Disney vs. Netflix
Featuring David Trainer
Published on: June 20th, 2019 • Duration: 22 minutesDavid Trainer, CEO of New Constructs, returns to Real Vision to update his winning trade on Disney and to discuss how the company’s new streaming service, Disney Plus, will fare against its competition. He discusses the current expectations for Netflix’s profitability, highlights Disney‘s growth outlook, and suggests how best to play the situation, in this interview with Justine Underhill. Filmed on June 18, 2019.
JUSTINE UNDERHILL: Welcome to Real Vision's Trade Ideas. Today, we're sitting down with David Trainer, CEO of New Constructs. Great to have you here.
DAVID TRAINER: Thanks for having me.
JUSTINE UNDERHILL: I want to start out with a great job on your call on Disney when you were last here in February. You were quite bullish on the stock. And it's been in the headlines ever since especially because of its Disney Plus, the new streaming platform. So, just to recap, when you were here in February, you were looking at the stock reaching a potential target of 170. It has gone up to 140. And that's about 25% upside since your call. Could you give us a little bit of background as to what you were looking at then? And where you see the stock going now?
DAVID TRAINER: Yeah, the main thing is that Disney's actually making money, a lot of money, while one of its principal competitors, Netflix, is losing a lot of money. And in addition to that, when you look at the pipeline of content that Disney has available to it, it's unrivaled by anybody in the world, whether it's Toy Story or Spider Man or Avengers, and I don't know. You know how many Avengers movies there are, right? There's like a new one every week. And they keep setting records.
It's a great pipeline. It's a great bench of content. But what makes Disney I think all the more powerful in this space is its ability to monetize that content. So, one of the great things about sequels is that there's not a lot of Lyft required, you don't have to go out and sell the world on a new concept. They're going to show up with very little advertising, because they've already bought in on the last one. And then there's the whole theme parks thing. And then there's the whole merchandising thing.
Disney, they make money on this stuff. And the theme parks are actually making money for the first time in a long time. They're seeing significant profit growth, but also the merchandise. And this ability to monetize the content is really unrivaled as well. And so, what you have with Disney is this ability to be really smart about buying new content. So, I remember when they first bought the whole Star Wars deal, I think that was a $3 billion deal. I remember we thought oh, my gosh, that's a lot of money. I think they've made 10 times that already. And then who knows how much more they're going to make.
JUSTINE UNDERHILL: Right, they have a theme park that they're opening now.
DAVID TRAINER: That too. And so, Disney was just when we first started talking about Disney, it was really undervalued, absurdly undervalued considering where its competitive position was and how profitable it was. And so, we think, yeah, 170 bucks, easy. I think that really this is more about the market wising up to how much better a business. Disney isn't Netflix because for a long time, I think Netflix won the PR war, and had people believing that somehow they're going to take over the world. And I think increasingly, people don't believe that, even if the stock price for Netflix still implies that.
They're starting to understand how much of an advantage that Disney has, especially as Disney and other content creators take content away from Netflix. Disney is able to create original content and monetize it. That's one of the hardest things to do in the history of the world. How many firms in the history of the world have successfully created monetizable great original content consistently over time? It's rare, very rare. How many firms can deliver content over the internet? I can deliver, I got a YouTube channel. And I could spend a lot of money making people or getting people to watch my stuff. And I can spend billions of dollars on creating shows. But I'm not making money. And that's not sustainable.
And so, I think really, the core of what you're seeing with Disney as a real competitive advantage is their ability to either require or create high quality and profitable original content in a way that nobody else in the world really can.
JUSTINE UNDERHILL: And actually, speaking of acquiring businesses, that's been a big part to their successes that they've been able to buy different companies like Pixar, like Marvel, like the Star Wars franchise and actually be able to build on it.
DAVID TRAINER: Yeah. One of the things that we liked about Disney originally is that their executive compensation is linked to return on invested capital, we've talked a lot about return on invested capital with you all. And we think, look, if management is committed to and the board is holding them accountable for performance that really directly translates into creating shareholder value, that's a much better investment. If you pay executives for things like non-Gap EBITDA or even just playing the EBITDA, there are ways that executives can grow those numbers while the underlying cash flows of the business are declining.
People don't realize that. It's probably one of the biggest travesties in society today that these compensation committees and these boards of directors are signing off on compensation plans that effectively incentivize executives to ruin businesses for shareholders. Disney is not one of those. They've been early in the adoption of return on invested capitals performance metric. And that's why their acquisitions are smart. Because if you pay attention how much money you pay for an asset, and you pay attention to how much cash flow you have to generate on that investment in order for it to be a worthwhile return, well, then you're much more likely to do well with that.
If you're not held accountable for how much you pay for an asset, and your performance can be great no matter how much you pay in an acquisition, you're probably going to overpay, because you don't care, you don't get paid one way or the other. And so, Disney has been really smart about acquisitions in a way that many, many firms are not. Most of the time, we were very critical of firms that do a lot of acquisitions. Disney doesn't do a lot, don't get me wrong. But one of the few years, the main things that they're intelligent about it, they don't ever pay, and they're able to make way more money on those acquisitions than what they pay for them at the end of the day.
JUSTINE UNDERHILL: And actually, beyond the February call you made, you've been bullish on Disney for quite some time.
DAVID TRAINER: Yeah. To be honest, I don't recall at this moment exactly when we first were bullish on Disney, I feel like it was sometime in 2017. But it's been showing up on our screens for a long time as a business that had great risk reward. And that means that the cash flows, the economics of the business are really strong, Disney has a high return on invested capital, higher than peers, and its valuation was cheap.
And when we talk valuation, what we talk about and what we focus on is the implied expectations to justify the stock price. And so, and we'll get into this more detail in a minute with respect to Netflix. But the expectations embedded in Disney stock price when we first got bullish on Disney were low. In fact, the effect that I think the stock price implied almost no profit growth.
For a business that was generating several billion dollars a year in profit, the market was not giving them any credit to continue that. This was when Netflix was winning the PR war even more, because they were an either or and Netflix is going to take over the world and businesses like Disney are going to die. So, I do know when we first got bullish, it was when Disney got so cheap that we're like, this is ridiculous. The stock market is not giving them any credit for future profit growth. And so, I think that was around 2017.
JUSTINE UNDERHILL: So, do you still see 170 as a reasonable target for Disney? And would you potentially take profits here at 140?
DAVID TRAINER: No, I think you should be long Disney for a long time. I think if it goes to 170, I think there's a good chance it's going to go to 200. What we're going to see here is the mythology of Netflix unwinds, is that a lot of the excess capital that went to Netflix is going to go back over to Disney. We call this a micro bubble concept where there are certain stocks that have attracted more market capital than they deserve. And often, that's at the expense of other stocks that deserve capital. Netflix and Disney are a perfect combination. Netflix is way overvalued, Disney remains undervalued.
And we think when the pendulum finally does to swing back, and it's easier for me to talk about the pendulum swinging when it's finally started to come that way, than it was in the beginning when I was- really, this was a message that was falling mostly on deaf ears because the Netflix fanatics are so fanatical about what they think about Netflix. And so, I think there's significant upside, and I think you probably don't really need to think about putting the brakes on until well over 200 bucks. And even then, it's not like Disney hasn't like been a long time very consistent performer, I see the likelihood of this business falling out of bed or getting off the tracks is pretty low. So, I think it's one of those that you can really consider holding for a long, long time.
JUSTINE UNDERHILL: Do you see any major risks to Disney at all? Or is there anything that would something happens there, and you back out of the stock? There are some analysts that after this 25%, 30% runup this year, have said now, I'm calling the brakes on Disney.
DAVID TRAINER: Yeah. We don't try to be cute about timing on stocks. So, this is a good business that generates a lot of cash flow, and the valuation is reasonable. I don't like to call tops and bottoms. That's why I'm saying, look, this is we think as something as a real long term holding. Things that would make us want to get out, I think if the executive compensation plan were to drop return on invested capital, I think that would be a big negative, because effectively, you're basically, it's like putting a hole in the bottom of the boat, saying, oh, we don't really care about being good stewards of capital. And if management doesn't care about being a good steward of capital, well then, how can investors trust them? Because that, at the end of the day, is the underlying premise of the capital markets, that executives be good stewards of an owner's capital.
JUSTINE UNDERHILL: All right. So, let's turn over to focus on Netflix. What do you see going on there? They've had an incredible runup over the past few years. How do you fight against that?
DAVID TRAINER: Well, mostly, we've lost. We've had our face ripped off with respect to being negative on Netflix for quite a long time. They were winning the PR war, I think convincingly as cheap as Disney was. Netflix was expensive, if not more, because they were convincing people that somehow they're going to take over the world, even though they lack the most important asset if you're going to be in the content business, and that is high quality original content.
JUSTINE UNDERHILL: But in some ways, they have been working on creating their own content, to a great expense, which we will get into in a moment. But as part of the problem that they face, the fact that suddenly, other companies are realizing the value of the content that they are supplying to Netflix itself. I know they paid Warner media 100 million dollars for Friends. Is that correct?
DAVID TRAINER: Yeah. That was a little while ago. We recently did a little digging and we found that something like 70% of the viewing time on Netflix is on content that they licensed. Three of the top four shows on Netflix, they get from other people. So, this is a business built on the back of content they do not own. I don't know if many people realize that. I hear that and I'm like, how do people think they're actually going to survive? Because they're still not making enough money, even with a licensed content on their original content. In fact, we've got a great chart that shows that the growth in expenditures on content is faster than revenue growth.
So, they're earning- for every dollar they spend on content, they're earning less revenue. So, the new content spending is yielding less and less- less and less revenue, and less and less subscribers. Really, at the end of the day, they're the same thing. So, the Netflix business model, right in front of our eyes, is effectively unwinding and for all the equity investors out there that still want to be bullish, rah, rah, rah on Netflix, I say, be careful of one thing. Because the debt investors are not even as patient as equity investors these days. The cost of borrowing for Netflix has gone up something like 270 basis points in the last several months.
So, the debt investors are starting to reel in the line a little bit on Netflix, even if the equity investors haven't woken up to smell the coffee yet. And so, look, again, I have my face ripped off for a long time. Sometimes it takes a while to be right. Disney is proven. And I think Netflix will suffer as Disney succeeds.
JUSTINE UNDERHILL: So, comparing Netflix to Disney, how do you look at valuations for both companies, especially given current stock prices?
DAVID TRAINER: First of all, when it comes to valuation, I always like to tell my new analysts, it's better to be a critic of a fortune teller than it is to be a fortune teller. So, we like to use what we call reverse DCF or reverse discounted cash flow modeling to quantify what the future cash flows have to be to justify the stock price. Because that's objective, its mathematical. And for Netflix, we've seen ridiculous expectations baked into the stock price for a long, long time. I've been going on record saying Netflix isn't necessarily a bad business. I think we've proven in some ways it is a bad business now, and for a long time, it's hard for people to understand that.
But I would say granted Netflix is a good business. Sure, I'll let you have that. But what I can't grant you is that they will ever fulfill the market's expectations for future cash flows as reflected in the current stock price. Right now, around 350 bucks a share. To justify that, Netflix has to grow its profits by 30% compounded annually for a decade. You know what 30% compounded annually for decade looks like? It's way bigger than Disney is today. It's way even bigger than what Disney is projected to be when we look at the market's expected cash flows for Disney, that's equal to like something like 800 million subscribers at 15 bucks a month.
So, whatever you think about how good a company Netflix might be, I can still argue it's not a good stock. That, of course, assumes that people are going to care about fundamentals. And all this time, I've been getting my face ripped off. People have not cared about fundamentals. But I think it's going to be harder and harder to ignore the fundamentals because I think the debt markets are already becoming a little less willing to lend to Netflix the money that they have been burning to keep the business going. As context, Netflix has burned $10 billion in the last three years while Disney has generated 20 billion.
JUSTINE UNDERHILL: All right, so you were talking about the implied revenue growth, what about implied profit growth?
DAVID TRAINER: Great question. Because at the end of the day, it's about profits. So, no, yeah, and Netflix is actually when you look at the current stock price, and you reverse engineer, or you put into your discounted cash flow model what the future profits have to be so that model will generate a price equal to the current stock price, it's a number that's even higher than what Disney is expected to be. So, Netflix at 350 bucks is pricing in already, the market is saying that Netflix will be more profitable than Disney within seven years. So, that's an enormous amount of growth.
That's why I'm saying to justify the current stock price, it's got to be like 30% compounded annually for a decade, 35% for seven years, 35% compounded annual growth over seven years. Put that into an Excel model sometime and just see that with $1 what that looks like. It's absurdly higher level, it's an absurdly higher level of profitability and growth. And what I love about this chart is that you see Disney's profits way above Netflix. And the future profits, yeah, growing slightly. But Netflix is like the super underdog thing. Its profits are way below Disney, but it's expected to rise super-fast and then be even higher than Disney.
And I think when you look at the valuation of the business through that lens, it makes it easier to understand this math that we're doing, because it makes it tangible that like here's one live versus another. And when I look at what the market is predicting Netflix will do, it's hard to stomach. NOPAT stands for net operating profit after tax. And that is a measure that we put a lot of time and effort into getting right across all companies and all sectors. So, it's an apples to apples number. It's based on a lot of research we do not just on the income statement and balance sheet, but in the footnotes and the MDNA. So, we're pulling it together a lot of information to get that right, we specialize in getting that number right. And that's the real after tax cash flow number that we're focusing on in that figure.
JUSTINE UNDERHILL: So, what cash flow does Disney need to have to justify its current share price?
DAVID TRAINER: Disney needs mid-single digit growth over about seven years to justify the current stock price.
JUSTINE UNDERHILL: Okay.
DAVID TRAINER: And if they do something like seven or eight or 9% for 10 years, 12 years, that's where we get into 180-200 bucks a share. The risk reward here is undeniable.
JUSTINE UNDERHILL: So, in terms of Netflix and shorting Netflix, it is somewhat risky. Would you short at current levels? And if you were to do that, how far do you see Netflix falling?
DAVID TRAINER: First of all, we've not really been that good at shorting. Shorting is a timing game. And I don't really want to pretend, especially since I've been wrong for years on that, that all of a sudden the timing is right. It's hard to know. The market can stay irrational for longer than you can stay solvent sometimes. That's a famous Warren Buffett saying about shorting.
So, I think if you wanted a short, you probably want to do it in a less risky way with options, or other derivatives things. So, you're not exposed to potentially the crazy runups that we see from what we call noise traders, people who are investing based on things other than fundamentals, and we have plenty of those. So, shorting Netflix and the timing of that is a really hard question. I think the smarter thing really, just get long Disney, don't own Netflix. And when it does come apart, it's tough to value the business. Because when you look at the value of the business today, based on the existing cash flows, it's less than zero.
So, if you assume that their current cash flows, they can maintain that into perpetuity, that the value of those cash flows is less the debt that the company's taken on, they also have significant option liabilities, because they've given out a lot of stock to folks. And so, the core business in Netflix has zero value. Will someone buy them, because they've got this great platform and this great customer base they can monetize? Probably. How much they pay? I just wonder. I wonder what the residual value there at Netflix. It's clearly not in the delivery capability. They do have a lot of subscribers, is there a way to monetize that? Possibly.
And even in the content that they have been creating, we found out, analyzing that a little more deeply, the shelf life is really short. Those shows are typically watched a lot in the beginning, and it drops off right away. That's another funky thing about the accounting at Netflix- they are amortizing the cost of creating the shows over several years, when really the revenue from creating those shows is only barely more than a year or two. After three years, it's dropping off a cliff.
I'm not going to say Netflix is worth zero, but I think instead of 350 a share, it's going to be hard to sell for much over 100 bucks a share.