Netflix Inc. (NFLX, Financial) reported last week that it missed its projected number of new subscribers for the second quarter. After more than doubling in 2018, shares of Netflix plummeted 14% in after-hours trading the same day of the announcement.
Although the new subscriber numbers fell well below the Street’s expectations, an additional problem for Netflix for the intermediate term is ensuring that its existing subscriber base remains loyal long term. Although it retains its lead as the originator of digital streaming content, due to a move away from providing licensed content from legacy media companies, Netflix's current customers now have become acclimated to original content and their voracious appetites will, at some point, become insatiable. This is a challenge that will not only confront Netflix, but every other media company entering the fray to compete with the original digital media disruptor.
While acquiring new viewers is necessary for revenue growth, an additional and somewhat overlooked risk for Netflix is that its subscribers may prove to be fickle. When other traditional legacy media companies begin to present their direct-to-consumer digital streaming offerings, which of necessity will include a plethora of original content and other forms of digital entertainment, the only way for Netflix to ensure viewer loyalty is by offering more and better content than what its competitors provide.
This is going to lead to an original content race, where each player will be forced to respond in kind to its competitors' offerings. A zero-sum game will ensue.
Generating that never-ending roster of original content is enormously expensive and will not diminish. So far this year, Netflix has booked content expenses of over $8 billion. It has estimated that it will spend an additional $4 billion for the remainder of the year.
Marketing the availability of its original content is expensive as well: Netflix has spent $1 billion promoting its shows and service in the past six months, up from $546 million in the prior-year period.
The inevitable dilemma for Netflix is that in order to finance the substantial and ever-growing expenses of producing new content, it needs a steady stream of new subscribers. Over time, however, subscribers will become price-sensitive to monthly subscription fee increases. Netflix recently increased its monthly fee; further increases will not be well received. It is relatively easy to simply cancel the monthly payments to Netflix and switch to the menu of offerings provided by AT&T (T, Financial) and Time Warner.
It will become a buyers’ market in the not-too-distant future and the production costs of providing original content consistently are going to be prohibitive. The competition between all the media companies vying for dominance in the new digital content market will be ferocious, a Hobbesian state of nature with each against all will ensue, with monthly subscription price inelasticity, at some point, curtailing or hampering revenue growth.
To make matters worse, in order to maintain its lead at its current forecasted rate of earnings growth, Walmart (WMT, Financial) has decided to throw its hat into the digital content ring.
Although Netflix recently acknowledged the potential for heighted competition, it stated that “there is room for multiple parties.” This statement may prove to be overly optimistic in light of the assets and cash some of these “multiple parties” will be bringing to the table.
As Netflix seeks a toehold into other foreign markets, it will have to provide original offerings for those specific countries. While this is occurring, U.S. viewers will continue to hunger for additional original content on a rotating and perennial basis.
In evaluating whether Netflix is worth $237 per share, it may prove instructive to revisit some of the timeless maxims enunciated in "Security Analysis"Â — the definitive and classic text on common stock valuation.
When assessing today whether Netflix's (or for that matter, Amazon (AMZN, Financial) stock price is rationally related to the prospects of its underlying business, one is reminded of Benjamin Graham and David Dodd’s description in the 1934 edition of "Security Analysis" of the pre-war and post-war manner in which investors valued stocks. The pre-war method was a traditional financial or fundamental analysis-based model. Analysis was confined to a company’s average earnings in relation to the stock price and the stability and trend of that company’s earnings.
In many ways, the pre-war model resembled what we would call value investing today. The validity of the model was exploded due to the rapid rate of economic change between 1919 and 1929, which rendered many otherwise sound and prominent companies less stable. Given its poor record, the fundamental method was supplanted by the price model, underlying what Graham and Dodd called the “new era theory” of stock valuation.
Graham and Dodd described, almost facetiously, the new era theory by way of a syllogism:
- The value of a common stock depends on what it can earn in the future.
- Good common stocks are those which have shown a rising trend of earnings.
- Good common stocks will prove sound and profitable investments.
The great danger in the new era, according to Graham and Dodd, was that too many investors ignored the price of a stock in determining whether or not it was a desirable purchase.
Although there are significant economic and business differences between the investment environment presented to Graham and Dodd and today's 21st century economy, the enormous price-value discrepancy warning seems to be valid today, particularly when it comes to how the market has priced the FANG stocks. Are today’s Netflix investors falling into the same “new era” valuation theory trap?
Just because many tech companies are asset-light compared to the industrials in Graham and Dodd’s days, doesn’t vitiate the underlying concept of overvaluation or the investment-speculation distinction.
Given the increasing cost and demands attendant on maintaining its position as the leader in direct-to-customer digital content streaming, perhaps it is long past time investors remembered the eternal wisdom of Graham and Dodd and start to question, with a very jaundiced eye, whether it is rational for Netflix to be selling at 130 times forward earnings.
It’s one thing to be king of the hill, but eventually, based on the ineluctable stock market laws of gravity, what goes up must come down.
Disclosure: I have no positions in any of the securities referenced in this article.
