The Nasdaq composite is at all-time highs, primarily from a few high-flying stocks. But will their prices continue to climb, or will they come back to earth? Anthony Okolie talks with Andriy Yastreb, Telecom and Media Analyst, TD Asset Management about the bull and bear case for Netflix.
Today we take a look at Netflix. Joining us is Andriy Yastreb, Telecom and Media Analyst with TD Asset Management. Andriy, let's start with the bull case. Your first point is a long runway for growth.
- Hi, Tony. Thank you for having me. So obviously the largest bull case for Netflix is that the company has a lot of room to grow. Currently, the company has just under 200 million subscribers, and the addressable market for the company is households with broadband connections, and there are over 700 million of those households globally outside of China, and that number is expected to grow to over a billion over the next 10 years.
In addition to that, there's always technological change, and we just discussed 5G recently. 5G will expand capacity and increase speeds of wireless networks will make them more compatible to broadband networks that we have today, which means that down the road in 10 years, the addressable market might be a multiple of what it is-- what investors just calculate from broadband subscribers only.
And as we look at Netflix's growth thus far, this chart shows that the growth continues, and it continues to accelerate, and COVID actually was positive impact for Netflix subscriber growth, which accelerated to over 41 million over the past 12 months.
- OK, let's talk about your second bull case, which is long-term margin expansion.
- Yeah, so if you look at Netflix's business model, the largest expense for Netflix is content, and content should benefit from economies of scale if the company grows and adds more subscribers. So what this chart shows, it shows the total content spending per subscriber, and it also shows additional content spending each year per new subscriber. And both of these lines are trending down, which tells us that Netflix indeed benefits from economies of scale, and that should help the company grow margins over time.
- And your final bull case is positive free cash flow.
- Yeah, so I think for Netflix investors and for Netflix bulls, free cash flow will be the holy grail of this story because for years Netflix has been borrowing billions after billions to invest in content and has been burning cash to grow its business. And I think the management has provided some guidance that it's going to generate positive free cash flow in the future. And because of COVID impact this year, the company generated $1 billion of free cash flow in the first half of the year because some of the content production was delayed and because subscriber additions accelerated as people were locked at home.
And I think eventually when the company reaches that stable free cash flow generation position, one of the major bear arguments against Netflix will be gone, and investors will start a new discussion of what Netflix is going to do with all that cash.
- Now give us your bear case for Netflix. Let's start with competition.
- So the main bear case for Netflix is that competition is heating up. In just the past 12 months, we saw a number of new services being launched, including Disney+, Apple TV+, Peacock by Comcast, and HBO Max by AT&T. In addition to that, let's not forget there's also Amazon Prime which has been there for many years.
And what that means is that if you look at consumers, consumer surveys tell us that consumers want to have between two to four different video subscription services, which means that this space is getting more crowded. It will be harder for Netflix to grow in the future.
And additional issue there is that some of these companies like Amazon or Apple or even AT&T, they sell a lot of different products and services. And for them, they don't really have to make money on video streaming. They can make money on something else as they bundle products together. And that means that the industry may not be as profitable in the future for Netflix as investors think.
- Now, your next bear case is higher content costs. Talk to us about that.
- So we are going back to the same free-cash-flow discussion. Bears are saying that Netflix has been burning cash for years, and that is expected to continue in the coming years as well. If we look at this chart, it's true. As revenue was increasing over time, free-cash-flow burn was getting worse and worse.
Even the messaging from management is that this is going to reverse. If you can look at consensus the next couple of years, analysts still expect Netflix to burn cash, and that goes back to the point that we had increasing competition. As companies like Amazon and Apple and AT&T want to grow in the same streaming space, they will be spending more on content, making content more expensive. And if that's the direction this industry goes, then it'll be harder for Netflix to get to positive free cash flow.
- OK, and your final point is valuation. Talk to us about that.
- So Netflix has always been a very expensive stock. Currently it's trading at over 70 times price to earnings multiple, and there are two implications for investors. First, if you look at the stock, it's been very volatile. Over the past 12 months, it traded as low as $252 and as high as $575.
And second point is that there's not much downside protection. If subscriber growth doesn't meet expectations or if free-cash-flow trajectory is not as positive as investors expect right now, valuation doesn't provide you with the downside protection, and the stock would decline significantly.
- OK, so we've heard both cases. Who's on top, the bulls or the bears?
- Well, it's a tough question, and I think if you look right now, Netflix is definitely the leader in streaming space, and this space definitely has a lot of growth opportunity ahead of it. But at the same time, the profitability of the whole industry and Netflix in particular depends not only on what Netflix does but also on what its competitors will choose to do, such as Apple and Amazon. So I think in the short term, Netflix is the main streaming-pure-play stock, so investors will continue to pay a lot of attention to this company.
- Andriy, once again, thank you very much for your insights.
- Thank you for having me, Tony.