David Einhorn Is Short Netflix
When gurus bet against companies, they often have valid reasons for doing so. David Einhorn (Trades, Portfolio) is considered to be one of the most influential short sellers on Wall Street because of his track record of identifying companies that would eventually collapse.
For instance, in a speech given at the Sohn Investment Research Conference in 2002, Einhorn recommended shorting Allied Capital, a company that would eventually agree to a takeover bid at a price that was 90% from its peak. The guru even went on to write a book, "Fooling Some of the People All of the Time," providing an in-depth analysis of how he figured out Allied Capital would go broke due to accounting malpractices. Probably his most noteworthy move was to short Lehman Brothers stock in July 2007, just before the financial crisis, which led to the bankruptcy of the company.
The renowned investor, however, has not had a smooth run in the markets in the last five years. Last March, Einhorn was dropped from the Forbes' billionaires list for the first time since making it in 2012. The significant underperformance of his Greenlight Capital hedge fund led to an erosion of his personal wealth. For instance, in 2018, the value of the fund declined a staggering 34% and increased only 14% in 2019, in comparison to the 29% gain of the S&P 500 Index. His short position in Tesla (NASDAQ:TSLA) is continuing to make losses for investors as well.
In a letter to shareholders on Jan. 21, the guru confirmed his fund is short Netflix Inc. (NASDAQ:NFLX). The company is undoubtedly the global leader in content streaming and is enjoying its first-mover advantage in many markets across the globe. Considering these factors, it's important for investors to conduct a thorough analysis of the company before reaching any investment conclusion.
Einhorn's case against Netflix
Investors need not go beyond the comments made by the guru in his latest letter to shareholders to understand the reasoning behind his decision to short Netflix. He wrote:
"We have been negative on Netflix's earnings prospects for a long time, and we used the late-2019 bounce in the shares to make it a more substantial investment. To the extent market sees the Netflix growth story as busted, there is a lot of downside in the shares. At present, Netflix burns several billion dollars a year in cash and has accumulated a heavy debt load, even before considering future content commitments. Netflix is no longer the only value-priced streaming VOD provider. There are now a half-dozen subscription services and in the coming year there will be additional credible entrants with deep content libraries. Not every customer will choose to subscribe to all services, and on the margin, substitution will occur."
A few concerns were raised by the guru, which will be analyzed in-depth in this analysis to determine whether or not investors should avoid Netflix shares.
Competition and the U.S. subscriber growth miss
Netflix is no longer alone in its journey. Until the third quarter of 2019, the company competed with the likes of Hulu and Amazon Prime in the U.S. and came out on top. For the first time, Netflix went head-on with Apple (NASDAQ:AAPL) and Disney (NYSE:DIS) in the fourth quarter of 2019, and the company could not meet its guidance for U.S. subscriber additions for the period.
New U.S. subscriber additions in Q4 2019 | 420,000 |
Company guidance | 600,000 |
Source: Company filings.
In a letter to shareholders on Jan. 21, Netflix CEO Reed Hastings blamed the miss on new competition.
While Einhorn appears to be spot on about this, there are a couple factors that could help the company get through this rough patch.
First, the target market for Netflix in the U.S. has still not been entirely captured by the company. At the end of 2019, there were 128 million households in the U.S., according to data from Statista. The number of households with fixed-broadband access stood at 110 million and the latest Netflix earnings report reveals that the company had around 62 million paying subscribers in the United States. These numbers suggest the target market has not been entirely captured by the company as of now.
Second, a subscriber does not necessarily have to let go of one service provider to use the services of another. This is one of the biggest differences between over-the-top services and traditional cable-TV. This means that Netflix can still survive even if Apple TV+, Disney+ and NBC's Peacock gain traction. In short, there could be multiple winners in this industry. According to a research report by Parks Associates, 46% of U.S. households have subscribed to more than one OTT service as of October 2019.
Parks Associates analyst Steve Nason wrote:
"Most OTT households are anchored by one of the three major OTT services - Netflix, Hulu, or Amazon Prime Video - but consumers are finding that they can't fulfill all their interests through a single service."
In the most likely scenario, Netflix will grow its subscriber base in the U.S. at a slow and steady rate over the next five years. Expecting the company to deliver as attractive numbers as posted in the last five years does not seem rational.
Growth outside North America will be challenging
Many Netflix bulls agree that growth will be slow in North America in the coming years and believe that the biggest driver of growth will be its international operations. This is not incorrect as the population with access to the internet in developing regions of the world is much bigger than in the United States. However, the internet penetration rates in these areas still trail behind developed countries.
Source: Internet World Stats.
The authorities in many of these countries are focused on building the necessary infrastructure to provide all residents wit access to the internet, but to successfully complete these projects, it could take a few years or even decades. This could become a constraint for Netflix to gain traction in these markets. In addition, many Asian countries do not provide unlimited browsing and telecommunication services providers often apply a fair user policy , in which the speeds are reduced significantly once a few gigabytes are consumed by a user. This is true for both mobile and fixed connections, and many analysts do not factor this into the analysis. This will prove to be a massive obstacle for Netflix to win customers in this region.
The below is an excerpt from Netflix's website that outlines the data usage.
"Watching TV shows or movies on Netflix uses about 1 GB of data per hour for each stream of standard definition video, and up to 3 GB per hour for each stream of HD video."
Another challenge for the company's international growth will be the broadband speeds in these markets. Apart from North America, Australia and Europe, download speeds could decline drastically, which might prevent users from subscribing to high-data-consuming services such as Netflix.
Source: Atlas and Boots.
The availability and usage of pirated content could prove to be a hard-to-overcome challenge in emerging markets, which is a unique obstacle the company must address.
Source: Tech in Asia.
According to Tech in Asia, more than two-thirds of the population in developing countries stream content on illegal sources, as these are usually free of charge to the consumer. Netflix will have to convince users to pay for its services, which might prompt the company to drastically reduce subscription prices. In fact, the company has already launched low-cost packages in India, which is considered one of the biggest target markets. These cuts, however, will translate into lower revenue per user, which was apparent in the fourth-quarter results.
Source: Company filings.
Netflix will initially find it difficult to report attractive revenue growth in regions outside the U.S. because of this discount pricing, even though it might be doing the right thing to attract new subscribers in hopes of monetizing them in the long run.
Overall, the going will be tough for the company in international markets in the future. There is no doubt about the potential for growth, but it will likely take more time than investors are factoring in today.
Balance sheet and cash flow worries persist
Einhorn is also correct about Netflix burning cash at an alarming rate. The company has not made positive free cash flow since 2011, which is now becoming a problem as growth in the U.S. is coming to a halt as the market matures.
Source: Company filings.
With the company taking on billions of dollars in debt to fund content creation, the debt-to-equity ratio has deteriorated considerably. This is not good news for investors as it increases the likelihood that Netflix will eventually run out of sufficient liquidity to facilitate debt repayments if growth slows down.
Source: GuruFocus.
Since it's natural for growth companies to amass massive debt piles in the initial stages of their business operations, investors have not punished Netflix shares so far. However, this might change in the future if the company misses its subscriber growth targets consistently or if competitors gain traction and eat into its market share.
Takeaway
Netflix shares are overvalued, and growth will likely slow down in the coming years. However, in the long term, the company might survive the headwinds and emerge on top because of its first-mover advantage and the high quality of its content. Even though the long-term prospects for the company are positive, this analysis leads me to conclude that in the short to medium term, the stock will come under pressure from lower-than-expected growth.
Disclosure: I do not own any stocks mentioned in this article.
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This article first appeared on GuruFocus.
