Netflix security analysis - Q2 2018

Disclaimer: please do not base your investment decisions on any other people’s opinions in the world except for yourself.

Hey community,

@Chris once asked whether there will be interest in some securities’ analysis and I mentioned that I could do it one day.

This time it shall be Netflix. It is a company I purchased when it was at $185 and sold at $250 thinking it is overvalued. Long story short, it got to $420 within the next 5 months making it my worst sale, but I think it was and still is extremely overvalued and would not risk getting back to it.

I will avoid subjectiveness and bias in the following analysis (until after the Conclusion) and most of the information will be presented in figures with minimal assumptions.

Netflix produces and buys licences for movies and TV series. It has achieved a mere 10,000% growth for the past 10 years. But that is sad history, let’s look at the contemporary information: on the 16th of July, Netflix has disclosed its financial results for the second quarter of 2018. We’ll figure out why the shares went down significantly in the past few days.

Results in the USA
Revenue from online streaming increased by 26% in comparison to the second quarter of 2017: from $1.5bn to $1.89bn. In April 2018, Comcast added Netflix to its subscription packages. Comcast has an audience of 50 million people.

Gross profit rose by 32% in comparison to Q2 2017, from $560m to $740m. Profit per Subscriber rose by 19%.

Netflix gross profit from paid subscribers in the US is presented below (In brackets - growth compared to the same period a year ago):

| Period  | Profit       | Subscribers   | Profit per Subscriber |
| Q1 2017 | $605m        |  49.4m        | $12.3                 |
| Q2 2017 | $560m        |  50.3m        | $11.1                 |
| Q3 2017 | $554m        |  51.4m        | $10.8                 |
| Q4 2017 | $561m        |  52.8m        | $10.6                 |
| Q1 2018 | $697m (+15%) |  55.0m (+11%) | $12.7 (+3%)           |
| Q2 2018 | $740m (+32%) |  55.9m (+11%) | $13.2 (+19%)          |

Results in other countries
Revenue rose by 65% in comparison to Q2 2017: from $1.16bn to $1.92bn. Since July, Netflix is testing a new Ultra subscription type in Europe: it is more expensive than others, some advantages are moved from the Premium and will be left only in the new subscription type. Discomfort for the users, income for the company, damage to the image.

Gross profit increased in comparison to the second quarter of 2017: from -$13m [loss] to $298m [profit]. In terms of profit/loss per subscriber, Netflix reached its peak of $4.3, which remains the same since the previous quarter.

The total revenue and profit grew thanks to higher subscription prices, and not due to a sharp increase in the number of actual subscribers. The company showed the result below the analysts’ forecasts and hence many investors sold their shares due to lack of confidence.

Netflix’s profit from paid subscribers in the rest of the world:

| Period  | Profit | Subscribers | Profit per Subscriber |
| Q1 2017 | $43m   |  44.9m      | $0.9                  |
| Q2 2017 | ($13m) |  48.7m      | ($0.3)                |
| Q3 2017 | $62m   |  52.7m      | $1.2                  |
| Q4 2017 | $135m  |  57.8m      | $2.3                  |
| Q1 2018 | $272m  |  63.8m      | $4.3                  | 
| Q2 2018 | $298m  |  68.4m      | $4.3                  |

Netflix achieved a cash-flow loss of $518m. According to the Income Statement, the company profitable, but Netflix does not receive real money. The difference arises from the accounting principles for calculating the costs: Netflix pays for their licences straight away in full, but when reporting these in the Income Statements, the cost of each licence is split for the duration of the show (e.g. if a series is 10 years long and they paid $10m on day one in cash, only $1m per year will be counted as cost each year for the next 10 years).

Netflix reduced the loss by 3%, but by the end of the year, the company will spend another $2-3bn creating and acquiring new content. Moreover, the company increased its loans by 10%, up to $10.6bn - and this is additional cost going forward, especially with the Fed constantly increasing the interest rates (2% it is already, whilst we are lucky with 0.5% in the UK).

Netflix’s ratios in comparison to its direct competitors:

   | Ratio          | Netflix | Disney | Amazon |
   | -------------------------------------------|
   | EV/EBIDTA*     | 119     | 11     | 51     |
   | EV/CF**        | (199)   | 13     | 49     |
   | Debt/EBIDTA*** | 6       | 1      | 0.4    |
   | ROIC****       | N/A     | 18%    | 11%    |
   | Revenue Growth | 31%     | 4%     | 28%    |

*The less, the better (close to or less than 10 is often a severe undervaluation [$MU is exempt from that logic]).
**Same as EV/EBIDTA but considers real cash flow instead of accounting profit. Hence Netflix at the moment is making a monetary loss from their operations.
***At least how many years the company will need to repay the debts. Under 3 - usually fine. Over 5 - risky. Netflix has a very significant amount of debts and it is particularly risky in the times of the Fed raising interest rates.
****Profitability. But excluding one-off costs (ever tried to “exclude from summary” one of your Monzo transactions? This is that). 15% and over is generally fine. As Netflix only has profit on the “books”, we could not get their ROIC but there is an indication for the competitors.

The price of Netflix’s shares depends on investors’ expectations of the subscriptions and revenue growth. Netflix shares are for those who are ready to take risks: the company does not pay dividends, the growth depends on the expectations of large investors. The company increases loans, but not its own cash - this is bad. Also, it is severely risking to lose all Disney’s content in 2019 since Disney is getting Fox (that is 100% legit now) with their user base, which could all be moved to Hulu (honestly, what else do people watch in cinemas other than Disney’s content?).

Whilst there are most likely hard times for Netflix to follow, it still has an enormous room for growth and development. It’s only got 120m subscribers, which is 1.5% of the world’s population. Going forward (10+ years we are talking about), with current global demographics and rapid technological development, significantly more people will be exposed to streaming services and if Netflix plays its cards correctly, they can still double their net worth every 5 to 7 years and thus it still can be a good investment decision in the long run. But at the moment it does seem like there are more undervalued companies out there. Even within the same sector.

Certainly, it is hard to include everything in one post so I tried to concentrate on the latest earnings report but happy to see more points raised by the community members if I have missed something paramount.


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