Sector Monday is my regular (or occasionally regular) post on the investible trends in a timely sector. I’m filling the first of the two weeks while I’m on break in Sicily (it’s nasty work but some has to do it) with a week of Sector Monday posts. Normally these posts run only on JubakAM.com and  never appear anywhere else. But for this vacation week and this Sector Monday Week I’m reposting these to my JugglingWithKnives.com and JubakPicks.com sites.
When my son was young, we used to spend the closing days of August in Vermont on the shores of Lake Champlain. The sun would be hot. The corn sweet. And you could almost convince your body that the lake was warm enough for swimming.
And then one morning, we’d wake up and the wind had shifted so that it now blew over the lake down from Canada. And you could hear the geese honking in their “v”s as they flew south.
The season was changing and the weather and the geese were a sign of that change.
I think that’s the way look at Netflix’s (NFLX) disappointing miss on new subscribers announced on July 16. The company had led Wall Street to expect the addition of 6 million subscribers worldwide in the quarter and had instead added “only” 5 million. And the company told analysts to expect slower subscriber growth for the second half of 2018.
That news wasn’t a sign that Netflix was about to go belly up. Or that it was headed for failure. Or that the company’s business model had failed.
It was, however, a warning of change in Netflix’s market as clear cut as that shift in the wind in Vermont.
Netflix faces more competition than ever. Everybody–except my Aunt Sally–is jumping into the steaming content game.
And that change means that competing is going to get more expensive. That the cost of “content” is going up. That the war to keep subscribers and reduce churn is going to get eat more cash. And that profit margins are going to slide.
Which doesn’t mean that Netflix stock is going to $0. But the change does argue that Netflix, which even after the tumble from its July 11 high of $418.65 to a close of $355.21 on July 28 traded at a trailing 12-month price-to-earnings ratio of 238, does face a serious re-valuation of what those shares are worth.
Let’s look at just some of the recent news from the streaming market. In 2019 Disney (DIS) will launch a new service, adding the assets that it is about to acquire with its purchase of 21st Century Fox, that will sell content directly to consumers. The Fox deal will give the combined company 50% of the North American movie box office for 2018. Disney will also gain majority control of streaming service Hulu. (Disney will move most of its content off Netflix beginning in 2019.)
AT&T (T), with court permission to go ahead with its purchase of Time Warner, will put more money into HBO’s programming. The new spending won’t approach the $12 billion that Netflix is projected to spend on content in 2018, but it will be a significant bump upwards from the $1 billion that HBO spends now.
Amazon (AMZN) has reorganized the management team at its streaming business and is projected to spend $5 billion on video content in 2018 on the way to $8 billion in 2020.
And, of course, there’s Apple (AAPL), which is slowly getting into the content business.
One of the results is that although Netflix remains a potent competitor–Gosh, the company has 120 million subscribers around the world–it’s dominance in the space is slipping.  A new study of more than 3,000 TV viewers by cg42  a strategic consulting company, found that 93% of those surveyed said they had used Netflix in the last three months of 2016. In the 2017 survey that number had slipped to 73%.
And remember while you’re trying to put a valuation on Netflix that Disney stock trades at a trailing 12-month price to earnings ratio of just 15.09. Disney has had some major mis-fires this year–can you say “Roseanne” and “Solo: A Star Wars Story”–and the Fox deal still have to pass muster with overseas regulators (and Disney still has to sell some of the regional sports cable stations it will acquire.)
And that Netflix is financing its much of its content expansion with debt. The company was free cash flow negative in the second quarter to the tune of $559 million. In its guidance Netflix said that it expects to be free cash flow negative by $3 billion to $4 billion for the full 2018 year. The company completed its latest bond deal–for $1.9 billion–in the second quarter to bring its gross debt to $8.5 billion with a cash balance of $3.9 billion. The company also said that even with rising interest rates, it calculates that the after-tax cost of debt is lower than the cost of selling equity to raise cash. Which means that for the moment–but not for aways–Netflix will sell debt and not stock to raise cash.
No one sees the competition in this market getting less intense. Disney won’t be able to integrate its Fox assets before 2019 and AT&T is just starting its own integration of the Warner Brothers studio assets with its streaming businesses. Amazon is driving ahead and Apple despite its caution is clearly moving to compete.
Over the next two to three years at least, this market will get even more competitive with more streaming services competing for consumer eyeballs and dollars.
