Netflix Defanged? Why this Hedge Fund Thinks So

Netflix has been a large part of the recent FANG bull run in the stock market.  The video streaming platform now dominates the domestic video streaming market, and is now being forced to look externally to maintain its growth rate.  This moat is far wider than a language gap.  Deeply entrenched TV consumption cultures in Korea, India, and other foreign markets have proven extremely difficult for Western studios to successfully produce content for.  China, potentially Netflix's biggest market, has a rigid film and TV censorship regime.  It also has a history of favoring homegrown tech companies like Baidu, Alibaba, and Tencent (all of which are or are rumored to be developing video streaming competitors).  Netflix originals like Matt Damon's recent The Great Wall have been critically received as culturally tone deaf, and a successful foreign content formula is yet to emerge for Netflix.

Content threats to Netflix are both foreign and domestic.  Disney, one of Netflix's largest content partners, poised to pull its branded content from the platform.  This includes all Marvel and Star Wars branded content, which will soon be hosted on Disney's own proprietary platform.  Amazon's Prime Video continues to pick up steam and produce its own content, and looms in Netflix's rear view mirror.

With these headwinds in mind, SumZero sat down with Carter Henderson of the Henderson Capital Group to hear his thoughts on the stock following his recent short idea on SumZero.

Luke Schiefelbein, SumZero: What about Netflix initially caught your eye as a value investor?  What catalyzed your entrance into the position?

Carter Henderson, Henderson Capital Group: As a deep value investor, Netflix sticks out like a sore thumb. Their valuations are incredibly high, I believe most of their performance has come from momentum and due in large part because they are grouped into the “FANG” stocks. Also, Netflix has serious liquidity issues stemming from their negative cash flow from operations for the last three years. Their cash and cash equivalents are only positive because of their cash flows from financing activities, which is debt issuances to fund their content investments. Moreover, they are operating in a saturated U.S. market in which it will be hard to add subscribers. Netflix will have to focus internationally where they do not have the pricing power in the U.S., the content will have to be “domesticated” and the margins are smaller.

Schiefelbein: What was the market missing?  What are your thoughts on the rise of Netflix branded and produced content?

Henderson: A consistent cash flow is needed for Netflix to continue operating in this manner and I do not see this happening. In 2017, Netflix got all of its cash from financing activities, which included $3.02 billion from debt financing and $88.3 million from issuing stock. Netflix has $2.82 billion of cash and if we continue to assume that Netflix will burn $1.8 billion in cash from operating activities a year then Netflix can only support itself for another 1.5 years before it will need another round of debt financing.

Netflix has good content but my concern is that it won’t stick and they are spending massive amounts of capital on something that doesn’t have a wide moat. Disney, who has plans to make their own streaming service, has content like The Lion King, Toy Story, Star Wars, etc. This is content that will be around 50 years from now because that has a moat but will people be watching Stranger Things in 50 years?

Schiefelbein:  What key metrics should investors be paying attention to as your thesis matures?  What developments in the next 6-12 months could be the most damaging for Netflix?

Henderson: I would tell investors to pay attention to Disney’s and Fox’s deal that will more than likely pull Disney related content from the platform. Netflix is receiving generous valuations compared to the previously mentioned companies, Netflix’s market cap is 1.8X that of Fox and only generates 41% of their revenue. I also say with a company like Netflix, their subscriber growth is a crucial metric to pay attention to. I see tough times ahead for Netflix growing their subscriber base in the U.S. and as we know from other internet companies, international regulatory concerns over the internet are a huge risk.

Schiefelbein: Where do you see Netflix’s subscriber growth coming from in the next 5-10 years?

Henderson: We look at subscribers for Netflix and more importantly how it is beginning to slow. Subscriber growth in the United States is declining, growing 23% in 2013 to 16% in 2017. There were 126 million households in 2017 and Netflix represents almost 50% saturation at their current U.S. subscriber levels. This number is potentially conservative due to accounts being shared between family and friends (I know I still coat tale off my brothers account). If Netflix continued to grow their U.S. subscriber base by 10% and the U.S. household growth rate continued at its average 1% over the past decade, then Netflix subscribers would exceed U.S. households by 2027. Moreover, if we estimate a case where 70% of U.S. households have Netflix then we can estimate that Netflix will have 98 million subscribers by 2027. This would conclude an annual growth rate of just 7% annually over the next 10 years, not a very exciting rate that would attract such high multiples for their stock.

Schiefelbein: How vulnerable is Netflix to the potential rise of Amazon Prime Video and Disney as alternative video streaming platforms?  Other video streaming platforms like Hulu have existed for years - what makes Amazon and Disney more compelling competitors?

Henderson: Netflix faces increasing competition from companies like Hulu, Amazon, TV On Demand, Disney and more. Amazon Video is their fiercest competitor, investing heavily into their own original content. Amazon Video is also a more diverse platform, last fall they had streaming rights to a portion of the NFL Thursday Night Football games. Moreover, if you are an Amazon Prime member you get access to Amazon Video with your service. Also, with the introduction of smart TV’s, their talking remotes, and On-Demand features, you no longer need to search through the Netflix platform. If I have a specific movie I want to watch I now just say it into my remote, it may be on Netflix or it may not. I believe if people were not surfing on Netflix any more than that leads to less content watched and less need for an account.

Disney announced a deal to buy 21st Century Fox for $52.4 billion in December 2017 and plan to yank Disney movies and TV shows from Netflix in 2019 for its own service. Once they own Fox they will be able to pull mainstream names from Netflix like Family Guy and Avatar. Furthermore, some of Fox’s shows have made their way to Hulu, a direct competitor to Netflix. Disney will now become a majority owner of Hulu and Fox will not renew its deals with Netflix.

Schiefelbein: What will the impact of the recent rate hike be on NFLX’s ability to issue debt?

Henderson: From Netflix’s 2017 annual 10-K, we know that the $3.02 billion in debt issued last year had a 4.975% yield. Netflix carries a B+ rating by S&P and B1 by Moody’s, also like you mentioned, the Fed is raising rates. It makes it very unlikely for Netflix to receive a loan at favorable or lower interest rates going forward unless they can improve their financial positioning significantly. Moreover, we know from the annual report that most of their outstanding debt matures in 2020-2022, and as it currently stands, Netflix doesn’t seem to have the ability to generate positive cash flow to pay for their maturing debt.

Schiefelbein: How much of a tailwind has the general tech bubble been for NFLX stock?  How much of a headwind could a stumble in the market be?

Henderson: Netflix has been caught up in the “FANG” trade, FANG being Facebook, Amazon, Netflix, Google (Alphabet). Every bull market has their basket of glory stocks that everyone wants a part of no matter what their valuation perceives, they just want to be in them because “everyone else is”. I believe the over buying in tech, especially in those names have had a direct correlation to why Netflix’s stock price is so high. Those valuations will turn on Netflix when the U.S. hits a recession, it is inevitable and when it happens those FANG stocks will be leading the market downwards. In a recession, people look to cut costs where they can, they are more inclined to cut a monthly $10 charge from Netflix for the time being instead of something they absolutely need.

Schiefelbein: What is the biggest risk to your position?  What is the most compelling bull case for the stock?

Henderson: Key investment risks include market momentum, Netflix is clearly the hottest stock YTD. This trend can continue if technical traders cling to high levels of volume or if fundamental traders blindly follow the momentum.  Netflix can swindle top content producers from Hollywood and provide content that will “stick”. Netflix has shown they are not afraid to spend massive amounts of money on producing original content, they can entice Hollywood talent to join their growing production team. Lastly, Netflix does a massive equity offering to pay off debt and build substantial cash positions. An equity offering would give relief to their debt problems and allow them to have more comfort to maneuver financially.  

Schiefelbein:  Where else do you see value in the market today?  Where else does your fund focus?

Henderson: We see a great source of value in financials, especially the large banks and the large asset managers. T. Rowe price has been one of our best holdings, we did a long research report on them last year and it has since returned a great profit for us. We also see great value in consumer goods, we have our eye on a particular well known company in the space who is currently out of favor with Wall Street. I believe that recessionary concerns are approaching, so finding deep value in a consumer goods company whose products are recession proof is a great place to be.

Schiefelbein:  Would you say that online research platforms are a large part of your research process?  

Henderson: Absolutely. Henderson Capital uses SumZero almost every day to read what other buy-side firms are researching. Every time we have a compelling idea we share it with the SumZero community, it allows us to get great feedback from other members. It’s also a great place to meet other firms and have the potential for capital funding. Without it, we would not be where we are today.