NFLX – Q3 2017 Preview: A Q3 Trade Is Taking Form

A volatile few months – The first half of Q3 2017 has been volatile for Netflix’s (NFLX:NASDAQ) stock price. Starting in July with our initiation at $146, NFLX jumped to $189 following a stronger than expected Q2 net subscriber additions before settling around $168 today. Also driven by news of Disney, Facebook and Apple entering the over-the-top (OTT) content market, Q3’s annualized volatility of 46% compares to a 29.5% annual volatility that Netflix has seen year-to-date.

Netflix might fall short of the guided 4.4 million net adds – After updating our regression model for Q2 data, we estimate that a lack of new, quality Netflix Original programming in the first half of Q3 is leading to net subscriber additions pacing lower than Netflix’s 4.4 million guidance. Our forecast model predicts that as of August 15th, Netflix has added only 2.1 million subscribers and is on pace to add 4.0 million net subscriber additions.

Q2 shows are more impactful to net subscriber additions than shows introduced in Q3 – We believe most of these Q3 net additions have been fueled by the continued success and allure of Originals such as 13 Reasons Why, Orange is the New Black and House of Cards. There has also been a surge in interest in content that has been cancelled, particularly Sense8. The content introduced in the first half of the quarter has failed to create anywhere near the impact that Q2 originals made – even Jason Bateman’s much hyped Ozark has barely made a mark.

Better Original Content slated for the second half– While content in the first half of the quarter didn’t create much buzz, the second half has crowd-pullers like Marvel’s The Defenders and Narcos season 3 slated for release. The table below shows the range of net subscriber additions we expect for Q3 2017 based on the performance of Narcos and The Defenders. The base case assumes Narcos performs the same as it did last season and The Defenders makes the same impact as Daredevil season 1.

EXHIBIT 1: Net Subscriber Additions Scenario Analysis

Source: Perspectec

Based on the above estimates, it appears likely that Netflix will miss it’s Q3 guidance.

Increasing confidence in our forecast model – Our forecast model after adjusting for Q2 data now has an adjusted r-squared of 0.99 with 17 degrees of freedom for predicting net subscriber additions. We have not made any adjustments to the inputs outside of adding the Q2 data to the dataset, which has modified our coefficients and intercepts for seasonality and adjusted search interest.

We have collected Google Trends search history data of all Netflix Originals (excluding Kids programming and comedy specials) relative to Netflix’s most popular show, 13 Reasons Why, and have adjusted for seasonality and internet penetration.

Increased competition is not affecting our current valuation – Over the past few weeks, Disney, Facebook and Apple have announced plans to launch their own video streaming services. Disney’s SVOD platform will be launched in 2019 and Apple’s plans do not have a definitive timeline. Facebook’s Watch platform is expected to have a launch later this year, but is aiming to compete with Netflix in terms of the viewer’s time rather than on content, similar to YouTube. Thus we have not adjusted our regression model for the increasing future competition. We believe Netflix can be more accurately valued based on its trailing 12-month subscriber metrics and valuation rather than predicting future revenue, earnings and cash flow.

Q3 SaaS metrics back a Sell Rating– Using the ‘Base Case’ net subscriber additions, we have calculated the expected Customer Lifetime Value (CLTV)- Customer Growth Cost (CGC) ratio for Q3 2017. Exhibit 2 compares the expected scatter plot for Netflix and its peers in Q3 to the values in Q2.

EXHIBIT 2: Comparison of CLTV-CGC for Netflix and its peers between Q2 and Q3 2017

Source: Perspectec, Comany Reports

In terms of its trailing 12-month valuation, Netflix remains a hold at it current price. However we see its CLTV / CGC falling from 1.2x in Q2 to 1.0x in Q3. A ratio of 1.0x implies the company is only earning back from the new subscribers what it spends to acquire them in the first place. Given the negative $2-2.5 billion cash flow predicted for 2017 and the need for increasingly expensive original content, Netflix needs to work to reverse this trend. If this 1.0 CLTV / CGC plays out along with our 4.0 million net subscriber additions, we believe the stock will move lower when Q3 results are reported.

Conclusion and Valuation – From the lower than expected net subscriber additions, we are issuing a sell on Netflix until after the company reports Q3 results. The starting price for our stock call will be the closing price of NFLX on the NASDAQ on August 30th.

Currently given a trailing 12-month CLTV / CGC of 1.13x based on an assumed cable company churn rate of 30%, a TTM EV/EBITDA of 113x provides a current valuation of $174. We believe the share price is fairly valued based on trailing 12-month data.

Post the move lower on Q3 results, we see the stock moving materially lower in the following days (below $160) before steadying back to ~100x TTM EV / EBITDA based on a 0.96x CLTV / CGC, which would translate to $165.

If the company reports results inline with consensus and their guidance, we believe the stock will be fairly valued and we would not anticipate a major move in the stock price.

In one year’s time there is a chance the stock moves higher. However our highest conviction call is to sell Netflix’s shares above $165 up until the Q3 report

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