Netflix, Inc. (NFLX) has lost 30% of its market cap since July 2018. Nevertheless, it is my strong belief that now is not the time to catch this falling knife. In fact, I argue that there is a lot more downside to come.
The Elephant in the Room
Most investors readily understand that Netflix has a high level of cash burn, or as CEO Reed Hastings calls it "cash investment." Further, during the market boom, few investors have questioned Netflix' amortization of its content schedule. However, back in the second quarter of 2017 Netflix's 10-Q states:
''The amortization period typically ranges from six months to five years.''
Then, once we fast forward 12 months, does the quality of Netflix's content dramatically improve, giving it that lasting appeal with consumers? I doubt that. Yet Netflix tweaks its amortization schedule in the second quarter of 2018:
"[...] we amortize the content assets [...], over the shorter of each title's contractual window of availability or estimated period of use or ten years."
This change of accounting is not difficult to understand. In essence, what Netflix is doing, is delaying expensing its content through its income statement. Any time that Netflix delays recognizing its expenses, the company succeeds in improving its overall operating margins.
Moreover, Netflix guides investors that over time its operating margins will continue to rise toward 13%. Even if this was to occur, it would imply that, although Netflix has guided that for 2019 it will have free cash flow burn of $3 billion, reaching peak cash burn, it would at some point in the future generate around $1.6 billion-$1.8 billion of positive free cash flow. In other words, Netflix presently trades for more than 65 times forward best-case scenario free cash flow.
Netflix has been able to sustain itself in an environment of abnormally low interest rates. Since the company consumes large amounts of capital it consistently falls back on its statement that,
''Our debt levels are quite modest as a percentage of our enterprise value, and we believe the debt is lower cost of capital compared to equity.''
Now, there are two problems with this statement:
First, to argue that debt levels are "modest" as a percentage of enterprise value, amounts to circular reasoning. Enterprise value is derived from debt plus market cap valuation. This argument does not provide investors with a margin of safety.
A company's market cap is the value at which investors are happy to price a company. If for some reason Netflix's growth was to slow down, investors might swiftly sell the shares, which would cause its valuation to fall. Thus, all of a sudden, Netflix's debt levels would no longer be a modest percentage of enterprise value.
The second problem for Netflix is that its debt has high appeal among creditors for as long as its revenue continues to increase, and the business model is a proven success. But as soon as Netflix's growth rate starts to decelerate, Netflix will struggle to raise debt on flexible and accommodating terms.
Which brings me to Netflix's declining growth rate. As the graph above illustrates, Netflix's guided fourth-quarter 2018 revenue points to the slowest growth rate in two years. Yet, at the same time Netflix's cash burn continues at an alarming rate.
What might be causing a slowdown in Netflix's revenue?
Who Is Watching Netflix? The Competition
Netflix's business model certainly has a lot of appeal. So much so, that the competition has taken note -- and are now pressing forward. Amazon Video, Apple, Disney+ and others are now jumping on the band wagon, developing their own direct-to-consumer strategies.
In fact, starting 2019, the space for scripted content is going to explode and become insanely competitive. Consumers will have more choice than ever before, in terms of both quantity and quality, and all available at a full range of price points.
In essence, what was previously Netflix's main competitive advantage -- a very affordable package for consumers -- will materially weaken. Particularly, given that tech-juggernauts Amazon (AMZN) and Apple (AAPL) are both likely to give up their top-rated content for free (or with minimal strings attached).
Netflix's End Credits
Given that Netflix's Streaming content obligations will be over $8 billion over the coming 12 months, and that the company only has $3 billion of cash and equivalents, Netflix will be left with few options but to raise the average selling price (ASP) of its packages, in order to bring in some much-needed liquidity onto its balance sheet.
For investors weighing whether the fall in Netflix's share price over the past three months offers a necessary margin of safety, I recommend that they stay firmly on the sidelines. This stock is materially more dangerous than meets the eye.