It’s been just under a year since I wrote about Netflix, Inc. (NFLX), and in that time much has happened, obviously. In my previous piece, I determined that the approximate potential size of the Netflix subscriber base is about 365 million households. The fact is that it’s possible for a few households to share an account, so it may be that the potential size of the market is actually smaller, but I think sooner or later Netflix will have sufficient market power to eliminate the sharing of an account.
Since writing my Netflix article, the company has gained about 30 million new subscribers, and the shares are up about 98%, against a gain of just under 18% for the S&P 500. In this second kick at the Netflix can, I plan to do a deeper dive and will attempt to work out whether the current growth assumptions embedded in price are reasonable or not. I’ll also try to demonstrate that this is a particularly tricky business to analyse, given the many unknowables. It’s an industry that simply didn’t exist a few short years ago, so sweeping statements about “what will be” should be met with skepticism.
In my view, the heart of investing well involves capturing the disconnect between current expectations and future reality. Any 9th grader can work out what a particular company has done in the past, and can spot trends that will harm or help a given industry and company. Much more useful in my estimation is the ability to sit back and determine whether the crowd is being too optimistic or too pessimistic about a given company. Thus, this analysis will attempt to first uncover what the future assumptions are, and will then try to work out whether these assumptions are reasonable or not.
I know you’re a busy crowd, dear readers, and for that reason I’ll come right to the point. I was somewhat surprised to learn that the growth assumptions currently embedded in price are somewhat optimistic but not egregiously so in my estimation. There have been several firms of Netflix’s size that have grown sales at the rate currently implied by price, so this stock isn’t a screaming short in my view. That said, there are certainly a host of risks here, and the shares are quite volatile. For an investor who’s concerned about minimizing risk, I think options are the best way to “play” the bullish thesis here. I’ll go through the specifics of my preferred approach below. Before getting to all of that, though, I’ll write about why I think forecasting is a particularly silly exercise in this circumstance.
I think it would be worthwhile to write briefly about the financial history here in order to anchor the discussion somewhat. In case you missed it, Netflix has grown dramatically over the past several years. In particular, over the past six years, the firm has grown revenue and net income at compounded rates of 24% and 38%, respectively. The fact that net income growth has outstripped revenue growth is obviously a very positive sign also. Earnings per share have grown at a CAGR of “only” about 37% because of some dilution.
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The company has also taken on a great deal of debt, with long-term debt up by an eye-watering CAGR of about 59% since 2014. This has driven net interest expense to grow at a CAGR of about 47% over the same time period. While I think this level of growth in long-term debt is unsustainable, I’m not currently overly concerned about it because the company also has an enormous cash hoard.
Finally, the first half of 2020 has been very good to the company relative to the same period a year ago. Obviously, lockdowns benefit this business quite a bit. Specifically, revenue was up ~27% in the first six months of 2020 relative to the same time last year, and net income was up over 130%. This enormous bottom-line gain was caused in part about a 23% reduction in marketing expenses.
In my view, Netflix shareholders have reason to celebrate, as the company seems to be firing on all cylinders financially. I think long-term debt is a problem, but I think the $7.1 billion of cash currently on the balance sheet ameliorates that problem somewhat.
Source: Company filings
The Absurdity of Forecasting
Obviously, financial history is less relevant to investors than is the financial future, so I need to shift from writing about what’s happened to what may happen. This is usually a challenging problem, but is particularly troublesome in this case. I think sweeping statements about the future are probably worse than useless, because we tend to accept our beliefs uncritically, and this can impart a false confidence in investors. It’s very easy to dismiss the point of view that you happen to disagree with as being silly, but I think as far as Netflix is concerned, both bulls and bears are standing on very shaky ground. As investors, I think we would be wise to acknowledge that the circumstances surrounding this stock in particular are more unknowable than most, and we should therefore act accordingly. I’ll try to point out how challenging forecasting is in this case by pointing out some of the poor argumentation presented by both bulls and bears. If you’re a member of one of these camps and you have reasonable arguments to contradict me, I’m all ears.
How Much Pain Can You Stand? Cracks in the Bearish Thesis
A common view that bears seem to express is that the company has taken on “too much” debt. In my view, Netflix’s balance sheet is actually rather strong, in light of the fact that they currently have ~47% cash relative to long-term debt, and cash represents about 17% of the entirety of the capital structure. I think this argument would have merit if there was evidence that Netflix couldn’t access credit markets. So far, that doesn’t seem to be a problem.
Some bears also fret that the stock is “too high.” This argument persists, in spite of the fact that betting against this stock has been a “widow maker” trade for some time now. Specifically, over the past seven years the shares have grown at a CAGR of ~40%. There have been gyrations, obviously, but if someone bought Netflix in early 2013, and hibernated for seven years, they’d be quite happy today. The idea that a stock should be avoided because it happens to have run-up in price should be dismissed on the face of it. Put another way, this argument was just as sound (unsound?) a year ago after the shares had risen dramatically. Someone eschewing the shares based on that would have missed out on the gains seen over the past 12 months.
The biggest problem with the bearish thesis in my view is that the market has been telling bears that they’re wrong for years now. If an investor develops a thesis about how the world works, and for several years the world signals to that investor that their views are incorrect, it might behoove the investor to change their tune. At some point, some of the bears need to understand that the market doesn’t seem to care about negative cash flow or competition or much else. I think investors would generally be wise to approach the market with some humility, and try to work out what matters and what doesn’t. That’s especially so in this case.
How Long Can This Last? Cracks in the Bullish Thesis
The market seems to reward Netflix for adding new subscribers. New subscribers demand new content and I think Netflix knows this, as evidenced by the fact that they’ve spent just under $61 billion in new content over the past 6 ½ years. A reasonable argument could be made to suggest that Netflix is on something of a financial hamster wheel. They need to invest enormous sums to create content in order to attract customers. The absence of new and fresh content will obviously have a negative impact on subscriber growth, as there’s a limited number of people willing to re-watch programming. It’s not obvious to me that the company can massively reduce investment in content and keep subscribers, let alone maintain subscriber growth. This is obviously more challenging in light of the emerging competitive environment, where consumers now have much more choice. Put another way, once you’ve seen “Tiger King,” do you really need to re-watch it? If Netflix doesn’t keep offering new and interesting content, why would you maintain your subscription?
In my previous article, I reviewed global demographic data and suggested that based on that, the total potential market for Netflix is ~360 million households. In this analysis, I didn’t count on the fact that more than one household can share one subscription. This reduces the total available market by some amount, and the fact that there are now ~190 million subscribers suggests to me that the company is over half way through its growth phase. It’s very unclear how the market will react when this company goes from high growth to anemic growth.
Related to the above, some of the thinking around the total potential market isn’t sufficiently nuanced in my view. A more robust analysis would be to drill down on country level analyses, comparing income in each country. I can attest from personal experience spending years in the so-called “third world” that the demand for a TV subscription in poorer countries is highly elastic. Consider that an Indian moviegoer could (pre-pandemic) go to the cinema for between $1.75-$3.50. Assuming that developing markets are simply miniature versions of developed economies, and that spending patterns will be similar, is a very tenuous assumption in my view.
I think the future is unknowable, and the future of Netflix is very, very unknowable. There’s a long list of actions each of the players in this drama can take over the next decade, the impact of which is impossible to forecast. For example, Netflix may try to steal some of Disney’s (NYSE:DIS) thunder by investing in a theme park or two…or twenty. Stranger things have happened. There’s also a long list of very good, very unanswerable questions about strategy. Can Netflix try to steal some of Disney’s thunder by making blockbuster assets that appeal as both theatrical releases and streaming content? To what extent is content portable from one region to another? This question will take on increasing importance as the international markets grow in importance. For my part, I like some of the content from commonwealth countries, but much of it is lost on me. This is significant, I think. As a Canadian, I “get” commonwealth content in ways that many Americans won’t. If content made in places like Australia, New Zealand, Britain etc. doesn’t necessarily port easily from one region to the next? Although I’m certainly not fluent, when I lived in Australia, I became capable of understanding about 25% of what passes for English down under. If someone like me who shares some cultural touchstones with that former penal colony can only catch 25% of what these people are saying, what hope does an English speaker have?
Finally, although Netflix is not operating in China at the moment, I see a growing opportunity in making content tailored to the massive Chinese diaspora. The content produced for these consumers may also need to be tailored to local tastes also, though. These are just a few of the long list of unknowables investors face as this industry is invented on the fly. The market is fairly new and people are still figuring it out. I’ve always found certitude in the face of all of this to be a bit ridiculous.
Turning Away From Speculation
Thankfully, we need not speculate about the clearly unknowable future. As investors we have a task that’s slightly less hard. While we can’t know the future, obviously, we do have the capacity to work out what growth assumptions are currently embedded in stock prices, and then compare those assumptions to history. This is therefore a two-step process, and it relies on either what is known now or what can be inferred with a relatively high degree of accuracy.
We can infer the currently assumed growth rate by picking apart a relatively standard finance formula. We use the algebra we remember from grade 10 to isolate the “g” (growth) variable. The advantage of this approach is that we can base our analysis on a set of current knowns. Although this approach is also uncertain, it doesn’t rely on forecasts that have ever growing error terms. In other words, by relying on the current knowns and very short-term forecasts, our analysis is anchored in observable reality. For this part of the analysis, I turn to the work produced by Professor Stephen Penman in his book “Accounting for Value.” I’ll offer the growth assumption below, and will expand on the Penman approach in the Appendix at the end of this article.
After reviewing the growth assumption embedded in price, I want to compare this to history. If, for example, we have evidence that thousands of companies of Netflix’s size have managed to achieve the growth rate implied by the stock price, we can reasonably infer that Netflix can do the same. If, however, the growth rate implied by Netflix’s current stock price has never been achieved, we should be very suspicious of the current price. Thankfully, back in 2015, the good people at Credit Suisse (NYSE:CS) put together an analysis that tracks how frequently firms of different sizes have achieved various growth rates.
According to the methodology described by Penman, the market seems to be assuming a growth rate of ~9% for Netflix going forward. This seems to be a fairly optimistic forecast. On page 7 of the Credit Suisse document, though, we learn that 22.3% of firms with revenues greater than $13 billion were able to grow sales at a CAGR of between 5-10% for 10 years. Thus, it’s not unheard of for a company of Netflix’s size to grow revenues at the rate currently embedded in the stock price. It’s a minority of firms that have been able to achieve this result, but history tells us that it’s certainly a possible outcome.
Another thing that’s relevant in my estimation is the comparison between the firm’s current size and it’s potential. At the moment, the company has about 193 million subscribers worldwide. Over the past twelve months, the company has generated revenues of ~$22.62 billion. This works out to ~$117 per subscriber annually. If we assume that the company will eventually reach 360 million subscribers, and holding all else constant, that works out to a future revenue of ~$42 billion and the company growing sales at a CAGR of 6.2%, over the next 10 years. The fact that that back-of-the-envelope analysis is congruent with the growth forecasts embedded in the stock at the moment suggests to me that my analysis is at least in the ballpark.
Finally, I like to look at the ratio that investors are currently paying to some measure of economic value. I think the lower the price paid for future economic benefits like earnings, free cash flow, and the like, the lower the risk of the investment. In particular, I want to see companies that are trading at a discount relative to both the overall market and to their own history. I have this need to find such stocks, because I’m a value investor. The approach may be less relevant to a stock like this that is obviously trading at a massive premium relative to the overall market. That said, though, it’s trading near the low side of its own multi-year valuation history per the following:
All of this leads me to being cautiously bullish on these shares. I think the company has a demonstrated history of growing earnings very rapidly, and I think they remain on a fairly decent growth trajectory. There are obviously risks from many quarters, but I don’t think the shares are morbidly overpriced at the moment.
Options As An Alternative
One thing I’ve learned from years of investing is that it’s frequently a good idea to hedge various bets. While I think Netflix stock is reasonably priced at the moment, I think there are unknowable risks out there, and I always prefer to reduce risk when possible. For that reason, I would recommend using short put options to reduce risk somewhat.
I consider short put options to be “win-win” trades, because I think the investor does well in any outcome. If the share price remains above the strike price, the investor simply pockets the premium and drives on. This is never a hardship. If the shares drop in price, the investor will be obliged to buy, but will do so at a net price way below the current market price. In other words, selling puts today that may obligate you to buy at a much lower price in future is much better than buying the more expensive shares today.
A more subtle benefit of selling put options is that in some sense they impose a Ulysses Pact on the investor. Some of us have been told that in order to invest well, we need to “buy low.” That bit of advice has always struck me as being fairly vacuous, because it ignores the hard part of the exercise. It’s only bad news that will cause a stock to trade “low,” and in that circumstance, the investor will have every reason to want to avoid the trade. The joy of short puts is that while in a cold state, the investor picks a strike price that aligns nicely with what they consider to be a reasonable long-term entry point.
At the moment, my preferred short put is the March Netflix put with a strike of $450. These are currently bid-asked at $29.05-29.75. This means that if an investor simply takes the bid on these, and the shares remain above $450, they’ll pocket the premium, and that’s never a bad outcome. If the investor takes the bid and is subsequently exercised, they’ll be obliged to buy, but will do so at a net price ~23% below the current market price. Buying the same asset at a discount of this size is the definition of lower risk in my view.
Now that you’re hopefully intrigued by the “win-win” character of short puts, dear reader, it’s time for me to pour proverbial water all over the positive mood by writing about risk. The nature of the world is such that we must choose between a host of imperfect trade-offs, as there’s no “risk-free” option. Short puts are no different in this way. We do our best to navigate the world by exchanging one pair of risk-reward trade-offs for another. For example, holding cash presents the risk of erosion of purchasing power via inflation and the reward of preserving capital at times of extreme volatility. The risks of share ownership should be obvious to readers on this forum.
I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money, and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.
Puts are distinct from stocks in that some put writers don’t want to actually buy the stock – they simply want to collect premia. Such investors care more about maximizing their income and will, therefore, be less discriminating about which stock they sell puts on. These people don’t want to own the underlying security. I like my sleep far too much to play short puts in this way. I’m only willing to sell puts on companies I’m willing to buy at prices I’m willing to pay. For that reason, being exercised isn’t the hardship for me that it might be for many other put writers. My advice is that if you are considering this strategy yourself, you would be wise to only ever write puts on companies you’d be happy to own.
In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day.
I’ll conclude this rather long discussion of risks by indulging my tendency toward tedious repetition, and I’ll use the trade I’m currently recommending as an example. An investor can choose to buy Netflix today at a price of ~$545.00. Alternatively, they can generate a credit for their accounts immediately by selling put options that oblige them, under the worst possible circumstance, to buy at a price about 22% below the current price. To repeat what I wrote earlier, buying the same asset at a 1/5th discount is the definition of lower risk in my estimation.
I think Netflix’s valuation isn’t currently outlandish. The stock is trading at a rich premium to the overall market, but a strong argument can be made to suggest that it deserves to trade at that level. Also, the valuation has actually drifted lower over the past few years. Finally, if investors do the work of unpacking what is currently assumed about the future, they’ll realise that prices aren’t overly optimistic. That said, this is a much more risky stock than a railroad, for instance, as the industry is being invented in real time. There are far more questions than answers at the moment, and so the risk here is quite substantial. Add to that the fact that the shares have been quite volatile, and a stock investor could be forgiven for wanting to avoid the name completely.
I think short put options offer an alternative to outright share ownership at the moment. I think short put options represent a “win-win” trade for investors, and I think these are the best way to “play” this name at the moment. For my part, I like Netflix a great deal, but I understand that there are risks here. I’d be happy to own the shares at a net price of ~$430, and for that reason I’ll be selling the puts described above.
My shorthand description of this approach is, by necessity, a truncated review of Penman’s work. I think most investors would benefit from a thorough reading of this material, though, and so I would strongly recommend that they pick up a copy of “Accounting for Value.” I’ll now try to offer the highlights of the approach that he goes over in chapters 2-3 of the book.
There are some assumptions embedded in this approach:
Investors would be wise to anchor as much as possible on the currently known, and explicitly make distinct that which is speculative. So value=book value+speculative value. This is Penman’s echo of Graham and Dodd.
Stock valuation is driven by changes in book value.
A company adds value to book value only insofar as the expected rate of return on book value is greater than the required return (R).
Here’s some of the math that we start with. It’s not as bad as it looks.
Value of equity = stock price
B0= Current book value per share, B1 = next year’s book value per share etc..
In the case of Netflix, book Value Per Share is currently $21.19
EPS1= Next period’s EPS forecast. In the case of Netflix, EPS1 is ~$6.21 and EPS2 is ~$8.89
r=the required rate of return or “cost of capital.” This is a charge that the investor imposes on future earnings, to compensate for both risk and opportunity cost. For my purposes, I impose a 10% cost of capital to compensate for risk.
ROCE=”return on common equity”. This compares and adjusts the return on equity by the required rate of return. We apply the required return charge to the ratio of next year’s earnings to current book value. We derive current ROCE by comparing short-term earnings forecasts to current book value, and then deducting cost of capital.
So in the case of Netflix, we divide next year’s EPS forecast of $6.28 by today’s book value of $21.19 to get 29.6%. We then subtract the required return (10% in my case), and multiply the resulting 19.6% to book value of $21.19 to get abnormal earnings of $4.15. Thus, year 1 ROCE is equal to $4.15.
g= the long-term earnings growth rate currently embedded in the stock price.
I don’t want to walk people through basic algebra. Suffice to say that when we plug in Netflix’s variables, and isolate the “g” variable in the above, we see that the market is currently forecasting a growth rate of just under 9% for this company. Please note that this is far below the multi-year growth rate we’ve seen during the high growth phase of the company’s history.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I’m not buying the stock at the current price, but I will be selling 1 of the puts described in this article over the next few days.