It’s hard to rate streaming entertainment giant Netflix (NASDAQ:) stock with any real confidence. There are just too many moving parts.
The novel coronavirus pandemic has undoubtedly propelled demand in 2020 and 2021 while boosting viewership during those years. Now in 2022, however, subscriber numbers are declining in the first quarter, and Netflix is forecasting a further decline in the second quarter. It’s hard to say whether these results signify the end of the company’s growth or just an unsurprising short-term slump after nearly two full years of strong demand.
The competitive environment has changed significantly. Three years ago, Netflix didn’t really have much competition. Since then, virtually every major media company has entered this space. Some will be real rivals in the coming years, others will spend billions with little result. Here, too, it is difficult to accurately assess the long-term situation.
Fundamental analysis has its own fundamental problem. Based on that, NFLX stock looks cheap. In contrast, the stock looks remarkably expensive using free cash flow. The rating that an investor uses, in turn, depends on their opinion of the company.
Investors should therefore try to use common sense to understand whether Netflix stock has fallen enough. Unfortunately, that doesn’t seem to be the case.
Netflix vs. ESPN
In the late 2010s, Netflix was probably the best entertainment company out there. In any case, she seemed to be valued as such. In 2018, the company became the most valuable media company in the world.
Back then, Netflix overtook Disney (NYSE:) to claim the title. One reason was that ESPN, a Disney unit, was struggling. ESPN’s trajectory will then be similar to Netflix’s today.
A few years earlier, ESPN was one of the best entertainment companies of all time. For example, in 2014, the company generated an estimated fee of $6 per month per cable and satellite subscriber — which was almost everyone in America at the time. ESPN was getting about $100 a year from almost every household in the country, regardless of whether they watched ESPN or not.
Advertising revenue was added to these membership fees. And when ESPN paid handsomely for the media rights, there was plenty of profit left. For fiscal 2015 (ended September), Disney’s Media Networks segment generated approximately $8 billion in EBITDA (earnings before interest, taxes, depreciation and amortization). To put that number in context, HBO, a high-quality company then owned by Time Warner, made only a quarter of that amount.
ESPN no doubt took the lion’s share of Disney Media Network’s profits, while other properties like Disney Network, ABC, and ABC Family had much less impact. In 2014, one analyst estimated ESPN’s EBITDA at around $4.5 billion — and ESPN’s standalone value at $50 billion.
The cable cuts — which led to reductions in cable and satellite subscriptions — have since weighed so heavily on ESPN’s earnings and valuation that it remains an apparent concern for DIS stock. But ESPN’s 2014 headlines provide an interesting heuristic for Netflix stock. Even with a sharp sell-off in NFLX stock from earnings, Netflix currently has an enterprise value of just under $100 billion.
Which again raises an interesting question: Should Netflix be worth more than twice ESPN’s peak value?
It is difficult to answer this question.
The problem with Netflix stock
It’s true that Netflix has a much larger international base (about 54% of its revenue in fiscal 2021) and has a much greater opportunity for growth overseas. But profit margins outside the United States are structurally weaker, as illustrated by Netflix’s price cut in India, the world’s second-most populous country, late last year.
In fact, Disney’s Media Networks segment’s EBITDA margin was just under 35% in fiscal 2015. For Netflix, that number is less than 23% over the past four quarters. Netflix is a less mature company that still spends heavily on marketing, but even a mature Netflix is unlikely to be as profitable as ESPN’s peak. And yet, Netflix’s business is currently valued at about twice that of ESPN.
One could argue that Netflix’s US operations (which generate higher revenue per subscriber) are worth slightly more than ESPN’s, while its international operations could double that valuation. But even that only gets us roughly to the current state of NFLX stock.
Admittedly, Netflix’s assessment based on this comparison alone is neither perfect nor accurate. However, due to the turbulence of the last two years, both valuation methods are a key question in relation to the results published by Netflix.
NFLX accounting and action
Looking at earnings, NFLX’s valuation seems reasonable, with ~19x 12-month GAAP earnings and ~13x EBITDA (with impairment focused only on tangible and intangible assets).
However, free cash flow tells a very different story. Netflix has a history of burning cash, including in 2021 and the first quarter of this year. A nearly $100 billion valuation for a cash-burning company seems almost ridiculous.
It’s accounting that explains the discrepancy between earnings and free cash flow. On its income statement, Netflix amortizes content over a period of years (typically over four years on an accelerated basis; see page 45 of the company’s Form 10-K). In the cash flow statement, Netflix accounts for the monies actually spent on content during this period.
When content spend increases, the cash flow statement shows a higher content cost than the income statement. Amortization includes only a portion of the current period’s expenses plus some modest arrears of monies spent in previous years. But as long as cash spend is higher in the current period than before, actual cash spend on content will be higher than the amortized figure.
In 2021, for example, cash spend exceeded depreciation expense by $5.5 billion. The gap was smaller in 2020, but only because Netflix’s spending plummeted amid the pandemic. (The gap narrowed slightly to $418 million in Q1 2022 from $565 million a year earlier).
This P&L accounting is based on a sensible idea: new content has some residual value for subscribers that dwindles over the years. Therefore, a portion – but only a portion – of these costs should be expensed in future years.
In theory, at some point the amortized cost will be greater than, or at least equal to, the cash cost, at which point Netflix (again, theoretically) becomes a revenue-generating machine. But for that to happen, growth in content spending will have to slow significantly at some point. That hasn’t happened yet, which is why Netflix is reporting earnings on a book basis, but isn’t generating positive free cash flow with the exception of 2020 (where cash costs have fallen sharply again due to external factors).
Declining subscriber numbers in Q1 and expectations for similar performance in Q2 suggest that Netflix may need to keep increasing spending just to keep its subscriber base reasonably intact. The fundamental problem with this scenario is that “actual” content spend is closer to actual cash spent.
This means that the valuation should approximate free cash flow based methods rather than revenue based methods.
From this perspective, the news for NFLX looks even worse than it compares to ESPN. A nearly $100 billion company that can’t generate free cash flow is definitely not a buy. It’s more of a short sale.
However, there are many moving parts here. Netflix needs some leverage to cut spending and improve earnings and free cash flow.
However, if the past two quarters look like what Netflix would look like in a more normalized environment, a $100 billion valuation won’t hold — and Netflix shares will continue to fall.