Author: Ross Griffiths, Published: August 11, 2017 at 9:00pm EST, Category: Earnings Review
Summary
Subscriber growth for Q2 beat estimates, aided by strong content releases. Management noted some “pull forward” from Q3 numbers, however, so caution is urged in forecasting Q3 subscriber numbers. Revenue slightly exceeded guidance, with EPS of 15c in line with consensus estimates. Cash burn was again elevated on content licencing costs, and international streaming memberships overtook domestic. Additionally, the company expects positive a contribution profit from the international business for the year 2017.
The valuation is impacted by some material post-results announcements. The news that Disney will end its agreement to licence Disney and Pixar content to Netflix in 2019 in order to launch its own direct to viewer streaming is tempered by the acquisition of Millarworld, a strategically beneficial move that could positively impact Netflix’s content library and profitability once integrated. The potential for further competition is also impacted by the launch of Watch, a new streaming app from Facebook set to include live sport in addition to traditional SVOD content.
Subscriber growth for Q2 beat estimates, aided by strong content releases. Management noted some “pull forward” from Q3 numbers, however, so caution is urged in forecasting Q3 subscriber numbers. Revenue slightly exceeded guidance, with EPS of 15c in line with consensus estimates. Cash burn was again elevated on content licencing costs, and international streaming memberships overtook domestic. Additionally, the company expects positive a contribution profit from the international business for the year 2017.
The valuation is impacted by some material post-results announcements. The news that Disney will end its agreement to licence Disney and Pixar content to Netflix in 2019 in order to launch its own direct to viewer streaming is tempered by the acquisition of Millarworld, a strategically beneficial move that could positively impact Netflix’s content library and profitability once integrated. The potential for further competition is also impacted by the launch of Watch, a new streaming app from Facebook set to include live sport in addition to traditional SVOD content.
Key Points
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Netflix (NASDAQ:NFLX) reported Q2 2017 results that beat management guidance and analyst estimates on subscriber growth, with revenue and earnings broadly in line with consensus estimates. Following the announcement, I remain optimistic on the company’s prospects, but maintain the view that the company’s stock appears overvalued. Q2 results were well-received by the market and the company’s stock rose to $183 in post-market trading. Given its elevated valuation, $171.40 at the time of writing, I am downgrading the stock to a SELL with a target price of $142 based on a DCF valuation and a multiple of 20X 2021 EPS.
User Growth Positive, but Competition Heating Up
Long-term estimates for subscriber growth remain optimistic, reflected in forecast user growth reaching the upper end of management targets. A clearer picture is starting to emerge, however, of the increasingly tough competition Netflix is likely to face in the SVOD space. Earlier this month, Disney announced its intention to end its licencing deal with Netflix in 2019 in favour of launching its own video streaming service. The family-orientated service will initially be launched in the US with a view to making it the “exclusive home in the US for subscription video-on-demand viewing of the newest live action and animated movies from Disney and Pixar.” This month also saw the launch of Facebook Watch, the social network’s new platform for viewing video through mobile devices, desktops and TV apps. Watch will initially focus on community-orientated content created by users, along with a weekly broadcast of an MLB game. Whilst more akin to YouTube than Netflix, Facebook’s vision for Watch as being “home to a wide range of shows, from reality to comedy to live sports” threatens entry into the SVOD space in future.
As a subscription fee business, revenue is expected to grow in line with memberships. However, an increase in costs is forecasted as increased competition for subscribers necessitates higher content spending. The model reflects this by maintaining ARPU around recent quarterly trends ($29 domestic and $23 international), but increasing forecast streaming content liabilities to incorporate margin pressures.
Long-Term Strategy Boosted by Millarworld, Rhimes Recruitment
Netflix fueled confidence in its international expansion in early August by entering negotiations on OTT streaming in Taiwan with mobile carrier Chunghwa Telecom. News of the talks followed the announcement of a licensing deal in China to offer content through Baidu’s video portal, iQiyi, a service attracting close to 500m monthly viewers. Further reason for optimism came in the form of Netflix’s acquisition of Millarworld, the entertainment company home to Kick-Ass, Kingsman, and Old Man Logan(1). The acquisition brings Netflix ownership of a leading creator of comic book-based content whose films have taken close to $1bn globally in box office sales. This is a timely acquisition following the announcement from Disney, bolstering Netflix’s library of popular comic book-based content(2) as it is set to lose Disney’s Marvel universe. Ownership of characters within an interconnected universe has proven successful for Marvel and DC Comics, providing scope for interwoven stories as part of a series, allowing studios to extract more content from their intellectual property than standalone films. It is hoped that Millarworld will be able to replicate this success for Netflix and that ownership, as opposed to licensing, of intellectual property rights to such content, will help improve margins by reducing spending on content, as well as improving existing content(3).
Repeatable Success of Popular Shows
Netflix had previously pursued a strategy of expansion in its content library, before a consolidation in recent years in favor of a ‘quality over quantity’ approach. This is becoming all the more clear as the company strives for the production and licensing of shows that can be extended to multiple series if well-received. This strategy is complemented by the hiring of Shonda Rhimes(4) and acquisition of Millarworld, with the re-commissioning of critically-acclaimed shows including Glow, The Crown and Stranger Things providing further support. It is the company’s hope that the success of new releases with scope for continuation will boost subscriptions and foster loyalty among existing members, as well as proving enduringly popular, a strategy that is proving successful with a year-on-year rise in Emmy nominations from 54 in 2016 to 93 in 2017.
Net Neutrality Legislation Under Threat
The FCC is set to comment on Net Neutrality regulations at the end of August, and any rollback of regulations could see companies such as Netflix forced to pay premiums to ISPs for high speed data connections through which to stream their content. Many analysts expect a reversal of Net Neutrality policies, particularly given the Trump administration’s drive to deregulate markets. The impacts of such a decision are not likely to be immediately felt, but could have a material impact on costs for companies providing data-intensive content online, so should be watched closely.
Valuation Risks
The Base case price target of $142 is predicated on 1) Subscriber growth estimates, 2) Ability to reduce content costs, particularly relative to revenue, 3) Ability to manage competition in SVOD space and loss of Disney, Marvel content.
User Growth Positive, but Competition Heating Up
Long-term estimates for subscriber growth remain optimistic, reflected in forecast user growth reaching the upper end of management targets. A clearer picture is starting to emerge, however, of the increasingly tough competition Netflix is likely to face in the SVOD space. Earlier this month, Disney announced its intention to end its licencing deal with Netflix in 2019 in favour of launching its own video streaming service. The family-orientated service will initially be launched in the US with a view to making it the “exclusive home in the US for subscription video-on-demand viewing of the newest live action and animated movies from Disney and Pixar.” This month also saw the launch of Facebook Watch, the social network’s new platform for viewing video through mobile devices, desktops and TV apps. Watch will initially focus on community-orientated content created by users, along with a weekly broadcast of an MLB game. Whilst more akin to YouTube than Netflix, Facebook’s vision for Watch as being “home to a wide range of shows, from reality to comedy to live sports” threatens entry into the SVOD space in future.
As a subscription fee business, revenue is expected to grow in line with memberships. However, an increase in costs is forecasted as increased competition for subscribers necessitates higher content spending. The model reflects this by maintaining ARPU around recent quarterly trends ($29 domestic and $23 international), but increasing forecast streaming content liabilities to incorporate margin pressures.
Long-Term Strategy Boosted by Millarworld, Rhimes Recruitment
Netflix fueled confidence in its international expansion in early August by entering negotiations on OTT streaming in Taiwan with mobile carrier Chunghwa Telecom. News of the talks followed the announcement of a licensing deal in China to offer content through Baidu’s video portal, iQiyi, a service attracting close to 500m monthly viewers. Further reason for optimism came in the form of Netflix’s acquisition of Millarworld, the entertainment company home to Kick-Ass, Kingsman, and Old Man Logan(1). The acquisition brings Netflix ownership of a leading creator of comic book-based content whose films have taken close to $1bn globally in box office sales. This is a timely acquisition following the announcement from Disney, bolstering Netflix’s library of popular comic book-based content(2) as it is set to lose Disney’s Marvel universe. Ownership of characters within an interconnected universe has proven successful for Marvel and DC Comics, providing scope for interwoven stories as part of a series, allowing studios to extract more content from their intellectual property than standalone films. It is hoped that Millarworld will be able to replicate this success for Netflix and that ownership, as opposed to licensing, of intellectual property rights to such content, will help improve margins by reducing spending on content, as well as improving existing content(3).
Repeatable Success of Popular Shows
Netflix had previously pursued a strategy of expansion in its content library, before a consolidation in recent years in favor of a ‘quality over quantity’ approach. This is becoming all the more clear as the company strives for the production and licensing of shows that can be extended to multiple series if well-received. This strategy is complemented by the hiring of Shonda Rhimes(4) and acquisition of Millarworld, with the re-commissioning of critically-acclaimed shows including Glow, The Crown and Stranger Things providing further support. It is the company’s hope that the success of new releases with scope for continuation will boost subscriptions and foster loyalty among existing members, as well as proving enduringly popular, a strategy that is proving successful with a year-on-year rise in Emmy nominations from 54 in 2016 to 93 in 2017.
Net Neutrality Legislation Under Threat
The FCC is set to comment on Net Neutrality regulations at the end of August, and any rollback of regulations could see companies such as Netflix forced to pay premiums to ISPs for high speed data connections through which to stream their content. Many analysts expect a reversal of Net Neutrality policies, particularly given the Trump administration’s drive to deregulate markets. The impacts of such a decision are not likely to be immediately felt, but could have a material impact on costs for companies providing data-intensive content online, so should be watched closely.
Valuation Risks
The Base case price target of $142 is predicated on 1) Subscriber growth estimates, 2) Ability to reduce content costs, particularly relative to revenue, 3) Ability to manage competition in SVOD space and loss of Disney, Marvel content.
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Valuation Inputs
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Ratings methodology
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Footnotes
1. Kick-Ass and Kingsman are not part of the acquired portfolio due to pre-existing film deals
2. Marvel shows Luke Cage and Jessica Jones are among Netflix’s most popular, with audience numbers close to blockbusters such as House of Cards and Orange is the New Black
3. Including owner Mark Millar’s contribution to Marvel inclusive, Millarworld’s global box office takings approach $4bn
4. Shonda Rhimes and her production company, Shondaland, have been behind some of the most popular titles to air on ABC, including Grey’s Anatomy, Scandal, and How to Get Away with Murder
1. Kick-Ass and Kingsman are not part of the acquired portfolio due to pre-existing film deals
2. Marvel shows Luke Cage and Jessica Jones are among Netflix’s most popular, with audience numbers close to blockbusters such as House of Cards and Orange is the New Black
3. Including owner Mark Millar’s contribution to Marvel inclusive, Millarworld’s global box office takings approach $4bn
4. Shonda Rhimes and her production company, Shondaland, have been behind some of the most popular titles to air on ABC, including Grey’s Anatomy, Scandal, and How to Get Away with Murder
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The author of this article has no financial investment or other conflict of interest related to the subject company or other companies discussed. Any views made or implied in this article represent the author’s opinions. Click here to visit Ross' Contributor page.
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