Thursday, April 16, 2020

Short Idea: Netflix

Looking at the Netflix results for 2019, I noticed the following:

  • Pre-tax income $2 billion
  • Additions to streaming content assets $14 billion
  • Amortization of streaming content assets $9.2 billion
They outspent the amortization of prior years' content by $4.8 billion. That means the business currently consumes cash. So is the net income figure real? Is the business worth anything - will it generate cash some day?

The answer to that revolves around whether Netflix's amortization (the way that the past expenditures on content are included in expenses over time) aligns with the useful economic life of that content. Here is how the annual report describe the amortization accounting:
Based on factors including historical and estimated viewing patterns, we amortize the content assets (licensed and produced) in “Cost of revenues” on the Consolidated Statements of Operations over the shorter of each title's contractual window of availability or estimated period of use or ten years, beginning with the month of first availability. The amortization is on an accelerated basis, as we typically expect more upfront viewing, for instance due to additional merchandising and marketing efforts, and film amortization is more accelerated than TV series amortization. On average, over 90% of a licensed or produced streaming content asset is expected to be amortized within four years after its month of first availability. We review factors that impact the amortization of the content assets on a regular basis. Our estimates related to these factors require considerable management judgment. Our business model is subscription based as opposed to a model generating revenues at a specific title level. Content assets (licensed and produced) are predominantly monetized as a group and therefore are reviewed at a group level when an event or change in circumstances indicates a change in the expected usefulness of the content or that the fair value may be less than unamortized cost. To date, we have not identified any such event or changes in circumstances.
That last sentence in the disclosure is eye opening. They have never taken an accelerated write-off of content that flopped? They've certainly had flops: Let's look at a detail of Netflix's expenditures on content vs amortization of content (the subsequent recognition of the expenditures in the income statement) over time.


Over the past five years (2015-2019) Netflix's spending on content has exceeded amortization by a total of $20 billion. They reported $3.9 billion of cumulative net income over that five year period. So the confidence interval around the true profitability of their business is that they earned somewhere between -$16 billion and +$3.9 billion. It is hard to reject the hypothesis that they are actually not profitable.

Suppose that Netflix subscribers need a constant stream of new content in order to stay interested and maintain their subscriptions. In that case, the true profitability of the business is toward the bottom end of that confidence interval.

Here is the argument I would make for pessimism about what subscribers are likely to want, and what Netflix profitability truly is. The highest value customers are the loyal ones who do not churn. Maintaining those subscription revenues does not require any marketing expense, but it will require fresh content.

The reported net income of Netflix is very sensitive to the amortization assumptions. Think about it: they had pre-tax income of $2 billion last year and spent $14 billion on content, only recognizing $9.2 billion of expense from prior years. In 2018, they spent $13 billion on content. A relatively small change in the useful content life assumption (recognizing an extra 15% of the prior year's spending) would wipe out reported profits for 2019.

When looking at a business that has had substantial growth - and Netflix has had very strong revenue growth - I think it is interesting to see how the growth was financed. Here is an example of the kind of value destruction that this can detect:
Here is the acid test of whether this is a good business or not: how did they fund that massive asset expansion from $68 million to $159 million? (Those are the figures net of depreciation; which required over $150 million of gross investment.) Did they bootstrap with cash flows, denying shareholders dividends but building the business with retained earnings? The answer is that total liabilities grew from $28 million in 2003 to the present level of $116 million.
How did Netflix finance its growth? At 12/31/14 (the beginning of the five year period), they had total liabilities of $5.2 billion and current assets (excluding capitalized content) of $1.1 billion, for a net of $4.1 billion of liabilities. At 12/31/19 (the end of the five year period), total liabilities had grown to $26.4 billion against $6.2 billion of current assets (excluding content), for a net of $20.2 billion of liabilities.

So, net liabilities grew by $16.1 billion over five years. They also grew the share count by 16 million shares which brought in close to $2 billion. A total of $18.1 billion of debt and equity (mostly debt!) capital raised for growth. This is in the same range as the earlier estimate (-$16 billion) of losses over the past five years. 

I am out of step with the market this cycle because I truly believe that companies that are not bootstrap profitable - that grow revenue but have to do it by selling debt and equity instead of reinvesting profits - are destroying value. They are Soviet style "negative value added" businesses, they are only worth money as enterprises in a bubble context, and they will eventually have to go away because there is not an infinite amount of wealth in the world to destroy. (Another example that cannot report profits even with the most aggressive accounting assumptions is Tesla.)

Businesses that create value return capital to their owners. The best businesses in history have been able to do this while growing. Think about it: what is a legitimate market signal that many more customers need to be served, and money invested in expanding to serve them, except profits?

Bulls will argue that Netflix could be, will be, more profitable when it raises prices. Why wait? Do you know many real entrepreneurs who borrow money instead of charging more if customers are happy to pay?

What do you pay for a business that is growing but where you have to squint to see whether it is profitable? Would you believe that the current market capitalization of Netflix is 9x sales, close to the magic 10x number?

20 comments:

Allan Folz said...

Businesses that create value return capital to their owners. The best businesses in history have been able to do this while growing.

You know what is absolutely hated -- out of step with the market cycle, if you will? Tankers. They are paying down debt, increasing dividends, trading a P/D (dividends)ratios instead of P/E's.

It's a little funny because just today there was a twit discussion on whether one really could have made 40-50X on the last tanker cycle. (tl,dr: yes)

So far as I can tell most investors on twit are still fretting and arguing over the day's stock price and, like I was saying about the Fed and mortgage bonds, are fighting the last war carping about the 2008-2012 over-build. (1) (2)

If you actually read the companies' investor docs, every one talks about record low ship-building order book in the industry. Then they quickly follow-up with that they also have zero to two ships ordered. And investors still don't believe it. It's almost comical.

To be sure, I'm being careful. I check my work and my assumptions everyday. But it's incredible (or should I say so typical) that no one wants to go near an industry that is earning a return on capital, and FOMO's over ones that spent the last 10 years issuing debt to buy-back stock as a means of papering-over the c-suite cashing out 7 & 8 figure comp packages for themselves. Ship owners have a bad rep for self-enrichment, but it's no different, and probably less, than what Fortune 500 management has done for themselves the last 10+ years.

Stagflationary Mark said...

After reading this post, I am now watching for the eventual and guaranteed exponential trend failure in the adjusted stock price (counting dividends and splits) of Netflix. It is definitely following unsustainable exponential trend behavior.

Fun facts:

* Since May of 2002, the exponential trend in the adjusted stock price has been growing at a fairly consistent 2.86% per month.
* As of today, Netflix has a market cap of 193 billion dollars.
* Should the market cap continue to grow at 2.86% per month, in 10 more years the market cap will be 5.7 trillion dollars. This amount would be even higher if the number of shares outstanding increases.
* Netflix’s adjusted stock price is currently 10% above its long-term trend.
* In June of 2018, Netflix‘s adjusted stock price was 88% above this same long-term trend (using hindsight since the current trend to date was not knowable in 2018).

Fun opinions:

* A 5.7 trillion dollar market cap in 10 years is laughable unless we actually do hyperinflate by then. Extremely unlikely. However, if we do hyperinflate, Netflix would be just about the last stock I’d want to own. I would cancel my Netflix subscription.
* Netflix is certainly not a bargain just because it’s only slightly higher in price than it was in June of 2018. Using hindsight, June of 2018 was definitely no bargain!
* I have absolutely no desire to buy Netflix stock just because many people are home right now watching Netflix. Everyone already knows many people are home right now watching Netflix. It should already be priced in, and then some.
* Netflix has become a long-term “sure thing” self-fulfilling prophecy, which inevitably ends very badly. There are no sure things. If there were, we’d all be rich.

Being the retired investment risk coward that I am, I will not be shorting Netflix. I can certainly understand the appeal though!

CP said...

Bearish argument on tankers:

They will make a lot of money as floating storage for as long as the crude oil contango persists. (https://quotes.ino.com/exchanges/contracts.html?r=NYMEX_CL)

But what happens after that?

Allan Folz said...

Bearish arg's... There's a twet for that too. :)

I think people are under-estimating how long the storage trade will last. We are looking at 10-20 MBPD surplus for the next 60-90 days. I'm seeing it said land storage will be full by May 1. (I should try to verify this myself, but given skyrocketing rates for VLCC's it seems legit.) That's 5-10 VLCC's into storage per day starting ~May 1, or 300-900 VLCC's. I think I saw the world fleet of VLCC's stands at 900-1100. So, 50-100% of the world's fleet gets set aside for storage? Then for every day of surplus you need that many days of shortage to drain the reserve. If they cut to even for 90 days before, finally agreeing to go negative and work-off the storage, that's a year from now before fleet is back to just shipping duty, albeit after that, with land storage full there will be a period of time when that will need to be worked off too.

I'm actually on guard for the possibility that storage trade lasts just slightly long enough to pull in all the doubtful types that think it is over this year. If goes into Q1 and beyond will investors then pour into the trade?


I do agree if there is a world-wide downshift in GDP oil shippers will feel it among the worst. They are a lever on GDP.

Ponch73 said...

NFLX hasn't generated positive free cash flow since calendar year 2011. Its current invested capital base is roughly $27 billion. That's an ugly combination. Nevertheless, these dynamics have remained consistent for 9 years, and the market has chosen to look past them.

What's the catalyst for the market beginning to value NFLX rationally? Increased churn as a result of competition from the likes of Disney and other content owners? Dramatic increase in content acquisition costs? Something else?

As an aside, I worked for NFLX's current CFO in a former life. He's very smart, but also the kind of guy who wouldn't hesitate to run you over with his car if it meant even an infinitesimal improvement in his career standing.

Allan Folz said...

Global VLCC fleet is 800.

"As of April 16, data provided by VesselsValue shows that of the 802 VLCCs on the water 60 are now being used as floating storage. Suexmaxes come in at 37 of the 566 live vessels while crude Aframaxes number 35 out of 694." (1)

Taylor Conant said...

Great writeup on Netflix. I would never short anything unless the market was giving "can't lose odds" on the price of the instruments involved, because it doesn't seem possible to consistently identify when the catalyst will occur that will resolve the short thesis. But your argument on the unviability of the business was solid and concise-- if you compare the economics of Netflix to a pure entertainment co (HBO, DreamWorks, that part of Disney, Pixar, etc.) you can see it is not a viable business. It's too bad you can't spot great longs as well as you can spot good shorts!

Anonymous said...

Great argument, but don't short, just walk away.

Anonymous said...

I'd move Netflix puts on the back burner, CP. It will work best when diagnostic tests ramp up and people feel safe leaving their homes, esp in urban areas. Who's going to watch Netflix once it's safe to travel again? Nobody. It is all about timing the drop in subscriptions / revenues... although one should always compare the relative value against comps at that point in time. Glta!

russ said...

The orc cop movie was pretty good.

CP said...

https://www.youtube.com/watch?v=6EZCBSsBxko

Anon2 said...

Looks like a pozzed Alien Nation.

Which brings up the second problem with Netflix, they've put politics ahead of business.

CP said...

See, a lot of the Netflix originals are trash. And they're spending tens of billions on this and pretending they are long term investments.

Anonymous said...

I agree that content cost/revenue model for Netflix does not make sense and they will probably have to create an ad revenue stream (possibly like Hulu with tiered pricing, no adds for a premium/some adds for cheap tier) at some point, but even then they will have to cut spending to a level lower than recent years. Historically, movie content got subsidized by box office/dvd sales, tv content got subsidized by ads/cable fees, but Netflix's streaming platform only monetizes through streaming fees. To some extent Hulu, Amazon Prime and Disney+ all have secondary cash flow streams and Netflix will have to develop one when the equity/debt markets wake up one day.

CP said...

Not a $200 billion business. Laughable.

Maybe $20 billion?

Anonymous said...

Agreed that the value of the content library is key and that the amortization policies are critical to understanding Netflix's current and future profitability. That being said, it is misleading to use a traditional theatrical lens to analyze Netflix because 1) it's a subscription business, not a transaction business and 2) content value is not linear

If you're trying to draw people to buy a ticket to see a movie in a theater and each movie is a discrete entity with it's own profit participants, it makes sense to analyze the returns of each movie. If you own all the profit (like Disney), it makes more sense to analyze the overall slate (perhaps each year) because naturally some movies will be hits and some will be duds and you want to know the value of all your efforts. The question of whether an individual piece of content hits or fails is somewhat irrelevant compared to the effectiveness of the total spend. Yes the Will Smith movie was probably a flop. But how much do you think Tiger King cost? Almost nothing by comparison and it is a massive hit that has been a top 5 most watched piece of content since launch and driven huge amounts of free press for Netflix. If you are a subscription service, the real measure of success is related to gross additions and churn.
I would criticize Netflix for not disclosing these key metrics rather than cherry picking individual pieces of content as being overpriced.

CP said...

So why do you think they don't disclose those key metrics?

Quite a few public companies seem to be fraudulent stock promotion schemes. You can tell because they raise capital but hide information ("key metrics") that would reveal they have broken business models. We have seen this before:

If the well was drilled by an entity with a cost of capital of 50 percent, it would definitely be a losing proposition. That would be a sign that the entity did not make effective capital allocation decisions. The decisions could be rational if the entity had hidden motives; perhaps principal/agent conflicts like a desire to look busy and stay employed drilling wells. By the way, how could the agents of that entity hide this? They would want to focus attention on the highest point on the chart, namely the nearly-instantaneous rate of initial production, and avoid discussing the rate of production decline, the present value of revenue, the present value relative to cost, and the internal rate of return of the well relative to other opportunities (like buying back debt) or to doing nothing.
http://www.creditbubblestocks.com/2012/08/modelling-unprofitable-oil-well.html

Fundamentally, they have not released what I would consider truly useful information about their well performance to date in the Bakken. They also have not addressed the concern about the debt maturities and capital structure. It seems to me that no news is generally bad news in cases like this.
http://www.creditbubblestocks.com/2012/04/gmx-resources-gmxr-provides-operational.html

What you will often find with E&P companies is that they will announce a production metric on a new well that tells you almost nothing. With production rates, it is important to know over what time period the test took place. This well is still on confidential status in North Dakota and the company isn't saying what time period that rate was over, what the decline rate was, etc. They are also reporting a "barrel of oil equivalent" number and not giving the breakdown between oil, NGLs, and natural gas. A guy actually called investor relations today and asked for the breakdown: no comment. He also asked whether or not the well is connected to a pipeline so that the natural gas can be sold. Again, no comment. I suspect it is being flared like other North Dakota wells.
http://www.creditbubblestocks.com/2012/04/gmx-resources-gmxr-and-not-very.html

Key principle: no news is bad news.

CP said...

Glenn Chan has noticed this:

Estimating a resource (e.g. oil, gas, minerals, etc.) is inherently subjective. Because of this, there is room to be overly optimistic. Many management teams in the resource sector have figured out that they can pressure their reserve estimators into delivering inflated estimates. The interesting thing about this is that management can blame the engineer if there are problems with the estimate. Management can basically get these engineers to lie for them without having to take any responsibility for those lies.
https://glennchan.wordpress.com/2014/06/10/smart-fraud/

When oil and gas companies sell assets to each other in private transactions, they will often open a data room where the acquirer’s team of engineers can look at the data and perform their due diligence. I find it strange that supposedly sophisticated institutional investors are comfortable with oil and gas stocks without being able to perform this level of due diligence.
https://glennchan.wordpress.com/2014/03/17/my-approach-to-shorting-oil-and-gas/

The majority of the promotions in the independent oil and gas sector don’t have promotion-friendly properties. Many of them are involved in the hype surrounding shale gas and shale oil. Because shale wells can be built quickly, a promoter can’t make too many outrageous promises about them. The wells should come online within a few years and demonstrate cash flow (or a lack of it). One way around this problem is to constantly be growing. When a company is rapidly expanding, it is difficult for investors to figure out the cash flows and economics of the old assets. As well, problems with aggressive accounting are pushed further out into the future.
https://glennchan.wordpress.com/2014/01/04/how-would-a-sociopath-fleece-investors-in-oil-and-gas/

He says, "Does the company try to help investors understand the assumptions behind the reserve estimates? This almost never happens. Companies rarely state projected cash flows, decline curves, etc. etc."

Anon2 said...

how much do you think Tiger King cost?

LOL. How much cash flow do you think Tiger King generates a year from now. People act like Netflix' catalog is comparable to the golden age of sit-coms. It's more like Lost in Space and Fall Guy re-runs. Netflix even openly states they aim for quantity over quality. OK, I'm game, but then why are they also paying top dollar to create that trash?

It is fitting CP brings up oil frackers. Netflix library is like a fracking well. Everyone thinks it's going to residual like a traditional well. It's not. It's has a couple great quarters when new, but then quickly dissipates, never quite covering it's cost of capital to create.

Once Netflix is cut off from capital markets -- and they will be, see for example Q3/Q4 2019 -- stock will crash and then it's a long, drawn-out restructuring story as bond holders fight over the corpse.

CP said...

Many such cases:

"In the last nine quarters (2018-YTD), Snap has issued 260m shares to employees (22%). That’s $4.2bn in new shares issued.

In that time they generated $3.4bn in revenue. So they’ve issued $1.24 to the market in shares for every $1 in revenue."