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The Netflix Saga

The recent collapse of the Netflix share price has generated much speculation around whether this a share to be buying, as it is surely “cheap” right now. Our issue with this overly simplistic view of things is that it gives no real consideration to the quality of the business, as it does not take into consideration the overall health of the company, or its future prospects.

The graph below tells one of two stories: either we're looking at a company in severe distress, or we're seeing the buying opportunity of a lifetime created by an inefficient market. The devil however is in the detail.

Netflix, currently the leader in streaming video on demand services, reported a loss of 200,000 subscribers in its first-quarter earnings report. That is well off its projections of a gain of 2.5 million. This was the first quarterly loss of subscribers since 2011 when the company moved to separate its streaming service from its DVD service. What cannot be ignored though is that the company expects to lose another 2 million subscribers in the current quarter.

Whilst its fair to say the share is a better buy at current levels than it would have been in the weeks and months leading up to this point, that doesn't mean that it's a great buy: one also needs to consider the overall health of the business, as well as the other options in this space. In our opinion Disney currently represents a better investment opportunity, not just because of their cash flow and alternate sources of revenue, but also because their business model is more diversified.

Netflix is currently valued at just under $100 billion with revenue of approximately $30 billion. Their operating income has not grown in the last year and the business does not generate free cash flow. Content creation is a considerable expense which has increased by more than 40% in the last 2 years to more than $ 17 billion. With added competition from Amazon, Apple, HBO, Hulu, Paramount and Disney the landscape has changed from the early 2000s when Netflix changed the way we watched movies. The balance sheet currently reveals total liabilities of $28 billion. With no free cash flow, and with significant challenges to revenue should subscriptions continue to fall, there is reason to be concerned.

It is true that the caliber of management in the business is solid and that they are already reviewing ways to address their challenges. They're taking steps to counter password sharing, which robs them of revenue, and they are considering the introduction of advertising as an additional revenue stream. However, Netflix as a “buying” opportunity must be considered relative to the opportunities we see elsewhere in the market and in our opinion Disney is a share we prefer to own at this time.

If it were as simple as just buying shares that had fallen the most in the past week, our lives would be much easier. But it takes a lot more than that to successful on a consistent basis.

- Warren Quin


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