Brian Nelson, CFA
First, my pet peeve #1.
In the case of our call on Kinder Morgan (KMI) from last June, “5 Reasons Why We Think Kinder Morgan’s Shares Will Collapse, (which they did)” we believed market observers and analysts were exploiting investors’ lack of knowledge regarding the specificity of various measures of “cash flow.” To no surprise perhaps, they are still doing it!
There are at least a half dozen measures of “cash flow,” three on the cash flow statement alone (CFO, CFI, CFF), one derived from the cash flow statement (CFO less all capex = FCF), and a handful associated with valuation (FCFF = EFCF, FCFE), and at least one associated with master limited partnerships, the most inappropriately-named of them all, distributable cash flow (DCF), which should not be confused with discounted cash flow (DCF), which is also used in the valuation framework, despite having the same initials. I still absolutely cringe when an author or executive just says “cash flow.” It needs to stop — investors are getting hurt. We need to be as descriptive as possible, and it goes up the ranks. Even fund managers need this level of clarity.
From my perspective, those peddling the term “cash flow” without qualifying it are trying to pitch you something. Demand more descriptive information! If authors do not know the differences between the various “cash flow” measures, they probably shouldn’t use them, but saying “cash flow” is just unacceptable, in my view. My “gramma,” God rest her soul, used to tell me that if you don’t know what a word means, don’t say it. The same should apply to “cash flow.” Did you know that even revenue can be a warped form of non-GAAP “cash flow,” too, if we suspended reality and exclude all expenses and capital costs from the calculation? Traditional free cash flow, as measured by cash flow from operations less all capital expenditures, remains the best measure to assess free-cash-flow generating capacity.
This brings me to my second pet peeve.
I was doing one of my favorite things on a Friday night, reading through a few 10-k’s, including Netflix’s (NFLX), and I continue to be in awe with the market’s apparent reckless abandon between the very idea of the tangible costs associated with growing a business to a point in the future and what it is today. We saw it with Kinder Morgan when investors were valuing the pipeline giant as if the massive capital outlays that propel net income aren’t investor’s capital and tangible cash outflows, but instead are somehow “free money,” and that valuing the company before certain expenses and capital costs on the basis of an industry-derived metric, as in the case of distributable cash flow, a misnomer, is the right way to do it. It was a nightmare!
I plan to write a more extensive piece on this topic, but there are a few things on my mind this morning as to how “growth” investors are getting Netflix completely wrong. The topic on Netflix’s “overvaluation” may be a very worn-out one, but I don’t think “growth” investors are really looking at things rationally, even in their own “language,” which is why I wanted to bring Netflix up again. Plus, there’s a lot to learn about the concept of intrinsic value in this example. The brief walk-through below also touches on one of the more important takeaways in all of investing – that there really aren’t value stocks or growth stocks or momentum stocks, but that there are either undervalued stocks, fairly valued stocks, or overvalued stocks. As the Oracle of Omaha rightly says, growth is and will always be a component of value.
Okay. Here’s how crazy things are with Netflix’s price at the moment. Let’s assume that revenue in its Domestic Streaming Segment doubles to ~$8 billion and that management does a full 10 percentage points better than its targets by 2020 and achieves a 50% contribution margin, good for contribution profit of $4 billion. Note, that in 2015, revenue and contribution profit for this division were $4.18 billion and $1.38 billion at a 33% contribution margin, so we’re talking about blockbuster, unbelievable growth and profitability assumptions. Let’s assume that its shrinking Domestic DVD Segment holds the line at $300 million contribution profit, even though the segment’s profits have been falling like a rock year after year.
So, we’re up to $4.3 billion in contribution profit to this point. Let’s now assume the miraculous transformation of its International Streaming Segment, which currently generates ~$1.95 billion in revenue with a contribution loss of ($333 million) in 2015 such that it becomes the “next biggest thing,” mirroring its Domestic Streaming Segment’s economics, so we’re talking ~$8 billion in revenue and $4 billion in contribution profit – that’s good for a completely unreasonable 50% contribution profit in a segment that had a -17% (negative 17%) contribution margin in 2015. Okay, adding the contribution profits of these three segments, arguably in a way “growth” investors are looking at the long-term picture, one arrives at $8.3 billion in long-term contribution profit potential – an unreasonably overly-optimistic assumption, in my view, but let’s keep going.
Now, let’s subtract the overhead costs, which we think growth investors may be overlooking, with just a “contribution” profit focus. Let’s assume that, despite the generous assumptions of 1) a doubling of revenue in domestic and the miraculous 10 percentage points of improvement above and beyond management’s optimistic 40% contribution margin target by 2020 for the segment and 2) replicating these incredibly fantastic operating economics in its international streaming business (unlikely), which is a fledgling, money-losing operation, and 3) holding the line with domestic DVDs, Netflix is also able to hold its overhead costs constant at about $1 billion a year, a mark that was less than the ‘Technology and development’ and General and administrative’ expenses in 2015, so we’re talking yet another very, very generous assumption. In this rosy, unbelievable scenario, we get to about $7.3 billion in earnings before interest (EBI).
Bulls, does this sound about as good as it gets or what?
Well, let’s go ahead and tax-effect the EBI at the Federal statutory rate of 35% to get $4.75 billion in earnings before interest, after taxes, a relatively high tax rate but remember Netflix is extremely profitable under this scenario. Let’s now go ahead and subtract a comparatively insignificant $150 million in capital expenditures in the form of the acquisition of DVD content assets and purchases of property plant and equipment, numbers less than the 2015 marks, to get to ~$4.6 billion in “pie-in-the-sky” enterprise free cash flow. If we assume that the scenario we outline above comes to fruition, by let’s say 2020, and we perp the $4.6 billion in enterprise free cash flow at a ~12% discount rate (single B rated credits all-in bond yields, for example, are in the high-single-digits and Netflix is primarily equity funded), we can get to the $38 billion market price of Netflix…in 5 years…or longer, maybe. Probably not.
Here’s the rub.
If you haven’t yet realized what’s embedded in Netflix’s current price over the long haul, what many “growth” investors may not understand is that you don’t get the value of a business 5 or 10 years from now today! Even if you believe in my completely irrational assumptions of 1) its domestic business doubling in 4-5 years and contribution profit soaring far beyond management’s wildest dreams and 2) its international business achieving the same levels of revenue and contribution profit as its domestic business in the same time – very, very unlikely, as we noticed that similar levels of content and marketing spend internationally are translating into but 65%-70% of the same level of revenue as in domestic, signaling that international is not shaping up to be anywhere close as profitable as domestic (compare components of contribution loss in the international segment’s 2015 results to those of the components of contribution profit in its domestic segment in 2013), and 3) its domestic DVD is as profitable in 5 years as it is today (unlikely), you still have to bring that “perp” value back to today.
Said differently, even if you believe in my fantasy assumptions, and you believe Netflix won’t have to leverage up the balance sheet (net debt is a deduction to equity value) bringing a $38 billion valuation in 2020 back to 2016 means that arguably one of the most optimistic valuations you can place on Netflix today is ~$24 billion, which would assume all of the “fantasy” assumptions as those outlined above. We’ll be taking a stronger stand on Netflix’s valuation in our 16-page report in the coming days, so stay tuned.