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:

Question I world love to ask $NFLX CEO Reed Hastings: how many users watched "Will Smith: Orc cop" this quarter and what is the current capitalized value of the original $90mm production cost?

Unfortunately it didn't pass the screening process for the prerrecorded YouTube video

— iso merry f🎄king christmas (@eriz35) October 16, 2018

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?

Out of the Money Puts?

Ridiculously overpriced garbage that might be worth owning puts on:

• TLT
• FB
• TSLA
• NFLX
• XOM

Cable Companies, Netflix, and "The Poverty Problem."

Last year, while we were short Netflix, I started paying more attention to cable companies. They have all been bleeding subscribers - hundreds of thousands of cancellations each quarter.

I found that there was one Wall Street analyst who was actually paying attention to the impoverished consumer: Craig Moffett, an analyst at Bernstein, who wrote a report called "The Poverty Problem.":

The often-quoted average family has annual income of $62,000 a year. But the median ... is only $42,000 a year. There's 40% of America that has no discretionary income... [T]he mean for each quintile was, in ascending order, $9,956, $27,275, $45,199, $71,241 and $149,951. The big take-away from this de-averaging exercise is that the top quintile now has 15 times the after-tax income as the lowest quintile. Forty years ago, this ratio was less than 8 to 1. [...] After the necessities of food, shelter, transportation and healthcare each month, the bottom 40% of U.S. households have already exhausted all of their disposable income. There is nothing left for clothing… for debt service… for cable… or for phone.

His argument was that this income distribution is uniquely bad for subscription TV providers. Close to 90 percent of U.S. households have cable TV. Hardly any other sectors are that exposed to the bottom of the U.S. income distribution; a group that is hanging by a thread.

Of course, big U.S. multinationals don't care about this (yet) because they think that they can sell Harley Davidsons to the Chinese. But owners of fixed assets like real estate, cable TV systems, and celular phone networks certainly need to care about the effects of global wage arbitrage.

Netflix Does Zero Coupon Convertible Bond Deal ($NFLX)

Netflix just announced a deal to sell $200 million aggregate principal amount of Zero Coupon Senior Convertible Notes due 2018. The Notes do not bear interest, and the initial conversion rate for the Notes is 11.6553 shares of stock per $1,000 principal amount of Notes, which is equivalent to an initial conversion price of approximately $85.80 per share.

The way to think about this deal is that the buyer is loaning Netflix $200 million at no interest for seven years, and is receiving seven-year options (which are really valuable) struck at $85.80 to buy 2.33 million shares. If you assume that those options would sell for $30, they would be worth about $70 million.

Other significant terms:

The completion of the private placement of the Notes is contingent on satisfaction or waiver of customary conditions, as well as a requirement that the Company shall have raised at least $200 million in aggregate gross proceeds from the sale of its common stock to non-affiliated third-parties.

Upon the occurrence of a change of control, which will be defined in the Indenture, each holder of the Notes will have the right to require the Company to repurchase some or all of such holder's Notes at a purchase price in cash equal to 120% of the principal amount thereof.

The Indenture will include customary covenants for convertible notes. In addition, the Indenture will contain a covenant restricting the ability of the Company to pay cash dividends or to repurchase shares of its common stock, subject to certain exceptions.

Smart Strategy for Netflix ($NFLX)

Since Netflix started licensing original series, the service has been seen as a potential savior for ill-fated productions that get shuttered over the objections of a cult following too narrow to sustain them. But rescuing a show that comes with a built-in audience--albeit one too small to survive on TV--may be a safer strategy than creating a new property out of whole cloth.

Netflix Crushed After Cutting Subscriber Guidance (NFLX)

ZH:"Netflix Plunges After Subscriber Guidance Cut".

Barron's:"...the world is moving to streaming and dumping discs, as evidenced from the big cut in Netflix’s DVD subscriber forecast. That makes outfits like Starz, which control distribution, more powerful..."

Yes! Here's the fundamental problem with Netflix: they were able to use the first sale doctrine to snooker Hollywood and build an impressive DVD rental business. Everyone assumed that this would translate into a profitable streaming business, as though a streaming business was just a question of "brand" or "mindshare". In my review of Hollywood Economics, I diagnosed the problem with Netflix:

[E]pstein has also written about the problems with the Netflix (NFLX) business model,

"Netflix can buy 10,000 copies of a major title for $150,000 to mail out, [but] it will need to spend about $16 million to license it for streaming. Such a 100 fold increase in price can obviously be deleterious to profits especially since Netflix still has to maintain its mailing centers, and buy DVDs, for the subscribers who elect to continuing using the mail-in service..."

He hit the nail on the head. The problem with Netflix is a problem of competitive position. There are several streaming movie competitors, and they all need to offer their customers the back catalog of streaming movies that people want to see. That means that they bid against each other; the content owners can play them off each other.

The rents from the streaming entertainment business are going to go to the content owners. And it is clear that Netflix does not understand this. Earlier this year, when the stock was at $300 (it's down 40%!), the company had a market capitalization of over $15 billion. The smart play would have been to sell stock and acquire content, either by buying libraries or by generating new content. 

Review of The Hollywood Economist: The Hidden Financial Reality Behind the Movies by Edward Jay Epstein

The Hollywood Economist: The Hidden Financial Reality Behind the Movies by Edward Jay Epstein is a book about one of the world's most cutthroat businesses. You may know Epstein as the author of the classic, absolutely must-read article Have You Ever Tried to Sell a Diamond?, about how the diamond cartel maintains high profit margins on perfectly ordinary lumps of carbon.

Epstein is fascinated by both industries, and there are certainly similarities between them. The movie studios have their own methods of keeping profit margins higher than under perfect competition, like oligopoly signaling:

"Major studios avoid simultaneously competing in the same demographic categories by using a service that reports the relative potential draw of various new movies appealing to the same category of viewers if offered at the same time."

Very clever! No uncomfortable meetings, which would be an antitrust gray area. It reminds me of the famous paper Collusive Bidding in the FCC Spectrum Auctions[pdf], which argued that a poorly designed auction mechanism had allowed telecom companies to coordinate a division of the licenses and enforce the proposed division by directing punishments at rivals.

Any industry that is cohesive enough to practice oligopoly signaling can probably make trouble for upstarts, and so Epstein has also written about the problems with the Netflix (NFLX) business model,

"Netflix can buy 10,000 copies of a major title for $150,000 to mail out, [but] it will need to spend about $16 million to license it for streaming. Such a 100 fold increase in price can obviously be deleterious to profits especially since Netflix still has to maintain its mailing centers, and buy DVDs, for the subscribers who elect to continuing using the mail-in service..."

The way that Hollywood is going to crush Netflix parallels the way that Hollywood crushed the Edison Trust. Thomas Edison owned most of the major American patents relating to motion picture cameras. His monopoly lasted for less than a decade before a federal court mysteriously ruled [pdf] that his exercise of his patent rights violated antitrust law.

The Hollywood Economist is a book about complexity. Movie studio lawyers create these incredibly intricate - really, needlessly complicated - contracts for allocating revenue from movies. It reminds me of something David Merkel said recently: "complexity is the enemy of the one receives it". The corollary would be that complexity is good for the party that creates it. Hollywood uses complexity to snare sophisticated investors who should know better, even hedge funds!

"Take JP Morgan Chase, which sent out a 'teaser' to hedge funds, reading, 'Despite compelling economic returns, major film studios are capital constrained and often must seek co-financing arrangements with other studios and other outside sources.'"

Yet we know from Epstein's analysis that the studios have mid-double-digit IRRs on their movies. So, why would they need outside capital? Because, they can get it on great terms from credulous investors!

Anyway, the book would have been a 3/5 except it was short enough to read in under two hours, so I'm raising to 4/5 for brevity.

By the way, Wal-Mart is Hollywood's biggest customer! Thus, Wal-Mart gets to censor, on behalf of its customers, the movies produced in the United States.

YouTube Launches Movie Streaming (GOOG, NFLX)

More competition in movie streaming: today, YouTube will "start adding around 3,000 new movie titles for rent."

More Competition for Netflix (NFLX, GOOG)

A two-year effort by YouTube, owned by Google, to get major Hollywood studios to offer their new-release movies for rental is coming closer to reality.

"Netflix expects Dish Network streaming push" (NFLX)

As I said, low barriers to entry...

WSJ: "Netflix Faces Rising Costs" (NFLX)

"Netflix doesn't say explicitly how much it spends to license content for its streaming service, but the company said in a letter to shareholders that it expects those costs to "increase substantially" in the second quarter and beyond. Mr. Pachter estimates Netflix's streaming costs next year will jump to between $1.6 billion and $2.2 billion from $700 million this year."

Netflix Down 5% After Hours on Earnings Outlook

No position, but certainly not long./

So Long, Netflix (NFLX)

Amazon is now offering all of its Prime members ($79/yr for free two day shipping on all orders) instant streaming of 5,000 movies and TV shows.

P.S. Did you know that Netflix outsources operations to Amazon?

Netflix (NFLX) and the Stupid Federal Reserve

By deliberately talking up the market over the past six months, Uncle Ben has chased all the shorts out of the market.

Whitney Tilson - who was a noted NFLX bear - has capitulated and covered his NFLX short. He says that new information has made him question his thesis, but I think the real reason was that he couldn't take the pain any longer.

The bearish case on Netflix has nothing to do with whether the company is growing quickly or how happy the customers are, which are Tilson's two main points. The bearish case is about whether NFLX is going to be able to get streaming content for the same sweet prices it is currently enjoying.

Bernanke's irresponsible statements about the equity markets have brought the markets to a fall-2007 state of delusional euphoria. Shorting "doesn't work" anymore so why bother?

A market crash where there are no shorts left to cover is going to be ugly. Wait and see.

Netflix (NFLX) Hits New All Time High

For no particular reason, Netflix is hitting a new all time high today. Market cap is now $11.6 billion.

No one seems to care about the problems with the business model.

No position except amazement.

"Amazon Puts On Brass Knuckles For Netflix Street Fight" (NFLX)

Amazon is reportedly developing a streaming video service that would compete with Netflix.

Netflix does not have a particularly strong competitive position. The barriers to entry are low and they are facing pressure from content providers (suppliers) who have wised up.

Covered the Netflix (NFLX) Short Before the Close Today

Hah. Saw that one coming.

Trouble Looming for Netflix (NFLX)

Amazon.com acquired the shares of Lovefilm (the European version of Netflix) that it did not already own. There were reports that the deal valued Lovefilm at about $300 million.

HBO: Netflix must charge more to use our content

"I'm hearing that Comcast is already preparing to pull NBC Universal's programming from Netflix when it's next up for review," Franken said. The cable industry is worried about the threat from cheaper options like Netflix; "they aren't stupid and they want to shut it down."

"Turner Chief Explains How TV Industry Will Neutralize Netflix" (NFLX)

Important article on Netflix (NFLX) at paidcontent.org:

If there was ever any doubt that the animus towards Netflix (NSDQ: NFLX) runs deeper throughout Time Warner (NYSE: TWX) than chairman and CEO Jeff Bewkes, get a load of what one of his top lieutenants had to say...
Addressing what he called “the elephant in the room,” Kent singled out Netflix as the fly in the ointment when it came to the syndicated acquisitions two of his biggest cable properties, TBS and TNT, count on as key to their businesses.

Nicasurfer has a good post about NFLX, "There are to many headwinds for this stock for me not to short it".

Blockbuster (BBI) Had the Chance to Buy Netflix (NFLX) But Dismissed It?

A Variety article about Blockbuster from 2005 quotes,

a former high-ranking Blockbuster exec, who recalls, "We had the option to buy Netflix for $50 million and we didn't do it. They were losing money. They came around a few times."

Instead, in 2000, Blockbuster inked a 20-year exclusive video-on-demand pact with Enron as the energy conglom launched into telecom. Blockbuster canned the pact after nine months.

Netflix is now worth $1.4 billion. Blockbuster's market cap is about $850 million.

And now, Netflix is worth $10 billion and Blockbuster is worth ~$100 million. Ouch!

I understand that Sumner Redstone paid $8.4 billion for Blockbuster back in 2004.

Meanwhile, the television and movie studios are looking for ways to "contain" Netflix.