A Fair Value For Netflix

How Much Is Streaming Content Worth?

I don’t want to bury the lead here. I don’t really like Netflix (NFLX). Not very much as an option for entertainment, and not even a little bit as an investment. Or, I should say, “not at its current price.” Yes, even though it is down something like 60% from its all-time high, Netflix is not an attractive investment to anyone concerned with Value Investing.

Ignore Personal Feelings And Emotions

One of the primary tenets upheld by most value investors is that value is value, and value is attractive. In other words, a value investor should be interested in purchasing undervalued companies, regardless of how much he or she “likes” the company. In fact, that’s pretty much the stereotype of value investors: they own “boring” companies in old-school industries that nobody’s interested in. Like ball-bearing manufacturers.

Because of this aspect of Value Investing (dispassionately considering the evidence, regardless of personal feeling or opinion), I have to take a huge deep breath. Frankly, as a contrarian to about 99% of cultural mores, I personally find Netflix to be: dumb, stupid, pointless, and frankly, harmful (due to binge-watching, digital distraction, and fostering “on-demand” expectations).

For example, I have precisely zero interest in watching a show or movie (but especially a show) that “everyone’s talking about.” Such a notion is sickening to me. So, I despise by default shows created for streaming TV (and that feeling extends beyond Netflix to other streaming platforms).

Just because that’s true, though, doesn’t mean that Netflix couldn’t be a good value, or that I wouldn’t purchase shares in the company. After all, I actively dislike most things that are highly esteemed, yet I still exist in this world, so that by itself isn’t a useful guide. Since Netflix has been in the news recently because of its most recent earnings announcement, I thought it would be appropriate to review their financials and see whether or not recognizable value is present.

The Criteria For Value

At Barrier Island Capital Partners, LP (the investment partnership I co-manage), we rely on traditional “fundamental” analysis to determine the attractiveness of a stock. The fundamental analysis we employ includes calculating and grading based on these metrics:

·  Price-to-earnings ratio (P/E)

·  Price-to-Net Current Asset Value (P/NCAV, total current assets divided by total liabilities)

·  Price-to-book value (P/BV)

·  Free Cash Flow per share (FCF/S)

·  Dividend yield (DY)

·  Dividend coverage

·  Price-to-NCAV+FCF per share (P/(NCAV+FCF)/S)

These, and one or two others, indicate the financial soundness and the money-making ability of a company, but all within the context of price.

One Of the Chief Problems

The first stumbling block to owning Netflix is the presence of long-term debt. We prefer zero. Why? Because it’s almost impossible to go broke when you have no debt, but remarkably easy when you’re levered up.

In all fairness, they did reduce long-term debt by $500 million in 2021, but that still leaves them with over $14 billion on the books. It looks like they’re not facing maturities the rest of this year or next, so they may well dodge the interest rate spike unless they need to borrow new money. Still, $14 billion is too much to consider.

The Second Chief Problem

The other major problem for valuing NFLX is the “value” of their content, which is listed as an intangible asset on their balance sheet ($30.9 billion as of 12/31/21). That’s what they value it at. How much is it really worth? Who knows? The true answer, which isn’t calculable in advance, is: that it’s worth as much as the total value of subscriptions gained as a result of the content.

Assuming an average price paid of $15.99 paid per month (a generous average), the yearly value of one subscriber is a revenue of $191.88. Netflix amortizes its content over about 6 years, which means that the $30.9 billion in intangibles gets used up at the rate of $5.15 billion per year (simplistic, and probably too conservative, but, hey, we’re value investors here). In my book, $5.15 billion divided by $191.88 equals a tad over 26,800,000 subscribers. Do you see Netflix adding that many subscribers each year for the next six years? Me neither.

Therefore, we can safely assume that the true value of their content is much lower. (Note that I’m not alleging any kind of fraud here; it’s not possible for them to know with 100% accuracy). How much lower? Truthfully, when we analyze companies for our investment partnership, we exclude ALL intangible items. If we do that, that leaves NFLX with a book value of NEGATIVE $16.7 billion. Even if we give them credit for 50% of their intangible values, book value is still negative $1.29 billion.

Obviously, this is a deal killer for us. For purposes of establishing a target price, though, I’ll proceed on the assumption that the intangible value of their content should be accepted (which I don’t, just for the record).

The Other Valuation Metrics

The bad news just keeps coming, as we prefer companies that have large Net Current Asset Values (NCAV - current, or short-term, assets minus total liabilities). Netflix has negative NCAV. Long-term debt rears its ugly head again.

The company had great Earnings Per Share for 2021, but if you take a three-year average, that puts NFLX PE at 29, which is way too pricey for us to consider. We want a P/E of 13 or lower to indicate significant value with a meaningful margin of safety.

Free Cash Flow, after being positive in 2020, was negative in 2021. Management has expressed optimism that they’ll stay positive in the future, but if I was a betting man, I’d bet against this. Still, even if it happens, they’re unlikely to generate the amounts of Free Cash Flow that would bring their Price-to-Free Cash Flow to less than 20 at current price (a key caveat).

Final Verdict On Value For Netflix

The honest answer to this question is that we can’t buy this company until the long-term debt is gone. Assuming that we could live with the debt, the price at which NFLX would be considered a “safe value” is $33 per share. And remember, that assumes that their calculation of intangible content value is correct. If we only give them credit for 50% of the value, their target price drops to $0. All fundamental ratios would yield negative numbers (other than P/E), which means we wouldn’t pay a penny for it.

Philosophy On NFLX

Besides the poor value proposition, I think Netflix has some major shortcomings from an existential perspective. Netflix was a great idea when it primarily re-broadcast other people’s content (OPC). Win-win for all, except for advertisers: consumer, original rights-holder, Netflix. A great relatively low-margin enterprise. Why would networks get into standalone streaming as long as Netflix only re-broadcast their existing content, and paid them for it? But, as soon as NFLX was perceived as a threat on the original content front, their business was ready to be done.

Weirdly, even though Netflix was first to the space, they were at a huge disadvantage to pretty much any other legacy media company that launched a streaming platform. Why? Because the legacy media companies already owned decades of content and (crucially), most of it was created before the recent digital content glut.

Think about it; generations of people love Friends. It’s a lasting franchise that will be beloved and most importantly remembered by its fans for as long as they live (though for the record, I can’t stand it). They will continue to stream it on whatever platform it's available on. Just speculation here, but I don’t think the same will be true of Stranger Things or any other Netflix-create series. (Or any other straight-to-streaming platform). Why? Because content is consumable, substitutable, and ultimately forgettable. A TV show, on the other hand (or at least one produced before 2019) isn’t content in the same way, and neither are movies that are traditionally Hollywood produced. Direct-to-streaming is content, with the same connotation as direct-to-DVD (even if streaming movies win Academy Awards).

TV and movies are not alone in this category. Books and music share the same plight. Both are simply content now. With the advent of independent publishing (made possible by the contentization of books by Amazon and Kindle) and digital music recording, production, and distribution, there are now oceans full of books and movies available in hundreds of sub-genres (if not more).

Am I just complaining that things aren’t as they used to be? That literature and music were better back in the day?

Not at all. After all, I’m publishing books for Kindle on Amazon. I’m writing this newsletter on Substack. If I had more musical ability, I’d be recording and releasing music independently.

What then? It’s just that given the world in which we live, and the way in which people consume content, combined with fewer (or zero) gatekeepers (like editors, record labels, and Hollywood studios), there’s too much content, and even the most touching, emotionally powerful show, movie, book, or album, is buried. Not just by the “next thing” but by the next 3,000 things, from millions of creators. Within the next day, or even hour. Once it’s consumed, it’s over and done. People are ready for the new stuff, and creators are starting from scratch.

And that brings me to the concept of binge-watching. This is another pyrrhic victory for Netflix. Yes, the fact that they are synonymous with binge-watching is a testament to their success. But, their fireworks of success have burned a huge hole in their own boat. And, here’s where their notorious lack of Free Cash Flow comes into play: as soon as they release a season, a series, or a movie, all the financial benefit to them is used up in one glorious binge-watching bender. They spend billions of dollars producing original content, but at best they simply hold even with their competitors, who are not only producing similar content but have classic and loaded backlogs of cherished movies and TV shows, which have already been paid for.

Just to maintain their position, they’re likely to have to increase their content spend. Remember that one year of positive Free Cash Flow? Chances are high that was just a blip. Now that subscribers are drastically slowing (or deliberately cut out, in the case of Russian customers), what can they do? Produce even more content. But content creation takes cash, so in order to stay relevant, there’s likely a torrent of cash-burning content production in the near future. If their cash flow doesn’t support it, that means more borrowing or issuing new shares.

Even if they manage to stay cash-flow positive, and really, their track record is against them, what does it matter? What is the (likely) achievable goal at this point? The streaming ship has sailed, and Netflix is just “one-of-the-gang” now. It’s likely not mathematically possible to grow subscribers, free cash flow, or net earnings, on anything like a “growth” trajectory given the current streaming landscape. Therefore, the price must continue to come down.

What Do You Think?

Agree? Disagree? Let me know what you think about Netflix as a stock investment!