You can rarely go wrong if the basis of your search for a long-term investment hinges on the following question: “What do the profits per share figures look like over time?” It is a single-question inquiry that will exclude some investments that will do well, but it will rarely lead you to an investment candidate that will perform poorly (in other words, this question will yield few false positives.)
Right now, I’d like to talk about one of the stocks that gets excluded under such a screen: Netflix. Over the course of my adult lifetime, it has been just about the best investment you could make. Over the past eight years, it has risen in value from $2 per share to just a tad under $100 per share. Increasing your wealth fifty-fold in eight years is, needless to say, truly life-changing as even a $10k investment in Netflix has grown into half a million dollars.
One of the reasons why I completely missed this investment, and feel no remorse about it as it is outside my circle of competence so there is no reason I should have felt entitled to profit from it, is that there is a huge disparity between the cash flows that Netflix generates and the profits that remain to stick to the ribs of shareholders. This is because Netflix pays huge amounts of money to license the content that it distributes to its users.
If you look at Netflix’s cash flows, you will see that the cash flow per share increased from $0.79 to $10.50 over the past eight years. This is cash flow growth at an astounding rate of 38% per year. It collects $4.4 billion in annual fees from its subscribers compared to $335 million in annual fees back in 2008. From a changing video technology perspective, it is a tremendous business accomplishment.
But bringing money always needs to be measured against the money that you are sending back out. And because Netflix buys the rights to stream a good chunk of its popular content, this means that Netflix must turn around and share an inordinate amount of the funds generated from its platform with the owners of the content that gets streamed (consider this: Netflix has to pay $30 million to stream Desperate Housewives, and almost $60 million to stream Lost.)
In 2008, Netflix had to spend $0.60 per share to get its hands on licensing rights. Now, it is spending $10.23 per share to get its hands on licensing rights. In percentage terms, the cost of content for Netflix has increased at a rate of 42.55% each year since 2008!
That is why I missed, and continue to not be enamored with, the Netflix growth story. So far, it is a business story of runaway growth coupled with even greater runaway costs.
This makes Netflix a fundamentally different case study from nearly everything else I cover. With almost every business that commoditizes something, getting bigger is always better because you will have access to bulk pricing and the costs per unit go down as the business expands (getting your hands on 100,000 gallons of milk will cost less per gallon than getting your hand on one gallon of milk, absent some personal connection to farm animals.) And even if there is some supply/scarcity issue with the business model, any uptick in the price per unit is usually minimal.
This is not the case with Netflix as it licenses content. Because Big Media is generally consolidated, and there is a small nucleus of shows/videos that are in demand, Netflix has to go to the bargaining table and contract with the likes of Disney who will demand ever-increasing premiums to license their content. If you are going to stream to 100 million people rather than 1 million, you’re going to pay somewhere in the ballpark of 100x the rate collectively across the content that you license. The typical advantages of size haven’t converted into profit improvement–in fact, as Netflix has gotten larger, its content costs have increased at an even higher rate.
Even though Netflix does create its own content, you still end up with the bottom line that Netflix only makes $100 million in profit despite generating over $4 billion in cash flows. I suspect that Netflix knows it will never get the content costs down on its own, as much of its quarterly conference calls focus on the pursuit of Netflix-sourced content that doesn’t come with the hefty licensing price tag.
The other possibility, of course, is a strategy that interweaves the Netflix business model with some type of content owner. This is why a potential Disney-Netflix merger could be quite lucrative. Disney has ownership of Marvel, Pixar, LucasFilm, ESPN, and ABC, and could implement a strategy that launches some of its own content onto the Netflix platform that reaches millions. The difficult question is trying to figure out if, and to what extent, Disney may be required by regulators to hold arms-length contract negotiations between its own subsidiaries in determining the cost of its content.
If there is a Disney merger, it would be an amazing bit of good fortune for Netflix shareholders because they would be reaping an enormous windfall from a business model that had a near-permanent deep flaw in its fundamentals. I have no idea how you appraise it going forward. It is very rare to find a company that trades at 10x cash flows while also trading at 367x normalized earnings.
I will say this, though. Usually when a large-cap company fails to earn a meaningful profit for years and years, it is because it doesn’t have the business model to do so. And historical investment returns are not kind to corporations that fail to convert from “Metric X of Success” to “profit growth” over the long haul. Netflix may work out well for investors if it is the target of a merger, but the current fundamentals suggest that it is trading at least partially on a greater fool theory.