Saturday, August 6, 2011 2 comments ++[ CLICK TO COMMENT ]++

Is Netflix's streaming model uneconomic? I don't think so

Netflix (NFLX) is an online and mail-order movie rental business that has been one of the high growth stocks of the last few years. Its valuation looks sky-high and there are quite a number of investors who are bearish on the stock. I don't have an opinion on the stock or its valuation but how about its business fundamentals? Is the online movie streaming model being pursued by Netflix sustainable?

A blogger on SeekingAlpha, Slim Shady, is apparently short the stock and provides a write-up, "Why the Economics of Netflix's Streaming Business Is Likely to Fail," purporting to show that Netflix's model doesn't earn enough money to justify any reasonable valuation for the company. I think there is a flaw in the author's argument. Here is his/her bearish thesis (bold by me):

Over the average lifetime of a subscriber of 1 year, at $7.99 per month, the company will receive about $96 of revenue. Their marketing cost to acquire a domestic subscriber in the 6/30/11 quarter was $15.06. As of 6/30/11, total Current Content on balance sheet due within the next 12 months was $499 million plus Content Obligations within 1 year off balance sheet were $625 million or a total of $1.124 billion, which is $46.62 per ending paying sub (which assumes that all current subscribers become streaming subscribers).

The annual cost to stream content is estimated at about $4 per sub. General & Administrative expenses and Technology costs have totaled about $1.28 per month per average paying subscriber, which is $15.36 per year. Adding it all up, you get the following economics of a streaming customer over its entire average life, rounded up to one year:

Revenues $ 96
Less: Marketing Costs to Acquire (SAC) $ 15
Less: Content Costs $ 47
Less: Content Delivery Costs $ 4
Less: General Admin & Tech $ 15
Total Pre-Tax Profit $ 15
Tax Rate 40%
After-Tax Profit over the average life of a streaming subscriber $ 9

The total after-tax profit over the lifetime of a streaming subscriber is only $9 - not thousand, just $9. At the current market value of $14.3 billion, it would take almost 1.6 billion new streaming subscribers (without discounting to the present value) to justify the current market cap.

Let's assume the figures quoted are reasonably accurate. If so, the author suggests that Netflix will earn $9 per customer per year. Given the sell-off recently, the market cap of the company is slightly lower than what is quoted but let's go with the quoted figure of $14.3 billion.

The author suggests that the valuation cannot be supported because it would take 1.6 billion customers (ignoring discounting, inflation, etc) to justify the valuation (i.e. $14.3b divided by $9). The implication is that the valuation is way too high since gaining 1.6 billion customers is almost impossible in this market.

There is a flaw with the author's analysis.

What the author misses is the fact that the market cap is a life-time figure — value of the company over its, say, 30-year (or whatever) life. Whereas the $9 revenue per subscriber figure is an annual figure.

You actually don't need 1.6 billion customers to justify the current valuation. If you attach a P/E multiple of 15—this is the long-term American average and is reasonable for an Internet service with potential customer lock-in through exclusive content deals—then the company only needs to earn an income of around $953 million each year ($14.3b divided by 15). As in the original write-up, I am ignoring discounting and simply looking at a simple computation. Furthermore, no thought has been given to potential improvements in efficiency or any decline in SGA or content delivery cost; conversely, increases in content delivery cost or other operating expenses hasn't been considered.

If net income needs to be $953 million and you are earning $9 per subscriber, you only need around 106 million subscribers. This is a far cry from the 1.6 billion customers that the original write-up indicated was necessary. Although 106 million is still quite high, it is within reach if you are really bullish on the company and build in rosy forecasts. Currently Netflix has a little less than 25 million subscribers I believe, so it needs to quadruple its customer base. It needs around a third of the total US population — a tall order and I wouldn't bet on that happening with a high degree of confidence but it is within reach.

So to sum up, if you are a fan of using P/E multiples, like I am, always be careful with market cap, which in theory is the discounted cash flow over the life of the firm; and any annual figures such as earnings, sales, advertising costs, and the like. If you are buying for $10 billion (market cap), you will be more than fine if the company only earns $1 billion per year.

Side Note:

Having said all this, I am not bullish on Netflix's stock and the future needs to be rosy to justify its valuation — it's a pure growth stock with possibly tiny margin of safety and it ain't my cup of tea. However, the business model is not as flawed as the author indicated in the write-up.

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2 Response to Is Netflix's streaming model uneconomic? I don't think so

August 6, 2011 at 7:37 PM

"Adding it all up, you get the following economics of a streaming customer over its ENTIRE AVERAGE LIFE"

"The total after-tax profit over the LIFETIME OF A streaming subscriber is only $9 "

Why would you assume that netflix customers would suddenly never cancel the service? Looks clear to me that author used current average lifetime of customer whereas you assume that this will increase indefinitely.

Even if you argue the one year net income part, Netflix still needs 1.6b customers unless customers re-sign up. No?

Sivaram Velauthapillai
August 6, 2011 at 10:30 PM

UBC VIP: "Why would you assume that netflix customers would suddenly never cancel the service? Looks clear to me that author used current average lifetime of customer whereas you assume that this will increase indefinitely. "

Not shown in my post but there is already an assumption of 10% churn rate in the original quote (but that churn wasn't exactly to address your concern and it had more to do with some issues of Netflix's recent change in pricing).

As for not factoring in user defections/cancellations/etc, I don't think it is a big deal in this case. This is a new market and Neflix (and others) are starting from a low base. I suspect that they will have net additions over the near future. It's kind of like cable television in the 80's or wireless carriers in the 90's. Users may cancel their service but net additions were positive for a long time. Once the market sort of matures (like cable TV or wireless communications in some market right now) then your concern about cancellations and churn needs to be considered more seriously.

To sum up, I think you raise an important issue but it likely won't impact the conclusion in cases like this, where you are starting from a low base with a company that appears to provide a valuable service with limited competition.

UBC VIP: "Even if you argue the one year net income part, Netflix still needs 1.6b customers unless customers re-sign up. No?"

I don't think it's accurate to view it that way.

Yes, you need every single customer you have to continue their subscription every year. But that is almost a given. There will be some churn (your first point above) but if you assume that is going to be small (or that you will gain more additional customers than you lose i.e. additions is net positive every year) then it is reasonable to assume that every subscriber will remain with the company the following year.

I think it would be misleading to assume that you need to re-acquire every single customer every year with the original marketing and acquistion costs! Unless you have reason to think otherwise (i.e. product becomes obsolete, pricing not good enough, etc), subscription businesses generally retain their customers. I think it is safe to assume that most customers will continually re-subscribe. Again, kind of like wireless phones or cable television. Yes, people can leave but when you factor in marketing and promotions, switching costs, etc, you will find that it will be misleading if you assume every single cable subscriber is going to leave and you need to re-aquire them. (You see more churn problems in wirless communications or cable television because they are more mature industries and each company tends to steal market share away from other similar companies. I don't think that is the case in online movie rentals since it is a new, disruptive, medium.)

So, it will be misleading to say that Netflix needs 1.6 billion customers. All it needs is around 106 million, which is still 4x what it has right now.

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