08/17/2018

Netflix, Disney and Time Warner: Investment Prospects as Streaming Media Matures

Netflix, Disney and Time Warner: Investment Prospects as Streaming Media Matures

• Netflix has appreciated significantly as first mover into streaming media, but now appears expensive as it faces increasing competition.
• Disney and Time Warner are positioned to deliver more attractive investment prospects as they increase their streaming presence and can be obtained at a discount to intrinsic value.
• Content asset accounting defers expense recognition and each firm’s application is subject to management discretion. Meaningful analysis should attempt to standardize application across firms.

The ongoing shift from programmed linear broadcast television to nonlinear streaming content is capable of delivering meaningful investment opportunities for active investors. Netflix stock has appreciated remarkably as a first mover and market share leader in streaming content, but investors are now expected to look beyond current levels of negative free cash flow and assume that as the company matures, the firm will be able to more efficiently invest in original or exclusive content while still delivering high levels of revenue growth and improvements in operating margins. Due to this, Netflix trades at more than 7x revenue while Time Warner and Disney trade at 2-3x revenue with a justification that Netflix’s heavy spending on content assets is only temporarily impairing free cash flow.

Content asset accounting is used to capitalize production costs as intangible assets, which are then amortized over the course of their expected life. Assumptions around the expected life for media investments are highly abstract but carry tremendous weight in the calculation of an estimate of intrinsic value. It is important to standardize the economic impact of content asset accounting across each firm to develop an investment thesis for each stock. Based on this, it is clear that streaming media exposure can be currently obtained at a discount in emerging competitors in Disney and Time Warner, while this increasing competition will make it highly unlikely that Netflix will be able to deliver the aggressive implied expectations reflected in their stock price.


*Detailed Models: NFLX | DIS | TWX

In short, the economic impacts of content asset capitalization can be significant, especially for a firm like Netflix where content licensing and production costs make up almost the entirety of their cost of goods sold. Delaying expense recognition reclassifies content spending as long-term investments, and period expenses are separated from COGS as an amortization expense. While it is reasonable for media firms to capitalize these costs while various films and shows are in production, it is likely that most new releases will generate the majority of their revenue in a fairly short window of time initially following their release while a small number of investments may lead to significant merchandising or franchise expansion opportunities over longer time horizons.

Based on content spending data provided by each of these firms, it is clear that Netflix aggressively delays expense recognition while Disney and Time Warner quickly expense productions as they are released. Only 10% of Netflix’s capitalized content assets reflect productions that have yet to be released, while these levels increase to roughly 50% for Disney and Time Warner. Disney is the industry leader in establishing significant merchandising opportunities and long-term fan engagement around various franchises across animation, Pixar, Marvel and Star Wars, but Netflix claims to have nearly three times their level of already released content assets.

Given their stock appreciation over the last several years, investors seem to have given Netflix benefit of the doubt as they have transitioned from a content aggregator to a content producer. To relay that sentiment, this model assumes significant improvement in operating margins to 19.1% by 2022 while revenue increases nearly threefold to $35B and asset efficiency improves by nearly 30% as content asset spending becomes more efficient. Despite this, the model still arrives at an intrinsic value estimate more than 25% below current market prices. It would also be reasonable to assume more conservative forecasts as increased streaming competition may lead to lower growth and margin forecasts, content spending needs may continue to expand at a pace consistent with revenue growth to meet international market needs and changing consumer preferences, and international expansion may lead to lower incremental margins than domestic levels. If Netflix fails to deliver on the first set of optimistic assumptions, an estimate of intrinsic value would fall much further.

Alternatively, conservative forecasts reflecting inflationary-based revenue growth and stable levels of operating margins and asset turns deliver mild upside for both Disney and Time Warner. These models also reflect sustainable relationships between content spending and expense recognition and likely discount the superior ability of these firms in creating universally beloved content over long-term horizons (especially Disney), which Netflix has failed to deliver on at this point outside of a handful of shows (including Marvel-licensed content that may have limited availability as Disney develops their own streaming platform in 2019).

Conclusion

On a forward-looking basis, it appears that streaming media investments in Disney and Time Warner offer a significant discount relative to Netflix. Current owners of Netflix shares likely have large tax considerations, given that the stock has appreciated nearly 94%/year since September 2012, but it appears that the recent run-up of the stock in 2018 has vastly exceeded a reasonable estimate of intrinsic value and offers a great exit point to realize capital gains while alternative streaming investments in Disney and Time Warner can continue to deliver upside going forward.

Appendix: Model Summaries
Netflix: $240.02 Price Target (26.9% Downside)

*EquityInsights.com – NFLX, 5/15/18

Disney: $120.46 Price Target (17.6% Upside)

*EquityInsights.com – DIS, 5/15/18

Time Warner: $103.29 Price Target (9.4% Upside)


*EquityInsights.com – TWX, 5/15/18

Economic Margin (EM) is a corporate performance metric owned by the Applied Finance Group, Ltd. that corrects accounting distortions to measure true economic profitability and accurately calculate intrinsic values for companies worldwide. Additional insight into Economic Margin is available on here. Additional insight into AFG’s approach to estimating intrinsic value based on forecasted Economic Margin levels is available here.

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