(The following post contains spelling errors.)
I am not a Netflix subscriber as I can't speak with 100% confidence about the user-experience but I have spoken with two users in past tow days and both praised the service and one of them was very proud of being their customer for more than four years. (I have been cable subscriber for more than 13 years but only because I don't want to spend time looking for alternatives and learn to operate on a new remote control). Never the less, having lived through the hyper-growth years of mobile phone providers and on-line service providers and have witnessed what happens to stock market valuations once subscriptions reach saturation point, Netflix will become a short at some point. Netflix might not be a short candidate yet though.
Positives:
* 11 million subscribers with average subscriber growth up over 35% annually since 2005. So far they have managed growth very well. With 100k+ titles and 12k titles available for streaming in NFLX library and 55 million DVDs. Technology to manage the process works! 600,000 USPS are ready to deliver.
* EPS growth despite of tough economic conditions. FY07 - $0.97, FY08 - $1.23. Tougher economic conditions have helped NFLX as consumers have found DVD rental as a substitute to other expensive means of movie watching. These consumers will continue to remain subscribers once economic conditions improve. (if one can afford them in bad times, they can certainly afford them in good times!)
* It took a decade for DVDs to replace video tapes and will take decade for Blu-ray to replace DVD. DVDs provide longivity of product for Studios so they have become core of studio's profits so they will continue to support movie-rental businesses. in 2007, 28% of studio film revenues came from theatrical versus 54% from home video (VOD 4%, Premium TV 8%, TV 6%)
* NFLX is growing at the expenses of traditional rental outlets. Blockbuster/Movie Gallery/Hollywood revenue growth is flat for past five years while NFLX has grown from $0.3 billion to $1.36 billion with could reach $1.6 billion in FY09. Video stores are closing across America. Mom-n-pop video rental stores are almost dead!
* Potential market size is huge. Home video market is a $24 billion large. DVD rentals is ~$8 billion out of this. Video on demand is picking up and already at $1.6 billion and NFLX will be a beneficiary of this growth as well as it scales up online streaming.
* Streaming opportunity is equally promising if not even more promising. Over 99 mm HH pay for TV and 60 mm HH has broadband and 30 mm+ pay for HBO and 73 M HH have a dvd player and internet access. Streaming market is much larger than DVD rental. Ecommerce growth, comfort with the using technology, improving VOD/DVR from cable/satellite/teco is training new sets of potential customer.
* Studios will keep what NFLX spends for postage and handling so they will support success of NFLX. Content availability is growing. TV networks are comfortable giving newer content to NFLX.
* Company is working well with consumer electronics companies to come up with solutions to bring video viewing from PCs to TVs. Netflix receivers or TV sets ready-to-receive streaming will make VOD easier. Higher the share of VOD, lower the churn and DVD usage for NFLX. This is a win-win situation for electronics companies as they can promote their products to NFLX's large subscriber base and provide differentiation.
* 20 million subscribers have used it and company claims that most cancelling subs say they will return. Subscriber acquisition cost (SAC) will drops as the brand has become a household name.
Negatives:
* Blockbuster will not walk away without giving a fight. BBI has $2 bn os sales and it won't walk away easily (even if it means money-losing fight). This is a wildcard! It is possible that BBI could become a leaner "kiosk" type of company with low-price point and also scale up streaming.
* Kiosks are growing to $500-600 million in FY09 and expected to grow at $1 billion by 2011 as per Adams Media research.
* Pirate Bay, Apple, Amazon, YouTube, Hulu and Studios themselves are scaling up online and offline distribution. Improving VOD/DVR from telco cable/satellite/telco. Comcast, Apple, HBO or Amazon entering internet movie streaming.
* Departments stores like Walmart has set up a DVD rental kiosk and charge $1/day. Limited service kiosks are picking up. Too early to tell if they will survive but kiosks are already clocking $200 million+ in revenues.
* DVD shipments to peak in 2013-2018 and VOD and online streaming will become the standard. If the company is not able to fight internet companies with deep pockets and studios themselves go direct to the consumers, NFLX could lose out.
* NFLX will need to allocate large capex to install streaming capabilities, add more streaming content, manage DVD substitution, retention and fight off well established cable/telco companies who could become much fierce competitor (unlike BBI in DVD rental business)
* Streaming spend will certainly pressure P&L, causing near-term lower growth in EPS. Automation drives efficiency in DVD rental and 60% of the process is automated but can further improvement possible?
* 97% of the subs are serviced in 1 Business Day. Company claims that it can not do better than this but also can not drop the expectations either so distribution costs will not go down further.
* With the budget deficit of the US growing, expect further hile in USPS First Class Rate is all but certain. Jan-06 +5%, Jan 07 up +5%, Jan-08 up +2%
Economies of scale working and business model is becoming more stable but growth comes with price and streaming is not same as mail-order rental!
* Marketing expense as a %age of Total Revenue dropped from 24% in Q1'05 to 17% in Q1'08. Recurring revenue grows faster than marketing expense. However keep in mind that churn is natural. The current churn rate of 4%/month will require marketing costs to remain at the current levels. in 2008, Gross subs were atr 6.8 mm and cancellations were at 4.9 mm, net subs at 1.9 mm. management defines marketing as variable expense. I disagree. In this business model, it is a fixed expense. To stay in business and even to retain its subscribers, marketing expense is required evil. Fixed costs are going to remain at 27-20% of the sales. (Fulfillment expenses are at 12% and content cost is at 60%). (See the IR website for data)
* Subscriber profitability grows with the length of membership. More than 50%of the subs are greater have been Netflix subscriber for more than a year. 3/4th of the revenues coming from old subscriber versus current year subscriber in FY08
* Streaming initiative could drag margins. Digital streaming is free to subscribers resulting in new layer of fixed costs. (IF streaming is not provided than NFLX can lose business to new competition) If a subscriber watches the same movie twice, NFLX pays to the content owner twice but revenues does not go up. There are no library nebefits as content providers need to get paid at every click or for certain duration and once the time expires, NFLX has to renew the agreement.
* Streaming offering for newer titles are less compelling than cable/satellite. Newer content will cost more to NFLX.
* 35% historic growth can't sustain as the high-base effect will be seen going forward. 20% growth will equate to 7-8% EBITDA growth. Will ARPU decrease or stay stable will determine the revenue growth as subscriber growth can not come in double digit as saturation will be reached within next five years.
* NLFX gets "internet business" P/E but it's capes-sales of 17% in 2008 is well above typical internet companies and no different than Blockbuster. NLFX is a capital intensive business as it needs to maintain and replenish the DVD library.
Lifetime Value of subscriber
* Return on Capital invested is at 30% and higher than NLFX's cost of capital.
* If NLFX grows at 20% yoy, it will need to grow subscribers at 23-25% (lower ARPU by 1-2%). If EBITDA margins remain stable at 11%, then EPS would be at $1.7 in FY09 (up 27% yoy).
Valuation - for every buyer - there is a seller and vice versa. I hate to say what is the maximum price or target price but looking at the current run-rate, NFLX trades at 12x EV/EBITDA. It's peak was 18 x EV/EBITDA in 2007. The forward P/E us at 24x (which is in line with its historic avg P/E of 26x). Will market continue to assign the growth company P/E multiples if revenue growth starts to drop is the question. Also, as the economy starts to recover, the "earnings growth" premium should go down.
* Average life time of a subscriber = 1 / 4.2% = 24.1 months ( where 4.2% is the churn rate for Dec qtr) (Since 2005 average life of subscriber has ranged from 20-26 months)
* Net Present Value of current subscriber (I calculated this with help of Credit Suisse analyst who cover this stock but I find the number reasonable)
EBITDA = (ARPU * Months * EBITDA %) = 13.53*12*25.6% = $41.6
EBIT = $41.6 -D&A of $24.1 = $17.5
Unlevered Cash Flow = EBIT - Tax - Capex per sub = $17.5 - (40%*17.5) - $3.9 + D&A of $24.1 = $30.7 per sub
PV of Yr1 at 9% cost of capital = 28.3
PV of Yr2 at 9% cost of capital = 23.3 (taking two years as the life time if 24.1 months)
NPV per subscriber = $51.6
NFLX Enterprise Value = $51.6 * 11.4 mm subs = $588.8 mm (for the current 20% market share)
* Market Implied EV and subscriber market share
Enterprise Value = $2,394.2 mm mcap - Cash $275.6 mm = $2,118.6
Enterprise Value / NPV per subscriber = $2118.6/51.6 = 41.1 mm subscribers
41.1 mm subs / Total US TV HHs 115 = 35.7%
In other words, market assigns value of NFLX at 36% market share which is possible for the company to achieve but not easy without burning $200-$300 mm per year in capex.
OR other way of looking at this is, to calculate payback period for acquirer if someone was to acquire NFLX at current mcap
Cash flow per subscriber/year * number of subscribers = $30.7 * 11.4 million = $350 million per year
Assuming zero growth it will take $2118 mm/$350 mm = 6 years.
I don't think it very expensive at 6 years payback for possible acquirer but it is not cheap either. Of course I am assuming that the company will not spend any cash for capex in this scenario which is not the reality! If we look at the valuation in terms of P/FCF perspective then this is trading at 20x P/FCF and 24x P/E.
Risks to shorting -
* Higher ARPU growth - unlikely! ARPUs have faller $17.46 in 2005 to $13.79 in 2008. (Subscribers have choice of plans raning from $5 - $48 per month)
* Higher subscriber growth - possible. It is the subscriber growth rather than average revenue per user that has driven the top-line growth.
* Success in streaming video business - it will reduce fulfillment and subscription costs and could improve operating margins
* Acquisition target - capital is scarce in capital market but NFLX could become an acquisition target for a larger internet company like Yahoo, Amazon, or Ebay or media company interested in it's 11 million subscriber base and solid management team.
I will wait until the price moves up to PEG of 1.25 or higher before shorting this. NOT very inexpensive but not a short yet!
DISCLAIMER: Do not have any position and bias is toward shorts. |
