EUR 850.00 For Business Accounts Only

Morningstar | Raising Netflix FVE to $120 but We Still Foresee Rising Competition and Massive Content Spending. See Updated Analyst Note from 19 Jul 2018

We have taken a fresh look at Netflix in light of the firm's recent quarterly results and revised guidance. As a result, we are raising our fair value estimate to $120 from $90 to account for slightly faster margin improvement in the U.S. and international segments, faster growth of international net subscriber additions, and slightly faster growth in the average monthly revenue per paying member in the U.S. Even with the increase in our fair value estimate, shares of narrow-moat Netflix still appear fundamentally overvalued to us.

Our 1-star call rests on five key points about Netflix and the competitive landscape in which it operates. First, we believe that the level of competition in the U.S. and internationally is increasing and will continue to do so in the near future. Disney will launch its own branded SVOD service in the second half of 2019 and other firms such as Walmart are reportedly planning on entering the market as well. Second, we suspect that these competitors plan on undercutting Netflix's pricing which should limit the speed at which Netflix will able to increase prices. Management at Disney has promised to price its branded SVOD offering significantly under Netflix at launch.

Third, we project that Netflix's free cash flow burn will continue as the company ramps up its investment in content. The reiterated 2018 guidance for free cash flow loss of $3 billion to $4 billion implies a loss of $2.2 to $3.2 billion in the second half which would be larger than the $2 billion burn in all of 2017. Fourth, we believe that the need for increased content and marketing spend outside of the U.S. will limit the rate of margin expansion for the international segment. Finally, we envisage a world in which Netflix is one of the major OTT media channels, not the only one or part of a duopoly with Amazon. We note that Netflix management at least publicly views their platform and its future in a similar manner to us.

Elaborating on our points above, we note that while Netflix has so far trounced its competition in the U.S. by reaching over almost 56 million paid subscribers, Hulu has posted impressive sub growth over the last few years and reached 20 million paid subs in May. We believe that Hulu will benefit from being controlled by one firm (Disney) as well as the further adoption of OTT pay TV in the U.S. As we have discussed in the past, there are a number of niche SVOD providers that cater to fans of very specific genres such as anime or Asian dramas that could pull subscribers away from Netflix and other mass market SVOD providers. Major firms are creating niche SVODs like the DC Universe offering from Warner Bros. which will launch this fall for $74.99 per year or $7.99 on a monthly basis. Outside of the U.S., Netflix faces regional players including strong competition within one of the firm's most important growth markets, India, where Netflix is chasing both Amazon and the market leader, Fox's Hotstar. Both Amazon and Hotstar are priced well below Netflix and Hotstar benefits from a very popular free tier that is ad-supported. Hotstar should also benefit from joining Disney with its new direct-to-consumer outlook.

Many Netflix bulls appear to view the current $8 billion annual content spend as a long-term investment that the firm can use to lower its future content spend. We believe that while content libraries do have value, Netflix is similar to more traditional media networks such as CBS or HBO in that the firm needs to constantly acquire and produce new content to both attract and retain viewers (also known as subscribers in the case of Netflix and HBO). If Netflix significantly reduced the amount of new content that it put onto its platform, we would expect churn to increase as viewers would flock to the other OTT providers and traditional channels which would be adding new shows and movies. While Netflix is building out a strong content backlog, competitors such as Disney, Warner Bros., and NBC Universal have been creating their respective libraries for decades and continue to expand them with new content. We also note that these firms can monetize both new and old content on multiple platforms unlike Netflix which has one primary source of revenue, subscriptions.

While Netflix is the largest global SVOD platform, we don't believe that viewers of the near future will only have a choice between Netflix and Amazon. Not only will there be SVODs from traditional firms like Disney, we believe that consumers will continue to watch linear TV. While cord-cutting and cord-shaving have hurt the traditional pay TV providers in the U.S., we note that the lower priced OTT bundles from providers such as Sling, Hulu, and YouTube have attracted over 5.5 million subscribers. While ratings are down for TV viewing, the average American household still watches over four hours of live and time-shifted TV a day according to Nielsen. Beyond traditional media firms like Disney and CBS, tech firms like Facebook and Apple have started to invest in content creation. We believe that the current stock price reflects a final state in which Netflix is either the only major content provider or part of a duopoly with Amazon, particularly for serial (or TV) content. The current 2022 consensus adjusted EPS of $12.99 implies just under 50% annual EPS growth from the current consensus 2018 EPS of $2.68. While we think that this EPS growth is very bullish, we note that the current levels around $365 still implies a very high 28 times multiple on 2022 EPS.