The Coming Netflix Collapse… Or Netflix and Chill On Your Stock
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Netflix’s stock price decline is the latest example that the Johnson dollar diversity dilemma hypothesis in full swing. We previously noted it in connection with Twitter.
The Johnson dollar diversity dilemma hypothesis is that you can tell how badly a company is doing by how much its CEO and board signal progressive causes–and that you can use that information to short a company stock.
The best example is how Goldman Sachs CEO Lloyd Blankfein laughably announced his support for marriage equality. Rolling Stone Magazine — when it isn’t busy faking rapes — pooh poohed Blankfein’s support but the Human Right$ Campaign didn’t exactly turn down the support. Another good one is how soon-to-be-felon? Elizabeth Holmes of Theranos hosted a Clinton fundraiser. Here’s a stat I had crunched: Of the 150 unicorns, 148 of them are led by men and only two are led by husband and wife teams (hardly the modern feminist archetype).
Enter Reed Hastings, the CEO of Netflix, who announced a $100 million effort to use Netflix to teach blacks and Hispanics. Oh boy. Are we really back to thinking MOOCs will save the world?
Naturally it came at the apogee of Netflix’s stock price. So we advised shorting the stock. You’re welcome. Today’s stock price is down 13%.
Hastings’s charity is useful because Hastings, a former Peace Corps member, hasn’t taken seriously human biodiversity, that is the study of how humans are biologically different from one another.
The insights from human biodiversity are relevant because Netflix’s stock price rests on the stupid assumption that the rest of the world will consume Netflix like America.
Hastings has long not understand this phenomenon, as an article in his school newspaper about his pathological white altruism shows.
Note how he tries to improve upon his beloved Africa.
At the Hhelehhele School in Swaziland, Hastings remembered his students as “super motivated.” However, his routine there was much slower than the fast-paced life he was used to. He enjoyed the routine of being fully immersed in the community but at times felt he was stagnating. He recalled occasionally thinking, “I would never dribble away my days at home like this.”
Hastings wrote in a letter to his “friends, enemies, Grandmothers, siblings and assorted no-goods” that though his days were full, they had acquired a monotony and “the strong feeling persisted that I wasn’t very challenged.”
Hastings countered this by taking on challenges outside of teaching.
“The answer to my boredom and under-utilization was to get involved with the community as a whole instead of limiting myself to the school compound,” he said.
In Ntonjeni, the small rural town in which Hastings lived, he began noticing opportunities to increase efficiency and add convenience to everyday life. For example, villagers struggled transporting water to the schoolhouse located on top of a hill. He wrote, “Great view, cool breezes, but getting water up there is a real bitch.”
Here, Hastings recognized an opportunity to innovate. Instead of spending money on water pumps that are “expensive and notorious for breaking down,” he developed a plan to build tanks to collect rain water on top of the hill. Hastings made his contribution sustainable by involving community members in the process, writing, “the parable about teaching someone to fish vs. catching fish for them is a big philosophy here.”
Hastings also got involved in the business behind harvesting honey from African killer bees, a project he described as an “escape valve.” Despite the peace the work gave Hastings, the actual work was far from peaceful.
“The ‘killer’ bees approaching America are the diluted descendants of our bees. Smaller, slower livestock (chickens, rabbits, etc.) are not infrequently stung into paralysis and death,” wrote Hastings. “Faster creatures, like me, can sprint out of harm’s reach with only a few bees giving spirited chase.”
For this project Hastings wrote a proposal requesting U.S. aid for Swazis to start their own safe and productive beekeeping businesses. The aid was granted, and Hastings, with the help of an agriculture teacher, taught an introductory course “covering how to build hives, manage bees, and market honey.”
Hastings’ systematic tendencies didn’t stop his time in Africa from being adventurous. He returned to the States feeling uncertain that he would ever experience the same freedom he had in Swaziland. In one of his letters he wondered “Will I ever again race across the hot savannah, bare chested, motorcycle purring, admiring the acacia trees heralding ‘this is Africa?’ I hope so.”
How’s that working out? Not well as the New Zealand and Australia examples show.
In New Zealand Netflix cracks down on people who pay for the service but watch the American version.
Major VPN services have been shut down in New Zealand as the Netflix crackdown gets real https://t.co/VOGc59Rczj
— nzherald (@nzherald) April 19, 2016
In Australia not enough skips bought the service.
Netflix is blaming Australia for its plunging stocks https://t.co/5FAeHMBqj8
— StartupSmart (@StartupSmartnow) April 19, 2016
— John McDuling (@jmcduling) April 19, 2016
Meanwhile they are boosting prices to subsidize the costly international expansion.
— psjofors (@psjofors) April 8, 2016
And Hastings still doesn’t want to disclose how many viewers its shows actually have.
Asked Netflix CEO, Reed Hastings, why they don't reveal their viewing figures. He joked back with this simple quote: pic.twitter.com/gUbsI3K0BH
— Scott Bryan (@scottygb) April 13, 2016
Ever the good social justice warrior Hastings also poured money into the campaign coffers of DeRay McKesson, who is running–and losing–a race for the Baltimore mayoralty.
Netflix’s Reed Hastings and Other Tech Execs Back Black Lives Matter’s DeRay Mckesson’s Bid for Baltimore Mayor https://t.co/GXS52Sj8eK
— The Startup Times (@TheStartupTimes) April 9, 2016
Gotta signal, man.
Meanwhile the costs are mounting — Netflix is predicted to lose a billion a year for the next two years and has a price to earnings multiple that is frankly insane. As Netflix goes international piracy is no longer a friend but a competitor. And the studios and other networks are noticing that they should control the pipe.
Netflix has routinely argued that piracy actually helps its business. That may well be true—in the U.S where ease of access and expanded offerings makes paying the $7.99 a month fee relatively cheap. Now that prices are going up ahead of a recession how likely is that to continue?
Even rich countries seem to be okay with piracy. A study by the European Commission found that 56% of Europeans stream movies for free. The piracy problem is particularly acute among the young and males and the highly educated. Worse yet licensing disputes intra-country turns even Canadians into pirates. Indeed U.S. Netflix has been illegally accessed by over a third of English-speaking Canadians.
The studios sell the content to Netflix with only American licensing making would be international customers suffer for an inferior product. The hacked Sony emails from 2013 reveals that this concern of border hoping is serious for the studios. Netflix has promised to fix this problem by restricting access. The problem, of course, is that it ultimately pisses off the international users who don’t like how they are paying to get an inferior product from the American version.
Indeed Netflix’s much vaunted January announcement that it will operate in 190 countries seems designed a way of getting around this rights issue but how long will it be before the studios start to renegotiate their relationships or opt out entirely? And how likely is it that Netflix will be able to negotiate the complex nature of telecommunications services in third world countries to say nothing of the rights concerns?
Credit card checks on cross border watching seem inevitable—if only to placate the studios who have already begun to demand it. Netflix admitted that they can’t really solve the problem of cross-border watching.
The studios then are left with two options: 1) increase the cost of the licensing rights (something they’ll be loath to do thanks to piracy) or 2) control their own pipes. Either option spells doom for Netflix. And both options look to be the play for the media companies who want to control their own pipes.
Traditionally big media companies have made quick money by selling content to streaming services like Netflix. But the never-connecteds – that is households that watch TV via the internet and not cable or satellite TV – are growing. Over the past 5 years, 3.8 million American homes have cut the cord – cancelling or refusing cable. This effect is drying up the money for the cable companies. The further young you go, the worse the numbers look. A new survey from ComScore, cited by Re/code, found that 24 percent of TV viewers age 18 to 34 don’t subscribe to a traditional pay TV service. Nearly 46 percent of those viewers never had cable to begin with.
Limits To Growth Abroad
If Canadians are griping about how Canadian Netflix sucks you can be sure that other countries are just going to avoid the service entirely. There’s not much of a culture of paying for content abroad. Netflix’s trouble to get Australians and Kiwis to pay up shows that even among our English speaking cousins the company has serious problems.
Netflix does not appear to have taken seriously the interests of state-owned telecommunications platforms in the developing world. The world’s fourth most populous nation—Indonesia—has severed ties with the company ostensibly over content issues and regulatory problems.
Indonesia's biggest telecom is blocking Netflix https://t.co/TsidbELqlM
— Jimmy Bearden (@JmmyBrdn) April 7, 2016
Indonesian customers are complaining.
— Arya Dega (@aryadega) April 18, 2016
Netflix’s expansion in America, too, may have more to do with regulatory framework rigged in its favor. “More than one-third of today’s expensively rolled-out bandwidth already is consumed in peak hours by a single company, whose customers represent a tiny minority—about 1.2%—of Internet users. Richard Bennett of High Tech Forum calculates: “If 12 percent of the Internet user population is streaming at prime time, the traffic load goes up to 340% of today’s level; and if it rises to 60%, the load goes up to 1700%.” And suppose users want super-high resolution 4k TV, which requires four times as much bandwidth as today’s hi-def?”
The content costs are getting out of control. You can’t keep producing multi-million dollar shows forever.
Netflix is trying to be a movie studio but without blockbusters. While the traditional studios have migrated to tent pole films to recoup the losses of the rest of their business Netflix has no such blockbuster capabilities. And its shows are getting old.
Amazon and Netflix got into a bidding war at Sundance but Amazon has a business that props up its Amazon Prime service. And Amazon through Prime has more U.S. streaming subscribers than Netflix has subscribers.
Let’s take a closer examination at those subscriber numbers.
Netflix’s stock performed exceptionally well in 2015, opening at $49.85 and closing at $114.38, with a return of 130%. In 2015, markets became incredibly enthusiastic (and totally stupidly so) about the potential for Netflix as a global player in the international subscription streaming market (given Netflix’s high growth in subscriber base internationally, despite stasis in its U.S. domestic segment).
Netflix’s segment performance helps to figure out (1) why the market gave Netflix a 130% boost, and (2) why the market is wrong.
The net subscriber growth in Netflix’s U.S. streaming segment topped off in 2013, with year-over-year growth rates of -9.2% and -1.2% for Net Subscription Additions for 2014 and 2015 respectively. The U.S. subscriber base has stagnated since 2013. However, the net subscriber growth in Netflix’s international segment has seen significant growth, with year-over-year growth rates of 52.8% and 59.9% respectively. So most of Netflix’s subscriber base growth is being drive by its international segment. Netflix is headed straight for the moon, right? Not so fast.
The U.S. domestic segment has high contribution margins. It’s a stable, profitable business. However, the International segment contribution margins are remarkably low. In other words, most of Netflix’s growth is extremely costly.
The heavy decline in contribution margin for Netflix’s International streaming segment in 2015 versus 2014 (i.e. contribution margin of -17% versus -12%) is peculiar. It’s entirely possible that Netflix’s management realized that the markets would reward them for purchasing substantial user growth and not necessarily penalize Netflix for bad margins (since most bubble stocks are evaluated on a “long run” basis rather than on a short term basis….markets care only about user (or subscriber growth) for the most part). Given these trends management was encouraged to go further into the red in terms of its contribution margin in exchange for boosted user growth and wound up mispricing Netflix stock.
As we can see from the chart above (ratio of Netflix’s market capitalization to number of Netflix subscribers, 2013-2015), the markets have been very enthusiastic about the subscriber growth in Netflix’s International segment. The markets believe that Netflix will be able to expand internationally and replicate U.S. margins. Netflix’s price per subscriber ratio has increased by 47.5% in a twelve-month period despite stagnant U.S. domestic growth.
The markets assume that Netflix will be able to replicate U.S. domestic contribution margins Internationally, but it’s very unclear what the endgame for this will look like, especially given that we are at the top of the business cycle. It’s also unclear why Netflix has such a high Cost of Customer Acquisition (COCA) internationally, especially given since Netflix’s International streaming segment has existed since 2011.
These three charts say everything about Netflix…and it’s a simple story: Netflix uses its stagnant, high-contribution U.S. Domestic streaming segment to prop up its low-contribution, high-growth International streaming segment. Netflix spends a lot of operating money boosting its International numbers so it can achieve the high user growth figures the market demands. Because markets value user base growth above all else, Netflix’s stock price gets a big boost.
There’s just one problem: a lot of cash is needed for this growth and Netflix is going to have to turn to its U.S. customers to subsidize its international growth.
Sure enough, Netflix is jacking up prices on U.S. customers.
— Business Insider (@businessinsider) April 19, 2016
Unfortunately for Netflix this price increase will mean slower subscriber numbers and the cycle will break even in the best of macro-economic environments.
What’s the meta argument here?
Like the FANG stocks, Netflix is priced on user growth rather than fundamentals so Netflix’s management pushes to get the user growth numbers as high as they possibly can, even if it involves sacrificing fundamentals. In an ideal world, the markets would force tech companies to optimize the (number of users)*(lifetime value of user) figure, but investors seem to care more about the former than the latter.
There was a truly preposterous October 2015 TechCrunch article, entitled “Are We Struggling to Value Unicorns?” that illustrates this line of thinking perfectly (it’s also pretty clear why it’s a wrong way to think about companies).
Here’s the author’s alternative to 65 years of mathematically rigorous finance theory :
A New Valuation System
Companies’ assets are ignored; even IP, staff numbers, customer bases and profit are all ignored — these are crusty, old-fashioned benchmarks of the past.
Instead, user growth trumps all. The ultimate metric for Silicon Valley is how many people use the service, not customers (people who pay). We‘re giant cathedrals to the new valuation metrics, most of which can be found looking at a list of Unicorns.
In 2015, we have Snapchat “worth” $16 billion, with revenue of, at the most, $50 million, while The New York Times is “worth” $2.2 billion, with revenue of $1.57 billion.
Why hasn’t the market priced this in yet? They have begun to price it in to a degree….Netflix has already seen more than a 20% decline since the beginning of the year. Netflix’s Price per Subscriber ratio should be closer to the one we saw at year end 2014 rather than the present price. When the tech bubble finally pops, we will see companies evaluated more on a (Lifetime Value of User)*(Number of Users) basis instead of a (Number of Users) basis, where the market assumes that profitability is an inevitability for all products that aim to be “something that everyone uses.” Netflix is one of the few big tech stocks that hasn’t seen a major decline yet (the other being Facebook), and a decline is an inevitability. For this reason, I recommend Netflix as an interesting short opportunity.