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Netflix Solidifies its FAANG-M Status

1 John Chapter 1 verse 7 states, "But if we walk in the light, as he is in the light, we have fellowship with one another, and the blood of Jesus, his Son, purifies us from all sin."


When I read this verse, it makes me think of a non-Christian going, hmmm, "and the blood of Jesus, his Son, purifies us..." Uh, that sounds really weird! But that's the point of The Gospel, or good news. Jesus Christ died on the cross for all the sins of humanity, and rose from the dead to end death's grip on humanity. So as the verse states, the blood Jesus shed on the cross has indeed purified anyone who accepts Him from all sin.


Wouldn't it be great if there was something to purify me from making investment mistakes and picking all the best options. Well, unfortunately, I need to use the capacity of my intellect, combined with putting as much transparency out there to hopefully generate a good dialogue on critical subject matter. Hey, sounds a lot like proclaiming the Gospel!


Diversification is a very interesting term. It is most often associated with a positive tone whether diversification of investments to mitigate risk, or diversification for business endeavors, assuming synergies. For me and when it comes to investing, I see diversification as a sign for caution, and sometimes even taking a more negative tone, whether being associated with monopolies, oligopolies, centralized strategies, or conglomerates. Most companies in FAANG-M have achieved the modern equivalent conglomerate status.


For FAANG-M, there is also the good and the bad. The good is all of these companies were once young, very young and offered investors some of the best aggressive growth opportunities over the past 40-50 years. The bad is that most of FAANG-M have become gigantic companies and reflect most if not all of the negative tone mentioned above, which directly relates to future growth prospects. Most are also entrenched in today's politically-driven centralized control and push against freedom, but that's just my personal opinion.


Today, this is a big reason why I do not own FAANG-M, as I do not believe that mid- and long-term they will outperform aggressive growth top performers. For investors who have owned them for 10-plus years, it's a simple decision to continue riding returns. Ten percent per year or better is simply icing on the cake. For newer investors, it's much more complicated, as the next generation of growth opportunities will likely yield stronger returns.


With the recent news that Netflix, Inc. (NFLX) will be looking to diversify into the online video game industry, there are two high-level points. First, Netflix has solidified its FAANG-M status by joining its peers with this business strategy approach to "diversify". Second, Netflix is continuing to do damage to its core business by avoiding a tiered subscription model incorporating advertising.


The latter is not the focus of this blog, but it continues to be a highly questionable decision that Netflix has made during the streaming pivot and likely will play a role in the company's need to begin its path towards greater diversification. This is strictly related to Netflix's inability to generate positive Cash Flow in a normalized economic cycle, with a continued risk of this once production spend ramp back up this year.


But back to point at hand, diversification. There are two reasons why Netflix is choosing to diversify into online video gaming and both in my opinion represent risks to investors. On the one hand, it is clear that Netflix is competing against video gaming for time spent during the day. In fact, the competitive list is quite large and intimidating when it comes to commanding attention from users from a variety of devices and uses. Just take a look at Roblox Corporation's (RBLX) relative competitors below, of which Netflix is one and the same.

Roblox's most recent Hours Engaged metric for the Last Twelve-Month, LTM period stands at 35.4 billion. Roku, Inc. (ROKU) provides streaming hours, which stood at just below 65 billion for the LTM. Netflix doesn't breakout a comparable metric but rather focuses directly on Average Paying Memberships which stood at a little over 205 million for the LTM (including July 20 earnings report). Roku, by comparison has nearly 54 million Active Accounts, and Roblox has 43 million Daily Active Users, DAUs. While accounts may be different, hours of activity cut across all users and companies.


The key for Netflix's streaming future and investment thesis is Revenue growth and Cash Flow performance. I am modeling Netflix's Average Paying Memberships to grow just below 13% per year towards 2025 - combined with increasing Average Revenue per Paying Membership, I think the company has a shot at breaking through $50 billion by then. Cash Flow is an entirely different story as I see risks as production spend ramps back up to pre-pandemic levels potentially returning Operating Cash Flow, OCF negative. I think that the 2020 10% OCF margin is a number that may not be seen again until 2025/2026. As such, I have a mid-term Price Target, PT at a little over $1,000 per share, equating to nine times EV/Revenue, and 90 times OCF/share, assuming a 10% OCF margin.


It is to these points that I see a pivot to online video gaming compounding risk regardless of whether Netflix chooses to develop it internally or through acquisition. In either case, the outcome will simply lead to increasing leverage, as operating segment investments will translate to increases in operating expense and CAPEX, and/or through acquisitions. Combined with near-term uncertainty on Cash Burn, and Netflix could significantly increase its debt position, especially if an acquisition is indeed performed.


During Q2 2021, Netflix also repurchased $500 million worth of stock. This further complicates and potentially exacerbates debt dependence. Adding it all up, Netflix will be increasing production spend to grow content, considering internal development of online video gaming or a potential acquisition deal, while also purchasing back stock. I see no short-term outcome that does not increase the debt position, which already stands at nearly 70% of the capital structure. All of these factors are clear justification for why I own positions in Roku and Roblox versus a company like Netflix. Both companies offer higher growth, with stronger fundamentals and financial positions. I do not like seeing companies returning "value" back to stockholders through dividends and/or share buybacks. The best "value" that a company can bring to shareholders is to win markets, and keep winning them through innovation and the occasional strategic deal that makes sense through synergies.


While Netflix is "joining the club" when it comes to FAANG-M and "diversification", I don't see as innovative of a company as I did from10 years ago. With The Walt Disney Company (DIS) now at 105 million Disney+ global subscribers, it's clear that over the mid- and long-term that Netflix isn't going to be the largest individual streaming company. It's also clear that a tiered subscription model including advertising is much more appropriate for a company like Netflix that has a stronger hodgepodge of content. Streaming competition will continue to increase, and Netflix is playing a risky game of converting the substantial majority of content to equate to an HBO Max or Disney+ service with no advertising - Reed Hastings has been bent on this without compromise since 2011. There are scenarios where even at $50 billion in Revenue, Netflix could still be negative or only modestly OCF positive. I see some of these risks as concerns, and further justification for the need to diversify, for me that doesn't sit well.


Slowing streaming growth combined with risks associated with transitioning to an entirely new operating segment should give investors pause to rethink their investment positions, especially those who have only held for the past year, or have been contemplating initiating a position recently. Even investors who have been fortunate to have owned Netflix the past decade, may want to think about their investment goals and objectives.

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