Who would've thought that one man’s irresponsibility would lead to a revolution in how all video media is consumed? Well, that’s exactly what happened in 1997 when Reed Hastings, the future founder of Netflix (NASDAQ:NFLX), continued to return his borrowed movies late to the store and wanted to find a solution to his problem: using the mail to rent out movies. Fast-forward a little over two decades and his solution to this problem has really altered the landscape for media consumption.
Although this type of technology was revolutionary, it can easily be duplicated by competitors. Netflix was smart enough to realize that this product could be duplicated by content producers. As a result, Netflix began investing in its own content 6 years ago, knowing that at some point its business partners who once provided Netflix content would pull their content and start their own streaming platform. Netflix was spot on with this prediction; however, Netflix might have not even predicted the amount of competition that would ensue. Multiple companies, including Disney (NYSE:DIS), have already removed some content from Netflix’s platform, while many other companies are expected to follow. In order to maintain ample content on its platform, Netflix has accelerated spending to develop its own content, which has just accelerated its cash burn over the past year.
This leaves Netflix in a position where it is losing valuable content, gaining competition, and burning cash, all while needing to prove to investors it can continue to gain subscribers at a high rate. Due to the increasing competition and Netflix’s poor positioning to adapt to this competition, I believe that Netflix is becoming an attractive short opportunity as it approaches all-time highs.
Netflix Users Love non-Netflix Content
Netflix is a great platform for the distribution of content; however, much of Netflix’s most valuable content is, well, not Netflix’s. In 2017, research firm 7Park Data found that more than 80% of Netflix streams were for licensed content. In fact, 3 out of the top 4 most viewed shows are not owned by Netflix, rather Netflix pays the company that owns the content to put it on its platform. Although this model has worked quite well for Netflix in the past, it now puts Netflix in a catch 22 situation.
When a content company such as Disney is able to obtain additional revenue from giving Netflix the right to stream its content, it works out well for both. For the content company, it obtains revenue that it would otherwise not have had. For Netflix, it gains valuable content that it is able to make money from. Sounds like a win-win situation. However, when content companies start their own streaming platform, the content becomes more valuable to them. Content companies with their own streaming platforms would greatly benefit from having content exclusive to their platform as it would help draw in customers. As a result, content companies now have an incentive to no longer give Netflix the right to stream their content.
This is where the catch 22 situation comes into play. Since the content companies now have a good reason to pull their content, either Netflix has to pay up, or risk losing the content that is an integral part of its platform. For example, Friends is the third most popular program on all of Netflix; however, the famous television show is owned by AT&T (NYSE:T) following the acquisition of Time Warner. AT&T is creating its own streaming platform that is estimated to be launched in the coming months. As a result, AT&T has a good reason to keep the popular show to itself as having it only available on its own platform would likely draw subscribers to its own platform. This is the reason why Netflix had to pay $100 million to keep Friends for 2019, compared to the $30 million it paid just one year ago. In essence, Netflix knows that this content is needed for their service and the content producers now have a good reason to not offer Netflix the service. Consequently, Netflix will be forced to pay much higher prices for its licensed content or lose it and the subscribers who will follow.
Competitors are Ready for War
Netflix has proven that not only is there a vast market for video streaming services, but the growth potential for the industry is big and content companies have taken notice. The list of content companies coming out with their own streaming platform is quite extensive, depriving Netflix of the monopoly it once had. This market shift will reduce pricing power and market share.
First, increased competition will lead to a decrease in pricing power as higher prices will just cause many consumers to go to competing services. For example, Hulu slashed the price of its most popular plan by 25% to just $5.99 a month. Additionally, Bob Iger of Disney directly addressed its price war with Netflix by stating “I can say that our plan on the Disney side is to price this substantially below where Netflix is." However, what did Netflix do in response to increased competition that offers lower prices? Well, the company increased the prices of all of its subscriptions, with its most popular plan increasing in price by over 18%. This is the exact opposite of what Netflix would be doing to avoid losing market share.
Valuation: Why Netflix Should Be Valued More Like Disney
Since it would be unfair to value Netflix on a P/E basis due to negative earnings, I will use the most common metric used to value a company such as Netflix, P/S (Price to Sales). Currently, Netflix has a P/S ratio of over 10. I believe that this ratio is astronomically high, especially compared to some of its current and future competitors. For this comparison, I will focus on Disney which is likely to be Netflix’s biggest competitor in the space.
As of now, Disney has a P/S ratio of slightly under 3. Disney is a content creator. Netflix is a content creator. Disney currently has the streaming platforms ESPN + and Hulu distribute content with the intent to add Disney+ to its arsenal in the coming months. Netflix currently has a streaming platform in place to distribute content. My point is, the capabilities of both companies are quite similar; however, there are two differences that can set them apart. First, Disney is in a better position to monetize its content beyond streaming with merchandise and theme parks. Second, Disney has multiple decades of content already in its arsenal, while Netflix began creating content just six years ago. For these reasons, I believe on a P/S ratio, Netflix is inherently overvalued compared to its competitors, such as Disney.
If Netflix were to be valued on the same P/S ratio as Disney, its valuation would be shockingly lower. Based on the math,(2.743/10.42=.263 ; .263 x 360.66)= $94.85), if Netflix was given the same price-to-sales multiple as Disney, Netflix (as I currently write this article) would be worth less than a $95. As a result, based on this key metric of price-to-sales, Netflix is overvalued by over 380 percent ($360.66/$94.85).
Risks and Mitigants
One major reason people believe that Netflix will be able to sustain these upcoming headwinds is that it was the first company to get into the space, also known as first-mover advantage. However, there is little brand loyalty in this space. In the end, people will pick which platform provides the best content for the lowest price.
A counter-argument to one of my main points is that Netflix original program viewing is increasing. Netflix is becoming less reliant, and, at some point, will rely little, if at all, on leased content. This is already true, over the past few years, as non-Marvel Netflix original content has increased its proportion of viewership. However, there are two main issues with this thesis. First, although increasing at a decent rate, if major competitors were to pull all their content off of Netflix, the available content on Netflix would decrease dramatically, especially as many of Netflix’s most popular shows could be part of what is pulled. Second, it is hard to tell how much of this increase is strictly people switching to Netflix original content because there is more produced or people switching to Netflix original content due to leased content being pulled off of the service. For example, if all the leased content was pulled off of Netflix, the proportion of original Netflix content being consumed would go to 100% as there would be nothing else to watch.
A third risk to shorting Netflix is the idea that consumers will potentially be customers of multiple streaming services. As of now, the average American consumer subscribes to three video streaming services, which would imply that there is room for multiple players in the arena. However, due to the large quantity of streaming services that are available or are planning to launch, I believe that over time Netflix won't be considered a "top three" pick by consumers. For example, Disney is planning to have three streaming services on its own (Disney+, Hulu, ESPN).
Conclusion
A lot is going to play out over the next few years as many content companies join the increasing field of competitors in the video streaming business. This idea is a fundamental short that will begin to play out in the next couple of months. As more companies begin launching more video streaming alternatives, Netflix will show weakness in subscriber numbers relatively quickly as consumers learn of alternatives. This will lead the market to focus on other valuations metrics, such as P/S, which will cause the share price of Netflix to depreciate.
Based on Netflix’s reliance on leased content as well as increasing competition from companies that have been successfully creating content for decades, I believe that Netflix is the underdog in the area. However, the market’s extreme valuation on the company implies that it is the clear favorite, which is just not the case.
