Netflix (NASDAQ:NFLX) lost around 15% of its market cap when it missed the net addition expectations during the second quarter.
A price increase was the most frequently cited reason for the missed expectations. However, that isn’t the only problem Netflix has. On the surface, it looked like a pricing problem, but the company is facing several other challenges including a tricky business model, poor expansion strategy and strong competition.
About the net additions
During the second quarter, the company missed expectations on all counts, including domestic and international subscriber additions.
As can be seen from the table, the company fell short of its guidance. And it’s not just related to price increases. Other culprits include stiff competition and lack of enough original content. Note that the company is guiding for 2.3 million net additions in the current quarter as compared to the analyst consensus of 3.5 million additions.
Business model concerns
Netflix relies on a flat-fee subscription for its revenue. The service isn’t priced very high to encourage subscriber growth. But the problem is that content is expensive; subscription fees can’t cover the content acquisition costs on a sustainable basis. In cash terms, Netflix spent more than 100% of its revenue on the acquisition of streaming assets during the first half of 2016.
Another problem is that content is licensed on a time basis; it’s not perpetual. Netflix has to renew license content constantly. Therefore, it’s not possible to reduce the spending related to content acquisition. Furthermore, according to Netflix, content owners always want multiple bidders in order not to give high bargaining power to only one bidder. Therefore, licensing high quality content frequently can get really expensive. There’s no way around spending on content if Netflix wants to retain subscribers.
Moreover, the company isn’t planning to generate revenue from lucrative advertising business. Unless Netflix incorporates advertising, it will be difficult to compete against seasoned content providers like HBO.
Right now, Netflix is burning cash in order to fuel growth. Cash balance decreased by 23% during the first half of 2016.
This is not an ordinary growth company that can increase cash flows later. The company doesn’t fit the model of declining average costs like other cloud-based service providers. Content costs will increase as the company grows. It can’t use the same content for every market because of taste differences. All in all, subscriber fees aren’t enough to cover for content costs; if Netflix reduces on content acquisition, churn rate will increase. Therefore, Netflix should use additional monetization options to keep up with content costs.
Netflix has launched its services in more than 130 new markets this year, but making the service available across the world isn’t going to solve the cash flow problem. The company has to acquire new content for new markets. Further, there are specific problems with every other market. For instance, in emerging markets, the problems include low disposable income of households, piracy of content and payment infrastructure challenges. Netflix has the following to say about piracy.
“Video piracy is a substantial competitor in many international markets. Music revenues have been falling for 15 years due to large scale piracy.”
The company adds that the video market will be “hopefully prevented” from the decline related to piracy. Due to the above-mentioned concerns, the initial uptake in international markets doesn’t look good. The cost of revenue was 94% of the revenue during the first half of the year, which was 91% on a year-over-year basis. This indicates expansion won’t lead to economies of scale and margin isn’t going to get better just because of expansion. Netflix should find some other way to monetize its content. Growth isn’t going to help margins a lot.
Competition and other concerns
As mentioned above, content owners don’t give up bargaining power to a single bidder, which leads to expensive content. Further, this leads to fragmented provision of quality content, and the consumer has to choose between service providers. Netflix argues that the entertainment market is broad, and multiple firms can be successful in the market. However, bull thesis is based on market dominance, not on the presence of many successful firms. Netflix’s valuation is based on perception of monopolistic dominance in the future. A forward PE of 100 can’t be justified on the basis of “many successful players in the market.”
Other concerns include use of market power by ISPs to extract interconnect fees, which will increase costs further. Raising debt financing from high-yielding markets will result in financing costs, which will pressurize cash flows even further. The company is planning to raise debt in 2017. The rationale is the tax savings due to tax deductible nature of financing through debt. But the company has to pay interest in contrast to equity financing where there’s no obligation. Debt finance will just put more pressure on earnings and increase the financial risk of Netflix.
Another problem is that Netflix focuses on contribution margin, which takes into account cost of content acquisition and marketing while ignoring the administrative expenses. But these administrative and other operating expenses are also increasing in line with growth. See the table below:
Source: Earnings release Q2 2016.
Other operating expenses increased by 39% while revenue increased 26.2% during the first half of the year on a year-over-year basis. This indicates that the metric “contribution margin” doesn’t reflect the actual contribution left after accounting for variable costs. Other operating expenses are also increasing, and the company should incorporate these in the calculation of contribution margin. Taking into account the other operating expenses, the company generated a mere 3% margin. That isn’t enough to justify a skyrocketing valuation that Netflix has.
Netflix has a business model problem where it’s difficult to keep up with the increasing costs of content acquisition. The company will constantly burn its cash if it doesn’t explore additional monetizing options. Only growth is not the answer to Netflix’s problems because the company doesn’t fit the criteria of decreasing averages costs. Further, many concerns needs to be addresses regarding the international expansion. With cash flows in the red, increasing costs of content and variable operating costs, Netflix won’t be able to benefit from economies of scale. Therefore, the inflated valuation isn’t justified and investors should stay away from Netflix unless the company adds some other revenue streams to its business model.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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