An example of bubble valuation, Netflix

Continuing the theme of the previous post…

Let’s take the example of Netflix (NFLX), a company known to most readers which also happens to be currently popular with the investing public. I think Netflix is a great product, possibly even a good business when stabilized, but it is likely to be a disaster as an investment given the current price of $420 (i.e. a market cap of $175 billion) supported by earnings of $0.6 billion last year and no free cash flow. It is argued that scripted programming streaming services are a “winner take most” market and, thus, it makes sense for NFLX to lose a copious sums of money to “land grab”. Profits are expected to come when the company doesn’t need to invest as much in programming as it does today, presumably after all of the land has been grabbed. Price increases are also expected to increase earnings.

Here are a few reasons why the investment is not likely to work out. Before I list the reasons I would like to restate a simple fact that is sometimes overlooked in the jargon-filled investment frenzy that is the current VC/tech environment. To be valuable, a company needs earnings in the foreseeable future. And for a company to have earnings (or to create them if it doesn’t), revenues need to exceed expenses.

With this simple framework, let’s compare Netflix with the traditional cable networks. The traditional networks routines report EBITDA margins of around 40%. This is achieved with 90-100mm subscribers paying from $0.5 to $7 per subscriber per month. The range is wide because of outliers; most networks seem to command between $1 and $3. Traditional network metrics suffer from the distortions of bundling. Not all of those 90-100mm subscribers necessarily watch each channel. They receive it as part of their ‘video bundle’, that great Achilles heel of traditional video model. So, for example, if 1/3^rd of the ‘customers’ actually watched a given network, the economics would stay the same if the network charged 3 times as much, so $3 to $9. This would be the appropriate comparison to Netflix. The rub is that no one really knows (though there are guesstimates) what the actual ‘true penetration’ of a given cable network is. There’s another way to think about the issue.

Netflix has 55 million subscribers in the US. Let’s say it gets to 100 million subscribers, i.e. every household that once watched linear TV now subscribes to Netflix. This is envisioned in some bull cases. This would necessitate Netflix replicate all of the varying tastes and preferences of all of its customers currently provided by the cable bundle. Let’s assume that such tastes and preferences are captured in the top 20 cable networks and scripted programming from OTA broadcasters. Not many folks watch some of the fringe channels that are crammed down their throats by the cable network owners. The top 20 channels and scripted programming from OTA alone would be responsible for approximately $20 per month in programming costs (and that’s being conservative). To run a 40% EBITDA margin on this number would require a monthly bill of $50 (in cable networks some of this is lowered due to advertising, which Netflix doesn’t do). Of course, Netflix has other expenses which cable networks don’t since Netflix is a content owner/licensor and ALSO a distribution platform with the attendant costs of advertising, customer service, billing, etc. So the bill could look even higher. This would be revenue side of the ledger.

But why should Netflix try to earn margins equal to cable networks? Could it be okay with less? To say that Netflix can run with margins less than traditional cable networks could work for Netflix as a company, but not for the $180 billion valuation placed upon it by the investors. My point is that the company can do fine even as investors grow poorer. A $180 billion valuation means Netflix needs to earn at least $8-9 billion at most 3-5 years out. This cannot happen without higher margins. Increased margins can come from two sources. First, more customers without an increase in content spend (i.e., people join Netflix to watch older shows). Second, price increases.

As to the first, I believe content life is shorter than many investors assume. The company needs to keep buying (like all media companies) and the so called “moderation” in content-spend is not in sight. As noted above, Netflix will find itself needing to invest to replace the total content production of the top 20 cable networks and OTAs if it is to indefinitely retain their customers.

Further, the company WANTS to keep buying globally to drive subs. The need to drive global subscribers is self-inflicted. If Netflix was just a US platform, I don't think they'd necessarily face a threat from some platform in China or India (unlike social networks, payment systems, etc. which have demonstrable cross-connections across geographies). But people (and management) say that shows from other countries are watched in the US and vice-versa which subsidizes costs of production by driving higher audience. But there are only 24 hours in a day! So for each person that watched a German show in the US, that person didn't watch an American show (on that day). So the American might've subsidized the German show but the German subsidized the American show. We simply cannot create something out of nothing unless people increase their TV viewing time (which is not happening according to reported figures). By trying to have a platform that's a little something for everyone, cost-wise, it starts to sound similar to the cost of a 20 channel bundle, but sold for $8-10 per month. In other words, Netflix will have to increase prices substantially.

On that $8-10 per month, it’s also unclear whether this will work very well in India (part of the bull case). That's a lot of money for most Indian people. Maybe in the cities it works for a small segment. But the competition (Hotstar) charges only $3 and the film/production industry ("Bollywood") is very advanced in India; they don't need to import shows. So why would a satisfied Hotstar customer move to Netflix to pay double? Perhaps for the occasional international show or Netflix Original. But password sharing (very common in India as it is here) will take care of that so penetration could be an issue.

As to the second source of increased margins, i.e. pricing, what seems to make today's valuation work out is a price of $25 or so (in addition to the linear TV, which customers will have to buy separately, that gives them sports and news, absent from NFLX). I don't know if people will pay that in the US, let alone in other countries. I'm not sure a price like that could be justified by "we have a lot more content that we invested in", again given just 24 hours in the day, people can only watch so much and many are focused on the latest releases (which happens to be what their friends are watching and what is on social media) and maybe something from two-three years back. Even the viewership of the great hits of just 3-4 years ago (Breaking Bad, etc.) doesn't seem that good (anecdotally).

To sum it up, I view new content as mostly ongoing customer acquisition and maintenance cost, which is similar to any other media company. But other media companies don't over-produce shows and charge little for them. So Netflix is going to have to price similar to any other media company, or continue to spend as they have and come up with reasons why free cash flows don't matter. Why this is so actually has to do with the phenomenon that launched Netflix itself: multiple distribution points for video (v/s the past) and the golden age of TV. The competition for the OTT ‘land grab’ has increased costs of video to a point that had made it unaffordable for the public. Whether the unaffordability flows through cable pipes or through Netflix (which currently subsidizes the unaffordable product in the capital markets by consistently raising debt from a currently-avuncular bond market) shouldn’t matter. I just don't see a "first mover advantage" for this industry. Customers are free to switch/cancel when the price gets too high or content reduces (due to moderation, if it is actually done), both part of the bull thesis.

Moving on to valuation, it is doubtful the company will generate free cash flow on any reasonable timeline that would support its current $420 per share valuation as shown above. Even if all works out as hoped by the bulls, the multiples are STILL high!

Update: In late July, BTIG put out a research report which calmly calculates a 17x EV/EBITDA multiple to the 2022 EBITDA which is expected to quintuple from 2018's EBITDA. So even if the most bullish case comes true, this is the multiple applied to it for the price of $360 (at the time of their report). Their PT is $420, which requires a 2022 EV/EBITDA of 20 and the same quintupling of EBITDA."

A Possible Bubble In Venture Capital

As much as I like Amazon and admire Jeff Bezos, I believe Amazon’s success (combined with the zero interest rate policy of the Fed) kicked off a type of thinking that, in my view, has now led to a bubble in Venture Capital and some areas of publicly traded tech companies (though not all; notably Google, FB are highly valued but within fair zone, Apple even has a bargain ‘multiple and growth combination’). Amazon was the initial (and possibly the only surviving) pioneer of this idea which took root in the late 90s and generally goes, "We are investing for the next 50 years, hence, earnings don't matter, we are building scale, gaining first mover advantage, profits will come later, we are plowing all our earnings into growth investments, etc.” It might be true for Amazon. But, as always, first the pioneers, then the imitators.

What has happened is that today this logic gets thrown around by every newly formed highly valued company as an excuse for losses (witness Softbank's grand 300-year plan and its investees equally grand losses). It's almost as if profits are anathema for a company with a big plan and grand dreams. Exhibit A: Uber, Lyft, WeWork, Slack, Spotify, Square, Shopify, etc. What started off with the companies has now been seized upon by investors to justify buying something (anything?) that they want to buy. The scooter companies (Lime, Bird) are the latest, but by no means the only, examples. Bird's latest valuation is $2 billion as of June 2018 funding....compared to a March 2018 valuation of... $300 million. So a 6.6x in three months. Uber invested in the rival to Bird, called Lime, and bought another scooter company called Jump. So unicorns investing in unicorns, all without profit. It started with a good idea but, in my view, we are now squarely sitting in the crazy territory where anything goes. The rationales given for losing money can even be made to sound legitimate to those only paying casual attention, to those blinded by the possibilities of high returns (drawing, of course, from the bottomless well that is past returns), to those who have not studied history, and to others who desperately want to believe. As an example, see this explanation of their investment strategy given by Softbank's investment professionals (http://fortune.com/2018/07/17/softbank-vision-fund-capital-investment-strategy/). Softbank not only justifies large valuations on companies with gargantuan losses, but also believes that putting more money into a loss making company actually serves as a competitive advantage (which strikes me as bull market thinking). Since only companies with large losses need large external capital raises, theirs seems to be a roundabout way of saying the more money you lose the better!

I think it's a great case study of social proof, commitment tendency, and authority principals at play. At the extremes, investors even WANT to be fooled, i.e. they might agree it's not okay to just focus on DAU, MAU, subs, etc. but as long as everyone else is focused on it, they might feel that's what the company should do so that the stock/valuation can go up quickly.

There is no basis in history that would allow engaging in this type of behavior without penalty. Examples include the Nifty Fifty of the late 60s and early 70s, the 1999 tech bubble, and others. If history remains a faithful guide and laws of mathematics (particularly time value of money) remain in place, there is every reason to expect that new investors will learn old lessons again.

In the next post, I take a specific investment to further illustrate this point.

Ross Stores, A Good Investment

I recently wrote an article for a financial publication discussing why Ross Stores (ROST) represents a good investment. At a high level,

1. Ross has has been around for about 35 years and their 'formula' has worked quite well for that entire duration (with occasional ups and downs that face all businesses). All of its growth has been 'organic'. Yet, Ross is currently in 38 states with dd’s DISCOUNTS in 17 states. There's a long runway.

2. Return economics on new stores are terrific, which translates to a very high return on equity. (Ross does not have material intangibles). Hence, the above-mentioned long runway can be pursued profitably.

3. Same store sales are good and will continue to be so.

4. Excess cash flow is used to pay dividends and repurchase shares. Since the business is attractive, the valuation is reasonable, both these uses leave shareholders better off. Lack of M&A reduces chances of misapplication of capital.

5. Even though the valuation is 'fair' and not cheap (at $77 per share), the current price will likely provide better than market returns over time.

For more details, including numbers, please see link below: