As I’ve written before, an investor can’t just look at the current fundamentals surrounding Netflix, Inc. (NASDAQ:NFLX) stock. The NFLX stock price is roughly 90x 2018 EPS estimates, and cash flow admittedly is sharply negative. But net margins are narrow, and subscribers are growing, meaning earnings growth should be substantial going forward. And if the cash currently being invested in content is successful in attracting recurring subscriber revenue for years, as is the goal, then it’s money well-spent.
Of course, that “if” is one of the bigger questions surrounding NFLX stock. It’s why investors focus on subscriber growth over earnings. Get the subscribers on board, with relatively high retention rates, and scale will take care of the profit concerns over the long term. Incremental customers come at low incremental costs for Netflix. That creates the operating leverage which will drive earnings steadily higher for years to come and support the current NFLX stock price near $200.
The Q3 report looked strong enough to keep that bull case intact. But it also highlighted the key concerns that give me pause about NFLX stock.
Netflix’s Content Costs
Last month, InvestorPlace columnist Chris Fraley detailed three hidden dangers in Netflix’s Q3 report, among them disappointing U.S. subscriber guidance. But Fraley also pointed to the growing amount of commitment to spending on original content, some $17 billion at the moment.
Again, if that money is driving subscriber growth, it could be well-spent. But the ramp in content is close to breathtaking. On the Netflix Q3 conference call, chief content officer Ted Sarandos said the company would release 80 — 80! — original films next year. The company is moving into anime and continues to launch and develop big-budget recurring content as well. By 2020, Netflix expects roughly half of its content to be original, with CFO David Wells saying on the Q3 call the figure could get even higher.
Netflix executives, including CEO Reed Hastings, justified the spend by pointing to increases in operating margins. Revenue is growing faster than amortization of those costs. As a result, operating margins are rising from ~4% to ~7%. But how long does that last?
NFLX Stock Expectations
On its own, I don’t mind the rising content spend. Netflix makes a good case that, historically, that spend has been worthwhile, given the move of both the business as a whole and, now, even the international operations toward profitability.
However, the concern might be how, exactly, Netflix can ever pull back on content spending. Netflix is training its customers to believe that for ~$12 a month, they can have the content of several TV networks and several movie studios, each and every year.
Right now, the amortization of that content is leveraged by revenue growth. But that revenue growth can’t last forever. Q4 guidance suggests Netflix will end the year with 54 million subscribers in the U.S. That’s over 40% of the ~130 million households in the country. There is a saturation point coming in the U.S., and simple math suggests subscriber growth will slow at some point down the line.
The question is: Can content spend slow, too, in that scenario? And I’m not sure that’s necessarily the case. With competition from Amazon.com, Inc. (NASDAQ:AMZN) and Hulu, among many others, Netflix is always going to have rivals nipping at its heels. It will continually need better and likely more expensive content, which when revenue growth slows, will limit the operating leverage the company is driving at the moment.
The broader point here is that once revenue growth slows, margin expansion slows as well. And even if that point is several years out, it may not be priced into a stock trading at 90x forward EPS.
Netflix’s Owned Content
There’s another aspect to the focus on original content that might change the long-term case for Netflix stock. Netflix’s operating model is evolving. As I wrote last month, its dominance in the space seems to be eroding. Instead of being the leading portal for streaming content, it’s becoming a studio of its own, and its suppliers are leaving. Walt Disney Co (NYSE:DIS) is pulling its content from Netflix, instead reportedly going it alone with its own streaming service. CBS Corporation (NYSE:CBS) is focused on its All Access platform. Time Warner Inc (NYSE:TWX) unit HBO is keeping its content in-house as well.
Netflix is moving from being an aggregator of content to a provider of content. And I’m skeptical that’s an attractive move. At the least, it raises risk (and, admittedly, reward) relative to long-term subscriber growth. Licensing diverse content from diverse providers puts development risk on those providers. Netflix now has that risk itself.
Basically, Netflix is moving toward becoming its own HBO. And that raises a valuation concern. Bear in mind that AT&T Inc. (NYSE:T) is paying a bit over $100 billion for Time Warner, of whose profits HBO generates less than half. Netflix, including debt, is valued at over $90 billion.
Are we sure that an original content-driven Netflix is twice as valuable, if not more, than HBO? Presuming subscriber growth continues apace and margins catch up, perhaps it is. But it seems a big ask and a potential stumbling block as the NFLX stock price tries to clear $200 and stay there.
Vince Martin has no positions in any other securities mentioned.
