faded away, including the most critically acclaimed show ever, "Breaking Bad." It became evident that the content creators could not brush Netflix aside, but in fact needed the firm for their very success. Time and again frightening changes in the competitive landscape threatened the firm, but it has blasted through each threat and now looks to be taking over the world's content distribution. Now NFLX is dealing with Apple and moving toward a different business model with original content. here comes the risk again. But, I've said it before and it continues to be true, Netflix is still the apotheosis of technological disruption and may be the best company in the world at it. The firm has broken everything. Its competitors underestimated it, then copied it, then fell to their knees to help it turn save their TV shows. It accounts for nearly 37% of peak period downstream Internet traffic in the US. Yes, it's more than "one-third of the Internet." I'm going to show you incredible, then simply impossible, and then discuss the risks moving forward which are substantial.

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Here is a summary of the fundamental factors driving the 4.5 star rating. NFLX revenue, and free cash flow are at all-time highs, smashing each prior record every quarter. At the same time, the company is spending more on R&D than ever before and its expansion into Europe is pushing margins and net income down, while subscriber growth is fantastically high.
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Risks and Rewards

We must note that Netflix is moving further into content development rather than solely distribution, and that is a totally different business and far more risky for a technology company.

Now, let's start with incredible.

On the last earnings call (July 15th, 2015) Netflix obliterated already lofty expectations. The company added 2.5 million new subscribers to over 65 million worldwide. Of those, 42 million are in the U.S. and another 23 million are international. International revenue represents 31% of total streaming revenue. Further, the company predicted it would have 69 million subscribers by the end of the third quarter, which would mean a staggering 4 million new subscribers. The company also beat the consensus EPS estimates reporting $0.06 (split adjusted) versus $0.04.

The success was attributed to all things Netflix, but in particular Spanish language programming and a launch in Australia. The company also expanded to New Zealand, and will further expand to Japan, Spain, Italy and Portugal later this year. Global expansion is planned to be mostly complete by the end of 2016, where margins should rise again. CEO Hastings said, "[the company is] committed to running around break-even globally on a net income basis through 2016 and then to deliver material global profits in 2017 and beyond."

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The results highlight Netflix’s progress in building the first global Internet TV channel, fueled by new shows such as "Daredevil," its first program with Walt Disney's Marvel Studios, and "Sense8," created by the directors of "The Matrix." Spending on films and TV shows will exceed $6 billion next year, the company said (Source: Bloomberg ). Again, content creation is a totally differnt business and therefore a totally different risk.

Netflix management has been methodically consistent in their claim that margins inside the U.S. are (and will continue to be) rising. In a rather stunning outcome, while management anticipated a 2% growth in margins per year, in the April earnings call the company delivered 3.7% year-over-year margin growth. The company has openly claimed a domestic contribution margin goal of 40% by 2020, but if margins continue to increase faster than anticipated, the stock could move up huge if that 40% all of a sudden sounds like a conservative number.

The firm now has 42 million domestic subscribers and has given a wide ranging 60-90 million long-term goal. If we see subscriber growth slow to the point where the low end looks more like the number, the stock could fall massively. I'll address rather myopically it's expansion outside of the United States shortly. First, a little time travel.

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On December 9th, 2013, Time Warner, the owner of HBO, CEO Jeff Bewkes stated clearly that HBO and Netflix aren't competitors. Of course they were. They competed for content, for subscribers and now they compete for viewers on a global scale. John McDuling aptly pointed out back then that Bewkes was either delusional or in denial.

It's now the "other guys" that are scrambling to change their modes of operation to keep up with Netflix. Time Warner has created HBO GO, which soon will be (or already is) a stand-alone subscription web service. That's simply imitation; delusion and denial are over. Netflix made that decision for Time Warner.

Now Amazon.com's streaming service creates its own original content. That's a reaction, not a plan. Netflix made that decision for them as well and Amazon is possibly the single most dangerous technology firm on planet Earth. You can read that article here: Why Amazon is Growing More Powerful and More Dangerous.

According to a stunning RBC survey, 77% of US subscribers would not cancel the service if a $1 monthly price hike was introduced. And here's impossible.



The international market survey results are astounding, with over 85% of French and German respondents expressing "extreme" satisfaction with Netflix as viewership is rising at an accelerated pace in both markets. Netflix already drives nearly a third of its streaming revenue from international markets. Those are simply insane numbers. They're impossible numbers. And now 30 more countries are going to get their first taste of Netflix by the end of 2015.

The bearish thesis here lies in a possible slowing international economy and Alibaba and Baidu's entrance in to the Chinese market as Netflix imitators. China may very well be simply out of the picture and that's a major loss for the firm. But, keep in mind, Facebook (FB) is also locked out of China and it's doing just fine thank you very much, hitting 1 billion daily users for the first time ever last week.

Netflix has broken a new record for revenue TTM every quarter since going public. That's over 50 consecutive quarters. The firm is outpacing its own stated goals for subscriber growth, and while it continues to spend heavily on R&D and SG&A relative to its past, those expenses appear to be well worth the cost.

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NFLX is up 12.8% over the last three months and up +46.5% over the last six months. The stock price is up +47.6% over the last year. But, the company is now trading 20% lower than it's all time high, which leaves us to question if now is the time buy the stock.

Let's look at a two-year stock chart with regression channel and 10-day momentum on the bottom.
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Revenue over the trailing-twelve months has increased for 50 consecutive quarters, breaking a new high each time.

NFLX's fundamental five star rating benefited from these results:
1. The one-year change was positive.
2. The one-year change was greater than +20%, which is an extra boost to the rating.
3. The two-year change was positive.
Finally, the 50+ consecutive quarters of an upward trend in revenue benefited the fundamental star rating.

Let's look at the remarkable time series of revenue TTM US$ Millions in the chart below.
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Before we turn to earnings and cash flow analysis, let's look at a different view of revenue on a scatter plot with peers for some perspective. On the x-axis we equal space the companies and on the y-axis we plot revenue TTM per employee in $millions.

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Netflix generates $2.4 million per employee which is larger than any company in all of technology including AAPL. This is starting to get ridiculous, but it's real. These are objective measures of fact.

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Net Income over last year for NFLX fell 5.7% coming in at $193 million. The quarterly number was also lower given the expenses incurred to grow internationally, but I do note, the number was still positive. Netflix is going to sacrifice a bit of earnings now for more growth and earnings in the future. This is where the risk thesis lives. If Netflix misses revenue or reduces forecasts of future revenue, the stock could totally collapse. The market has been violently punitive to growth firms that miss forecasts; see Twitter as example A1.

In our next chart we plot net income TTM US$ Millions in the blue bars and the quarterly results in the gold line. Note the rising bars from a year ago and the dip in the gold line.
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Levered free free cash flow (FCF) is up 15% year-over-year and ~60% over two-years. In fact, levered free cash flow has broken a new all-time high for 20 consecutive quarters. That trend too may suffer, so Netflix better hit its revenue and subscriber numbers and not bring down forecasts.

Let's look at the visualization of FCF through time, below.
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Research and Development has broken a new all-time high for ten consecutive quarters and selling, general & administrative (SG&A) expense has broken all time highs for four consecutive quarters. The costs make sense given Netflix's venture into international markets. Expect to see both of these numbers rise. These will impact earnings and free cash flow, but, again, blow out revenue and subscriber growth numbers makes all of this worth it (a lot).

In our final time series chart we plot SG&A in the blue bars and Research and Development in the gold line.

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Summary
The bullish thesis for Netflix is simple: Netflix has broken everything. It has killed all of its competitors' attacks and created such a large new industry that massive technology companies (like Amazon) are entering while old school media are hurrying to do it themselves (like Time Warner/HBO). Netflix is the giant. New players emerged with the backing of Netflix's content competitors and now everyone is simply copying Netflix. And now the impossible is happening; growth and acceptance internationally seem like they very well may surpass domestic sales sooner rather than later. Margins are increasing faster than anticipated domestically and if that is coupled with hitting subscription growth forecasts, that's a truck load of money to the firm.

The bearish thesis for Netflix is based on a weakening international economy which includes both the EU and emerging markets, a strong dollar (which hurts all of the numbers reported by Netflix other than the actual number of subscriptions) and ultimately a break-even point internationally that does appear to be much higher than that in the U.S. Further, the company's stated goal of 60-90 million domestic subscribers could suddenly feel closer to the low end if growth declines and that could be a catastrophe for the stock. The lock out of China is actually a hedge in that nothing is expected, but if real headway is made, NFLX stock could double in a year.



The bottom line is, if Netflix misses revenue and subscriber numbers the stock could trade much lower and a 20% dip from the highs will look like a fantastically high valuation and a terrible time to get long. Content development is also a risk to eye as is the ever present Apple and Apple TV.

But if Netflix hits and exceeds revenue and subscription growth numbers and continues on its path to increased domestic margins, my goodness, this company could be worth $100 billion in market cap in a matter of two-years. Make no mistakes, the risk is gigantic. The opportunity is equally as gigantic.

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