The fantastic growth story of Netflix (NASDAQ:NFLX) came to a grinding halt in the first quarter of 2021. Only 4 million new subscriptions were added globally compared to 6 million expected. Q2 of 2021 looks worse, with a forecasted gain of about 1 million more subscribers. NFLX stock as a growth stock may finally be transitioning into a value stock.
Covid-19 pandemic lockdowns helped subscriber growth last year so last year’s growth numbers were a bit of an anomaly. Netflix is still growing, but NFLX stock is not pricing in the inevitable slowdown in subscriber and revenue growth.
NFLX Stock Growth slowing down
The focus on quarterly subscriber numbers is all near-term noise. There are more serious questions to ask about Netflix’s long-term future. What happens when Netflix becomes a mature company? What happens when competition from Disney (NYSE:DIS) and AT&T (NYSE:T) chips away at subscriber growth? What happens if someday subscribers don’t grow at all? Netflix says:
“…the rise of streaming to replace linear TV around the world is the clear trend in entertainment.”
I wouldn’t say that’s a given just yet. I still expect cable and satellite TV to have a renaissance as viewers get tired of and overwhelmed by too many expensive streaming options. Many people are looking to declutter their lives and reduce expenses. Reducing multiple rarely used subscriptions is often a good place to start.
Content spending is still very high
One answer to Netflix’s slowing growth is more and better content. The two problems with that are 1) every other streaming channel is offering more and better content, and 2) it costs a lot of money to buy or produce more and better content. Netflix spends billions of dollars every year to license or produce content for streaming. The company has to refresh content constantly or else risk a high churn-off of subs.
Netflix will spend $17 billion in cash on content in 2021 according to CEO Reed Hastings. What is the expected return on that? Will viewers even care about content produced in 2021 five to ten years from now? It’s an interesting business model, but cash on cash returns are low, and may stay that way for the foreseeable future.
Netflix total content related finance obligations at year-end totaled $19.2 billion of which $12.2 billion is considered off balance sheet. I wonder if Wall Street analysts include this in their debt leverage calculations?
Valuation as expected, is stretched
Kudos to Netflix for transitioning from a DVD business to a streaming model, from a U.S. company to a global one, and from licensed only content to becoming a large-scale producer of its own content. The market has rewarded NFLX stock for that growth and innovation with a return of over 1,200% over the past 10 years. But the market looks forward, not backwards.
Currently NFLX stock trades at 49x 2021 estimate EPS and its enterprise value/EBITDA ratio is about 14x. The current price embeds about 35-40% annualized operating income growth for the next 10 years. That’s virtually impossible due to increasing competition, ongoing content spending, and the almost certain likelihood of an economic recession in the next 10 years. Giving NFLX a generous 20% growth rate for the next decade, the stock would be valued in the low-mid $300’s range according to a discounted cash flow calculation. Even at that price level, the company’s EV/EBITDA would still be stratospheric at 27x.
Conclusion
I’m probably the only person that still orders DVD from Netflix (yes still $239 million of revenues for Netflix!). It’s doesn’t make me an out of touch luddite (yes, I’m a digital subscriber as well), but it does give one a sense of technology history and how things change unexpectedly in the media world.
There is no margin of safety in Netflix stock now. Just look at the risk factors in the latest 10-K filing (page 4-16). There’s a lot of things that can wrong with NFLX stock, but only one or two things that can go right (get more subscribers forever, raise prices). The company expects to be free cash flow neutral this year, and have expectations that free cash flow will be sustainable going forward. This will allow them to be self-sustaining and avoid accessing the capital markets.
One scary comment in the first quarter 2021 press release was:
“Our board has approved a program to repurchase up to $5 billion of our common stock beginning in 2021 with no fixed expiration date. We expect our buyback program will begin this quarter.”
This is potentially disastrous. Buying back shares at extraordinarily high and unsustainable valuations is a sure-fire way to destroy shareholder value and waste the companies own capital. Particularly with the stock market at all time highs. Save your money, Netflix. That $5 billion will come in handy one day and could produce a lot of good movies.
At some point in the near future, Netflix will mature and it’s stock will catch up with the reality of its business. Then NFLX stock will join the league of fallen angels such as Cisco (NASDAQ:CSCO). All growth stocks become value stocks at some point, and Netflix’s transition may be sooner than you think.
On the date of publication Tom Kerr did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Kerr, CFA is an experienced investment manager and business writer who has worked in the investment and securities business since 1994.
