Irrational Competition Makes Netflix Stock’s Long Term Ominous (NASDAQ:NFLX)

Netflix

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By Valuentum Analysts

Nobody truly thought that Netflix (NASDAQ:NFLX) would have made it this far. The company has seemingly always had poor credit metrics, and how could a company that was founded on mailing DVDs transition to streaming effectively. Well, despite the long odds, Netflix has done it, and the company has done so well that it even became one of the tech giants in the acronym “FANG” — consisting of Facebook (META), Apple (AAPL), Netflix and Google (GOOG).

As we look out over the next few years, however, the path for Netflix may seem a bit more troubled than that of five years ago. For starters, it seems like there is a new major streaming servicing popping up every year or so, and premium channels continue to compete for consumer dollars. The content that Netflix has produced keeps customers coming back for now, but it’s a hugely costly endeavor at times, and some content just doesn’t resonate.

The industry has changed quite a bit during the past decade, and while Netflix’s competitors are going full-steam ahead with content creation, Netflix is now the one pulling back a bit, focusing more on profitability. Here’s what the company wrote in its third-quarter shareholder letter:

Our competitors are investing heavily to drive subscribers and engagement, but building a large, successful streaming business is hard – we estimate they are all losing money, with combined 2022 operating losses well over $10 billion, vs. Netflix’s $5 to $6 billion annual operating profit.

Though we applaud Netflix’s focus on profitability, having rivals that are investing heavily to steal one’s customers is never a good thing, especially if they may be acting irrationally. For some time, Netflix has been competing with Amazon (AMZN) Prime, but the number of streaming services has exploded in recent years. Disney (DIS) Plus, HBO Max, Hulu, Paramount (PARA) Plus all have attractive attributes, and while there may be many winners, industry economics may not end up too attractive in the long run.

Netflix’s Key Investment Considerations

Investment Considerations

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Netflix is a video streaming service where subscribers can watch unlimited TV shows and movies streamed over the internet to their TVs, computers, and mobile devices. The company has over 220 million paid memberships in 190+ countries. Its international growth runway is enormous, though its domestic operations are more profitable.

As Netflix continues to scale up its business, we forecast in our valuation model that the company will eventually become a free cash flow cow, but such a view cannot be guaranteed, especially as irrational competition heats up. Paid subscriber growth and future pricing increases are expected to improve its financial performance over the long haul.

Netflix’s total contractual obligations (debt, content, lease, and other purchase obligations) are simply enormous. Should Netflix’s paid subscriber growth disappoint, its outlook would weaken materially. The company’s paid subscriber base has grown at a robust pace in recent years, though maintaining that level of growth may prove difficult going forward.

New market entrants have created sizable competitive headwinds for Netflix, though its longer term growth outlook remains promising, albeit one with plenty of risks. The company needs to retain access to capital markets to be able to fund its growth ambitions and refinance maturing debt.

Netflix is investing heavily in original content to differentiate its service in the crowded industry it operates in. Part of this strategy involves placing a great focus on growing its local language content library in numerous markets worldwide. During the third quarter of 2022, Netflix had some big winners with respect to content including The Jeffrey Dahmer Story, The Gray Man, and Purple Hearts.

We’ll be monitoring how Netflix’s lower priced ad-subscription plan performs in the coming years, but it is another lever that the company can pull — in addition to price increases and cracking down on sharing passwords — to drive revenue higher. Given its large membership base, even small successes in this area could be a needle-mover. Management expects its low-priced ad plan — Basic with Ads — to be about $6.99 per month in the U.S. and have about ~5 minutes of ads per hour.

Netflix’s Cash Flow Valuation Analysis

Cash Flow Generation

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The discounted cash flow [DCF] model gets a lot of criticism these days, but it’s still the best way to look at companies. For starters, we may never know, or rather can never know, with precision the exact intrinsic value of a stock because of the forward-looking nature of forecasts and the subjective substance of estimating discount rates, among other future considerations. To be successful, the analyst, however, does not have to know the true intrinsic value with precision.

The goal of enterprise valuation in stock analysis, or valuation approaches in equity investing, more generally, is not to pinpoint precisely what a company’s stock is worth. This is impossible. Where most criticism of enterprise valuation rest is that the output of the process, the fair value estimate, is very sensitive to several key future assumptions and forecasts.

However, the very idea that those future forecasts are difficult to predict is consistent with the concept of pricing volatility, as future market expectations iterate over and over again, and logically defines enterprise valuation as an important causal pricing framework. Market volatility can be explained in part by changes in expected growth rates, interest rates, tax rates and other key drivers of the enterprise process.

That these assumptions are ever-changing and that prices are ever-changing is an important logical link. If, on the other hand, everybody knew the future, and therefore, the exact intrinsic value of stocks, we wouldn’t see much volatility in the markets at all. Stocks would, or rather should, trade at their “known” fair values. The fair value estimate sets the anchor for prices.

In some ways, it is the imprecision and sensitivity of enterprise valuation that may offer a core analytical advantage. In evaluating the sensitivities of certain drivers behind the company to changes in forward assumptions, one gets a feel for the valuation impact of a change in a particular driver. For example, a one-percentage-point change in the mid-cycle operating-margin assumption for a company such as Amazon could have widespread implications on an intrinsic value estimate given the company’s significant earnings leverage and sensitivity to small changes in its operating margin.

The same one percentage point change in the mid-cycle operating-margin assumption for a company such as Microsoft (MSFT), however, could be immaterial. The analytical inferences of assessing such sensitivities not only explain how changes in value occur, their drivers, but also why the share prices of some stocks are more volatile than others as a result.

To focus on precision in value estimation is folly, and it is neither the goal nor even the endeavor to pursue precise value estimation, as it is unreasonable to believe that even the most talented analysts can get every future assumption “correct” within the enterprise framework. Even if the analyst did get everything “correct,” the stock price may still not fully converge to that estimated intrinsic value if the market simply disagrees.

Incidentally, this is why paying attention to the information contained in share prices matters, even for value-focused investors (more on this later). In instances where price-to-estimated fair value convergence may never occur, however, it still is helpful to use the enterprise valuation framework to understand the drivers behind security pricing, and to arrive at a better understanding of the behavior of a subset of active management, or those that apply extensive discounted cash-flow modeling as a key driver of buying and selling activity, which causes price changes.

It should not reduce the utility of enterprise valuation even if one fully embraces the criticism that the future enterprise free cash flows of an entity will always be unpredictable to varying degrees. The future enterprise free cash flows of consumer staples stocks such as Coca-Cola (KO) or Kimberly-Clark (KMB) may be steadily growing, and analysts may be able to estimate such future enterprise free cash flows with only a very slight margin of error when they are reported.

On the other hand, the future enterprise free cash flows of a fast-growing Internet darling such as Meta Platforms or Alphabet may result in a much larger disparity between future projections and actual results when they come in. Therefore, it is only reasonable to assume that the analyst may require a much larger share-price discount to estimated intrinsic value in considering an investment in Meta Platforms or Alphabet than for Coca-Cola or Kimberly-Clark.

Let’s now talk Netflix. We think the company is worth $285 per share with a fair value range of $185-$385. Shares of Netflix are trading at ~$295 per share. The margin of safety around our fair value estimate is driven by the firm’s HIGH ValueRisk rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them.

Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 6.5% during the next five years, a pace that is lower than the firm’s 3- year historical compound annual growth rate of 23.4%.

Our valuation model reflects a 5-year projected average operating margin of 19%, which is above Netflix’s trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 8.4% for the next 15 years and 3% in perpetuity. For Netflix, we use a 10% weighted average cost of capital to discount future free cash flows.

Valuation Breakdown

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The Importance of a Margin of Safety

The concept of a margin of safety is well-documented in the writings of Benjamin Graham and the works of his student Warren Buffett. A stock trading at $50 per share, for example, but estimated to be worth $100 per share may offer the investor an adequate margin of safety because, even if the true intrinsic value of the company is $75, the large difference between price and the estimated fair value offers the investor a very important safety-net against losses.

Whether the market ever comes to price the stock at $75, however, is another thing altogether, and a consideration that makes observing price activity and the information contained in prices all the more relevant. Graham and Buffett’s margin-of-safety framework can be further extrapolated to view equity valuation in the context of a range of fair value outcomes or a cone of fair value possibilities, with the fair value estimate being the most likely probability along a fair-value distribution function.

For example, it may not necessarily be accurate to say that a company is worth precisely $25 per share, when the stock is likely worth somewhere between $20-$30 per share, and it may not be truly undervalued or overvalued, respectively, until it breaches these bounds around the fair value estimate. But why? Well, an analyst can only estimate what a company’s future enterprise free cash flow stream will look like.

Certain factors will hurt that enterprise free cash flow stream relative to forecasts, while other factors will boost performance relative to expectations. That’s how a downside fair value estimate and an upside fair value estimate could be generated to form a fair value estimate range of $20-$30 in this discussion. Value can never be a precise point fair value estimate because the future cannot be predicted with precision. Now let’s look at Netflix’s margin of safety.

Range of Potential Outcomes

Range of Potential Outcomes (Image Source: Valuentum)

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate Netflix’s fair value at about $285 per share, every company has a range of probable fair values that’s created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Netflix. We think the firm is attractive below $185 per share (the green line), but quite expensive above $385 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

The discounted cash flow model gets a lot of criticism these days, but it is the best way to estimate the intrinsic value of a company, in our view. Multiples suffer as they use single-year snapshots of a particular metric, and those that use multiples make all the assumptions of a DCF in one fell-swoop because every multiple can be expanded to a DCF. Those that use multiples instead of the DCF may not even know they are implicitly using the DCF whenever they assign a multiple to a stock!

Concluding Thoughts

Netflix may be the best positioned streaming service out there with higher engagement than that of Prime, Disney Plus, Hulu, but competitors are not backing down, and that means competition is likely to step up considerably in coming years. Netflix is facing some headwinds due to the stronger dollar, but that is of lesser concern in our view than how the industry shakes out in coming years.

Developing new revenue streams such as advertising and paid sharing will be key, but these are obvious business models, and given how fast the advertising market has deteriorated the past few quarters, we’re not sure how successful Netflix will be in taking share against Google, TikTok, and Facebook in the current an ultra-cyclical demand environment. We take Netflix’s additional revenue streams into consideration with respect to our fair value estimate.

We don’t like the streaming industry backdrop as much as we use to — Netflix’s rivals are investing billions to scale up their services, and this has forced Netflix to continue to adapt, whether it be spending more on content or rolling our lower-priced ad plans to compete. Our fair value estimate is currently in line with where shares are trading, but we wouldn’t be surprised to see shares trade down to the low end of our fair value estimate range ($185) in coming years.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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