If you enjoy movies and TV sitcoms, Netflix (NFLX) offers one of the best tradeoffs for consumers in Western Civilization’s entire experimentation with capitalism. If you watch 50 hours per month, your effective cost of entertainment is only twenty cents per hour. I don’t there’s a better value proposition in the market than that.
Consumers know a good deal when they see one, and Netflix reported yesterday that it picked up 5 million new subscribers to brings it total subscriber count to 93 million. Adjusting for the lower subscriber charges abroad, this means that Netflix is bringing in $5.5 billion per year from its subscriber base.
When you see the price of Netflix stock climb to $143 per share in after-hours trading, the $60 billion valuation for the streaming giant at first sounds reasonable.
But the reality is more complicated than that. Netflix is distinguishable from firms like Pepsi, Colgate, or Johnson & Johnson because its fixed costs are enormous. It has to pay obscene-sounding licensing fees to have access to the content it streams to its consumers.
And, the more appealing the content, the higher the fees.
When Netflix chooses to create its own content, it must engage in the capital intensive endeavor of paying actors, screenwriters, and all the accompanying costs of producing content while taking on the risk that its in-house sitcoms will not be successful with its customers.
At the present tally, these annual content costs are a little bit above $5.1 billion. This is nothing new—the entire story of Netflix’s existence as a publicly traded corporation has been one of finding ways to get its subscriber base revenue just a little bit above its costs to farm the content.
Even with all of this good news, Netflix has only managed to carve out a profit engine for itself in the $350 million range. At a $60 billion valuation, this means that Neflix is trading at 171x earnings.
Every generation, there is a crop of stocks that get valued as though profits do not matter. Then, something happens—slow revenue growth, a major macro event, a new hot industry—and investors regain their senses. The current valuation of Netflix can only be justified if you think that Netflix has a reasonable chance of hiking its monthly subscription cost from the $10 range to above the $30 range. If you think that is doable without significant customer hemorrhaging, then you at least have a rational basis for the investment.
As for me, I shy away from the enormous input costs that don’t have a chance of coming down. I’d rather own shares in the successful content producers like Disney, or Viacom when it is trading at its present rate of $39 per share. If you produce good content, people have a tendency to find a way to it. The platform is just a mechanism of access that frequently changes as soon as a better mousetrap is built. People don’t intrinsically like Netflix; they intrinsically like cheap and convenient access to entertainment.
It is the same story that plays out in retail. Unless your dad worked at Kroger, you are not going to feel inherently loyal to the place. If Wal-Mart has cheaper deals, and it’s just as close by, people tend to become Wal-Mart shoppers (although Wal-Mart has at times carried a social stigma so people avoided being seen there for fear of being judged, a reputational effect that Aldi seems to be working through right now).
I don’t think Netflix makes sense as a long-term investment at $143 per share. The high content costs aren’t going to go away—even if Netflix leans hard on original programming. That means, to trade at a sensible valuation in line with everything else in the history of the developed markets, Netflix will need to raise its subscriber costs. Netflix needs to more than double its monthly cost, without losing many customers, for a coherent investment thesis to emerge.