We know that the market can remain irrational longer than we can remain solvent. And when the fundamentals remain so detached from a valuation, investors start to throw in the towel and start to doubt themselves.
For now, Netflix (NFLX) remains a testing stock, which many are watching as a proxy for market sentiment. Ultimately, I'd argue that Netflix is a stock that needs to be avoided at all costs.
Missed Free Cash Flow Targets
Right off the bat, full-year guidance for free cash flow burn went from negative $3 billion to negative $3.5 billion. That extra $500 million of free cash flow burn was allocated towards higher cash taxes and additional investments in real estate and other infrastructure.
The way this was phrased in the investor letter, it made it seem like the extra loss was a one-off cost to the business. However, from my perspective, this is the cost of doing business. Higher taxes are simply the reciprocal of higher earnings, are they not?
Similarly, as the business grows over time it will continue to have a greater need for real estate and infrastructure. For a company valued at north of $160 billion, this level of cash burn should give investors pause.
What Are Investors Actually Pricing In?
For now, all we know is that Netflix's free cash flow capabilities are going to start to improve at some point after 2019, and that 2020 should see an improvement over 2019. But it will be several years before Netflix starts to break even on a free cash flow basis.
Having said that, new CFO Spencer Neumann made a point of stating that Netflix should start to be increasingly self-funding in 2020. Furthermore, what continues to be particularly bewildering for prudent analysts, is that once again management made references to Netflix having a significant cushion between its total equity capitalization and its debt-to-capital ratio -- surely, that can not make for a strong bullish argument on the company's stock price?
Is that not akin to saying that if the company misses its own internal estimates, and if the debt markets were to close themselves to Netflix, that Netflix will still be able to dilute shareholders, as a means of supporting its elevated free cash flow burn?
The whole thesis on Netflix is contingent on the company continuing to be viewed as the great growth stock of the past. It is not dissimilar to Keynes' beauty contest whereby investors are willing to pay up for stock if they believe others will find it attractive, too.
But Netflix's revenue growth is decelerating at a fast clip. In more detail, we can see that this time last year, Netflix's growth rate stood at over 40% both in the actual quarter of Q1 '18 and in its forecast for Q2 '18. This time around, for Q1 '19 revenue it was only up 22% and the guidance for Q2 '19 is pointing towards 26% growth.
This once again highlights the discrepancy between its top line growth rate and its valuation. For example, on average last year, investors were willing to pay 8x its revenue during a period when the Netflix's top line was growing at 40% year-over-year. Fast forward to this year, when its top line is only growing at mid-20% year-over-year, only now, investors are willing to pay 10x its revenue.
The International Opportunity
Netflix's investor letter made a point of highlighting just how fragmented the global mobile streaming market is. However, this is misleading on two counts. Firstly, because it is extremely challenging to monetize opportunities in overseas markets. Netflix is well aware of this difficulty since the operating margins which Netflix derives from its International members are approximately a third (operating margin of 12%) compared with what they are in the U.S. (operating margin of 34%).
Secondly, Netflix is not necessarily the type of platform that transports well to mobile, as viewers might find watching a 2-hour feature film on a mobile device challenging, especially compared to YouTube (GOOGL) or Snapchat (SNAP) . Thus to argue that Netflix has plenty of growth opportunities on mobile might be a stretch.
The Bottom Line
It's still extremely challenging for investors to make a rational bullish case for Netflix. The company's cash flow burn is going to come out worse than originally forecast. Its top-line growth continues to decelerate. The competition continues to make inroads into Netflix's space. And its valuation multiples are pricing in greater hopes and expectation in face of opposing facts.
All of this leads me to the conclusion that this stock should be avoided.