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Down Goes Netflix
The bar was set low and Netflix still tripped over it
Netflix laid another egg on Tuesday. The streamer badly missed on subscriber growth in Q1 2022, actually losing subs (-200,000) for the first time in a decade. Previous guidance — already poorly-received by investors — called for 2.5 million new subscribers this quarter. Not even close.
The bar was set low and Netflix still tripped over it.
Wall Street was not thrilled. NFLX fell by as much as 38% yesterday amid a flurry of price target downgrades, made all the worse by Netflix’s estimate of another 2 million lost subscribers in the upcoming quarter.
Even after this week’s steep drop, I don’t have any particularly dazzling insights or convictions on Netflix as an investment. But this whole rigamarole is EXACTLY why I favor value investing…
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It’s easy to fall in love with Netflix’s story: The once-plucky upstart that conquered the video rental market. The cutter of cables that grew into the world’s largest streaming service.
There’s a certain romance to investing in a company that legitimately upended the entertainment world — but that leaves investors perilously close to succumbing to hype. There’s been a lot of that in Netflix’s shareholder base over the past few years.
But, in value investing, story doesn’t matter.
What does? Valuation.
When Netflix hit $700 per share last November (thanks to Squid Game mania), it traded at north of 60x earnings. That right there pretty much rules out cheapskate value investors like me, especially since Netflix was already a large-cap company.
As I’ve mentioned before, Dr. Jeremy Siegel’s research on the subject is crystal clear: High valuations and large-cap companies are a volatile mix that costs investors money.
“History has shown that whenever companies, no matter how great, get priced above 50 to 60 times earnings, buyer beware.” (Siegel)
It doesn’t matter how much I use Netflix or whether I prefer the service over Paramount+, Hulu, Peacock, Disney+, et al. Either the numbers make sense or they don’t. And, with Netflix, they’ve never really made sense.
Valuation always matters. You can pay too high a price for growth. Even explosive growth.
Even Netflix’s big drop in January only burned off some of the over-valuation. NFLX lost 20% over night, but still traded at close to 40x earnings.
Not very tempting.
Especially considering concerns over the streamer’s slowing subscriber growth (lol), content costs, and churn.
This is the problem with overvalued stocks. Growth can’t (and won’t) go on forever. And, when a large-cap media behemoth like Netflix trades at nose-bleed valuations, any little bump in the road brings the whole house of cards crashing down. Far too risky for me.
I don’t know where Netflix goes from here — up or down — and I’m still digesting whether this latest price plummet puts it back in my value wheelhouse. (Doubtful, but I’m keeping an open mind.)
But I still have some big concerns. Namely:
Minimal free cash flow
Sky-high valuation (at least until yesterday)
Ever-rising content costs
Back in February, after Netflix’s first big drop of 2022, I touched on these concerns. Not much has changed on this front since then, so I’ll re-up those thoughts below.
On free cash flow:
After years of big FCF losses, it briefly turned positive in 2020 before sinking back negative this year. One explanation for 2020’s high mark is that content costs (the price of creating, producing, and licensing new shows and movies) were much lower that year as studios shut down during the pandemic. Once large-scale production resumed in 2021, FCF turned negative once again.
Netflix isn’t exactly undervalued, even after its recent slump. NFLX still trades at 40x earnings, which ranks well above other blue-chip tech growers like Apple, Meta Platforms (formerly Facebook), and Alphabet (formerly Google).
It’s not rocket science that companies can only support higher valuations if they’re still growing. Fast.
But the bigger the company, the harder it is to grow. And Netflix is already pretty darn big with 222 million global subscribers.
Netflix’s recent nosedive shows the danger of playing in this high-risk area of the market. Any sign of weakness, no matter how small, can cut that lofty P/E ratio down to size.
On content costs:
It all comes down to content costs. Shows like The Crown, Stranger Things, and The Witcher (among many others) don’t come cheap. In fact, each of those three reportedly costs more than $10 million per episode to produce.
The $13-17 billion annual content outlay, which increases each year, remains a major drag on the company’s cash flow. If it’s driving growth, no big deal. If it’s just playing defense against Disney+ and other rival streamers, then we’ve got a problem.
These costs could be a perpetual issue for Netflix, since it needs to build up a huge library of content practically from scratch. Content that Netflix used to license from Comcast, Disney, Warner, ViacomCBS, etc. is being clawed back for those companies’ own streaming services. And, through no fault of their own, Netflix’s library of legacy content pales in comparison to the others.
Content costs aren’t going down any time soon and Netflix will likely always need to be at the head of that pack. It’s gonna get expensive.
Arguably, only the valuation metric looks better today than it did a few months ago. FCF could improve if Netflix cracks down on password sharing and implements a lower-cost, ad-supported subscription tier. But, for now, that’s just speculation.
Anyways, I feel for Netflix bulls.
It’s never fun to see almost 40% of an investment position wiped out in one day. But it’s a whole lot nicer to look at all of this as an impartial observer and not a panicked investor.
I’ve got the timeless principles of value investing to thank for that.
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Disclosure: This is not financial advice. I am not a financial advisor. Do your own research before making any investment decisions.