Two major reasons to worry about this FAANG stock

From Austin Root, Portfolio Manager, Stansberry Portfolio Solutions:

It’s an enigma…

Streaming giant Netflix (NFLX) is one of the most compelling growth stories the entertainment industry has ever seen, growing from nothing to a dominant industry force in a little more than a decade… And yet, at the same time, it’s the perfect example of how not to run a business for the long haul.

Following the company is kind of like “binge watching” one of its award-winning programs. Every new quarterly report is fascinating, packed with reasons for both optimism and dread… and the more time I  spend following it, the less sure I am of how things will ultimately end for the stock.

Today, we’ll look at the factors that make Netflix’s earnings the Wall Street equivalent of “must-see TV.” There are many reasons for optimism about Netflix, but three stand out above the rest.

For one, Netflix already disrupted one industry, and it’s now in the process of upending two others…

First, Netflix destroyed the brick-and-mortar video-rental business. You may recall the company’s origin story… Tired of paying late fees to Blockbuster when he didn’t return movies on time, Reed Hastings founded Netflix, which got its start by mailing you DVDs that you could keep for as long as you wanted.

But in 2007, Netflix turned its focus from physical DVDs to streaming over the Internet, and the company took on a much larger industry: cable TV. Not surprisingly, at about the same time, growth in the total number of pay-TV subscribers in the U.S. began to slow. By 2016, pay-TV subscriber counts had flatlined. Today, they’re in freefall. It turns out, $11 a month for unlimited access to countless shows and movies beats spending $70 (or more) a month for limited access to far less content.

In 2013, when Netflix began to create its own original content, it took aim even higher up the media industry food chain by going after the movie and TV studios themselves. This meant that traditional media-content companies like Disney (DIS), Sony (SNE), Comcast’s (CMCSA) NBCUniversal, and AT&T’s (T) Time Warner saw one of their highest-paying customers become the competition. It’s still not clear how this will turn out, but the old-guard media titans don’t like it one bit.

Second, Netflix is huge and still growing like a weed…

In 2010, Wall Street marveled that Netflix grew to 20 million total subscribers. As of this past September, the company had nearly 140 million subscribers, growing by almost 20 million in the first nine months of 2018. For the past 10 years, Netflix has grown its user base by more than 30% per year on average.

Today, Netflix accounts for an astounding one-third of Internet traffic in the U.S. during peak usage times. And while Hastings anticipates domestic growth will slow, international growth is just getting started – and has actually accelerated in recent months. That means Netflix’s subscriber base should continue to grow rapidly for many years to come.

Finally, Netflix has incredible pricing power…

Consumers are streaming a lot of Netflix content, and that means the company can increase its prices with virtually no long-term effect on subscriber retention or growth.

As I noted earlier, the standard Netflix plan costs $11 a month, compared with the average cable-TV subscription, which costs around $72. For many folks, this cost ratio is way out of whack. In fact, the average American under the age of 50 now watches more content per month on streaming services like Netflix than on cable TV. And that means that on a usage basis, Netflix is an absolute bargain.

On the other side of the argument, there are two major reasons to be worried about Netflix going forward…

Competition is fierce… and getting fiercer. In a recent letter to investors, Netflix management said…

We compete for entertainment time with linear TV, YouTube, video gaming, web browsing, social media, DVD and [pay-per view], and more… As Internet entertainment grows, more companies see the large opportunity.

In other words, Netflix is seeing increased competition coming from all sides.

It’s competing against traditional media companies like Disney and Time Warner’s HBO, which are starting to focus more on their own streaming services. Disney’s shift is particularly worrisome. Among Netflix’s most-watched content were Disney’s animation and superhero offerings (Marvel and Lucasfilm). Disney recently announced that starting next year, it’s pulling its new content from Netflix in favor of its own streaming service.

Netflix also faces competition from global tech behemoths Apple (AAPL), Google parent company Alphabet (GOOGL), and Amazon (AMZN). These three should terrify shareholders.

Apple has Apple TV… it’s starting to invest in its own content… and its $240 billion pile of cash is larger than the GDP of most countries. Google owns YouTube, the No. 2 streaming site behind Netflix, which is also investing in premium content. And Amazon’s Prime Video is a rapidly growing No. 3. CEO Jeff Bezos – who seems to be taking over every other industry – has recently declared video as a likely “fourth pillar” focus for the company.

Not only do these three companies want to provide you with content, but they want to control the “pipes” for how you consume that content. They all have operating systems – Apple’s iOS, Google’s Android, and Amazon’s Alexa – whose goal it is to be the operating system for your life. That means on your phone, in your home, and pretty much everywhere you can imagine… And that includes making their own offerings the default way for how you watch shows and movies.

The second – and even bigger – concern is that Netflix’s current business model is totally unsustainable…

Netflix has a dirty little secret: It’s burning through cash like no other media company on the planet.

This is by far Netflix’s biggest problem, and one that it will eventually need to solve. It makes the company’s business unsustainable. The worst part is, the bigger Netflix grows, the more money it loses.

You won’t see this on its income statement. The company has changed its accounting methodology to make sure of it. According to the income statement, Netflix is profitable. It generated more than $500 million in net income in 2017, and analysts expect that to double this year.

But as any vigilant investor knows, net income doesn’t always tell the true story about a company’s actual earning power. To get that, we must look at a company’s free cash flow (“FCF”). We call FCF “the number that doesn’t lie.”

Free cash flow is what’s left after a company pays for all cash expenses and capital investments. That makes it a great measure of a company’s true earnings power. It can use that FCF to reward shareholders through dividends and buybacks, or to invest back into the company for incremental growth.

It’s worth noting that sometimes the profits reported on a company’s income statement understate its earnings power. That’s often the case with subscription businesses such as Stansberry Research or a software-as-a-service (“SaaS”) provider. These businesses generally receive cash up front – sometimes for long-term service relationships – and record revenues and profits over time.

But in the case of Netflix, it’s the opposite… The company’s income statement vastly overstatesits earnings power.

The main reason for this is a delay in when Netflix recognizes spending for media content. Consider the following: On its investor relations website, Netflix writes…

In 2018, we expect to spend close to $8 billion on a [profit and loss] basis on content for our members.

Now, $8 billion is a ton of money to spend on content – more than any other company spends besides Disney. But the problem for investors is that the amount Netflix will actually spend this year – on a cash basis – is more than $12 billion.

Rather than recognizing all of this spending today, Netflix delays the profit hit. Management argues that the useful life of this content is far longer than just a year, so the company should spread those costs over time. But this makes Netflix’s financials aggressive… and misleading.

The following chart shows this powerful trend at work…

Over the past five years, Netflix has reported a total of $1.2 billion in net income. In reality, its true earnings power is much worse… Over the same period, Netflix hemorrhaged free cash flow every year, for a total of negative $4.8 billion… or a difference of more than $6 billion between the profits Netflix reported and the losses it actually generated.

But it gets even worse… Netflix has already forecast FCF losses of $3 billion to $4 billion in 2018 and 2019 each year. This amount of negative FCF is shockingly bad for a company expected to generate less than $16 billion in revenues in 2018.

In other words, for every dollar of revenue it generates this year, Netflix expects to losearound $0.25. How’s that for a viable long-term business model?

Netflix can’t continue like this forever. At some point, the company must make money. And yet, a recent letter to investors suggests that won’t happen anytime soon (emphasis added)…

With continued “success,” we will invest more in originals, which would continue to weigh on FCF, even after we achieve material global profitability. As a result, we anticipate being free cash flow negative for many years.

Investing in the stock today means you’re signing up for billions in losses per year for the foreseeable future.

Now, I’m not saying you should sell shares of Netflix short…

As I explained earlier, the company is an industry disruptor, is growing rapidly, and has tremendous pricing power.

Still, FCF would have to dramatically change for the better before I’d tell any investor to buy shares. That could happen… Netflix could grow its user base faster than its content spending. But over the past eight years, the company has grown its subscriber base by 29% per year while growing the cost of its content by 54% per year.

Or Netflix could take advantage of its pricing power and raise the cost of a subscription on a happy user base that would be likely to oblige.

But until then, investors should stay far, far away from Netflix. It’s growing too fast and its customers love it too much to sell short today… But its market is too competitive, and its cash flows are too negative to go long.

Netflix is a fascinating company to analyze…

And over the past nine years, it has been a great example of a stock that can soar during a bull market starved for growth companies.

But it also represents a great lesson on the difference between accounting net income and true free cash flow. Ultimately, you can’t ignore FCF.

When the bear market finally arrives, Netflix could become the poster child of what not to own. By then, no one will care that Netflix added 1 million subscribers if it burned through billions of dollars to get them.

In the meantime, I recommend keeping close tabs on Netflix’s quarterly numbers, because its share price could tell us a lot about the health of the overall market.

Regards,

Austin

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