Like the celluloid once used in filming a key tenet of culture at Morphic is transparency. In this spirit, we are therefore taking this opportunity to talk about the recently reported results from Netflix in light of our earlier blog.
That we were only long Netflix puts over these results illustrates the interaction between portfolio construction and risk management, two other key pillars of our investment process alongside research. Both are continual and essential processes in the search for alpha as they help us monitor the expected returns and individual risks of our investments, and construct portfolios accordingly.
Having disappointed the growth narrative with below-expected subscriber growth in the previous quarter we felt that there was a natural risk that the management do all they can to prevent such a miss this quarter thus pleasing those investors with the growth obsession (the majority). Also, we observed public commentary from various credible potential acquirers such as Bob Iger, CEO of content producer Disney who would naturally be envious of the distribution network which is Netflix.
In light of this we decided to close our physical stock short position, remain holding put options and then reflect on our investment thesis in light of the new information contained in the results. The put options would enable us to participate in any stock price fall but reduce “gap risk” if the market really liked the results.
So, how do we interpret these results?
Source: Bloomberg, Team analysis
Net income increased to USD 51.7m and the cash outflow almost doubled versus the previous quarter to USD 462m.
We had previously noted that the cash flow trend can be explained by the way the Company accounts for its principal assets and related expenses, the content it produces and acquires. This last quarter saw content costs, on and off-balance sheet, accelerating even further away from the lower rate of revenue growth:
Source: Bloomberg, Team analysis
And in terms of how much Netflix spends on content per customer, this has now overtaken the amount of revenue it generates with the associated accounting expense increasing but at a level which still flatters the margins:
Source: Bloomberg, Team analysis
Well, the Company could deliver economies of scale in any area of its costs which would result in higher margins and profitability. However, until the rate of increase in cash content expenditure declines to a level at least in line with that of revenue, the problem of cash out flow will remain. On this note Management refers to its debt to total capitalization ratio (5%) being low relative to similar firms, and indicated on the conference call having comfort with 20% in the long term (circa USD 10bn at current market capitalisation).
We are rather more familiar with traditional measures of leverage such as net debt to EBITDA. Assuming a similar operational result next quarter would see a total adjusted EBITDA of circa USD 560m for the year (Management like to think of stock-based compensation as being cost free!). Guidance is for net debt to be circa USD 2bn by the year end, more than 3.5x adjusted EBITDA. In our sepia-tinted world, continued cash outflows of the current magnitude may result in debt markets rapidly closing in the absence of a yet to be discovered new lending paradigm. And this is before any mention of the circa USD 8bn of off balance sheet content commitments.
We also recognise that our earlier assertion that content has a shorter life going forward may not be correct. We note that Netflix’s expenditure on in-house production is increasing and it appears sensible to assume that a successful series can be followed by several seasons and thus the life span of the concept may exceed that of say an individual movie, however, every new season requires more expenditure. Unfortunately, the Company’s opaque reporting makes it impossible to analyse detailed trends within the content assets.
In so far as Management have indicated prices will not rise for the moment, we maintain that the growth narrative will be threatened by the slower level of content growth that is required to generate positive cash flow (and which is implied in expectations of higher margins).
In light of these new results we conclude that our original thesis is intact and that any potential acquirer of Netflix has just had USD 8bn added to the potential cost. This alone suggests a more attractive risk/return profile to a short selling strategy than previously.
Management indicated that they will elaborate on the scale of “material profitability” that is expected in 2017 when they report the results of the current quarter (in January). Our view remains that next year will likely test Management’s ability to pull the two levers of price and content growth without doing serious harm to the growth narrative which, for the next quarter at least, appears secure if the instant reaction to the results is a true vote. However, if cash flows do not improve significantly our conviction remains high that the deteriorating credit situation will inevitably weigh heavily on the market price of Netflix.
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