In our Framework Investing Office Hour sessions last week, we had several good discussions – one on autonomous vehicles, the other about our recent research and articles on Netflix.
One long-time Framework member who dialed into the Netflix call is a veteran Hollywood producer, who works on creative projects for Disney, Amazon, and other content creators. I was gratified to hear that he thought the contention at the heart of my last article – that Netflix is Uninvestable – is literally true.
The views of this insider – who is also a thoughtful and experienced investor – has helped fill in some details about Netflix and the industry. I and everyone else on the call found his insights enormously helpful.
He agreed with the point that I made in the intro to my last Netflix article – that the company is amazingly innovative and resilient. Reed Hastings, he made a point to say, has been phenomenally successful at redirecting the firm through its relatively short history and has made a fundamental change to the paradigm for media consumption with the innovation of streaming. Over the past few years, Hastings has again shifted the company from simply a provider of other networks’ productions to a content creator in its own right. I was surprised to find that in the 2017 10-K, Netflix describes itself as “the world’s leading internet television network.”
In our member’s words, “I wouldn’t want to short Reed Hastings.”
That said, looking at Netflix from a business perspective, he sees a raft of issues. Here are some of the points we talked about specifically:
- Netflix is losing access to some very valuable content libraries very soon. Netflix will not be able offer streaming content produced by Disney, Pixar, Lucasfilm, or Marvel after 2019 as Disney is launching a streaming service of its own. Disney is also a part owner of Hulu, so may use that platform to distribute its valuable original content. Keep in mind that Disney has offered to acquire Fox assets as well, and while that deal is still up in the air, if it clears, Disney’s library would be even more valuable – and potentially out of Netflix’s reach.
- Scrambling to create content for its own platform, Netflix has been throwing money at creative projects and a lot of the spending looks uneconomic. The insider said that friends inside Netflix report a chaotic environment with few or no cost or capital controls for each of its creative projects and series.
- Netflix’s profligacy is rippling through the rest of the industry. Our insider says that Netflix is spending so much on salaries and creative projects that he simply passes over prospective employees with “Netflix” on their resumes because he knows it will cost too much to bring them on board.
- In a creative arms race, other content producers have also entered the streaming service game, and the number of programs being produced has increased enormously. At some point, someone working a 40-hour week will simply not have enough hours in the week to consume all the (high-quality) content being created. This is a boon for consumers, but an arms race environment can be very damaging economically to companies and their owners. Disney’s Bob Iger has already said that Disney’s streaming service subscriptions would be sold at a significant discount to Netflix’s basic subscription rate – a statement that should worry any Netflix owner. “The Golden Age of Television”, as some have called our present times, could also be termed a bubble. When the price you spend to create product becomes not recoupable with future cash flows and it is clear to investors, many of the companies in this space will suffer greatly, if not retrench or go out of business.
In short, Netflix’s original content does represent elements of a long-lived company asset – a content library. However, asset quality matters and Netflix’s undisciplined spending suggests that quality may suffer longer term. Also, compared to other content companies, Netflix’s bench is not nearly as deep, as its original content history is decades shorter than most of its competitors.
Because most of the value of a company is tied to the rate at which its cash flows will grow into perpetuity, and because these cash flows are so very uncertain, I reiterate my earlier contention: Netflix is Uninvestable.
Whether you are successful speculating on Netflix from the long or short side, you will never know whether your success is due to luck or skill.
Counterpoint – Another Insider Weighs In
Twitter is a mixed blessing. I post article links there and while doing so does help me get my work in front of a larger audience, I get to experience the joy of people calling me a moron.
This is precisely the reaction of one Twitter user, who also seems to be a Hollywood insider. One set of his comments, unedited, are below:
“Your strategy against Netflix is moronic. The stock more than doubled YTD, and has gone from $32 to $324 in 5 years. They recently moved into the billion person market of India and every time they raise the subscription price the cash register rings and rings”
The commenter does have a point. Anyone can see that Netflix’s subscriber growth has been phenomenally rapid as have returns on the stock. Price does not equal value, though, and by keying off past price increases, one ignores the “tail-risk” associated with Netflix’s liabilities or the effect of present and future competitors (including Amazon, whose video streaming service might be thought of a sort of a marketing arm of its Prime Member service).
Another point that is worth mentioning is that this commenter’s caustic current of comments in my Twitter feed displays many behavioral biases which have, time and again, proven so destructive to investors. One in particular is the bias known as the Overconfidence Effect. While the overconfidence effect (an effect that seems to be less extreme in women, by the way) has only recently been studied by academic economists, the concept is an ancient one.
One Twitter account that I am delighted to follow is Sententiae Antiquae (“Ancient Maxims”), which translates classical Greek and Latin snippets into English. I’ll leave you with the ancient response to someone suffering from the Overconfidence Effect. This maxim is a useful one for all investors:
“Don’t be arrogant when you are lucky or wretched when you’re not”
εὐτυχῶν μὴ ἴσθι ὑπερήφανος: ἀπορήσας μὴ ταπεινοῦ. #Cleobolus
— sententiae antiquae (@sentantiq) May 9, 2018