Short Netflix, Long Disney
Featuring Andrew Freedman
Published on: July 30th, 2019 • Duration: 23 minutesAndrew Freedman, CFA, communications sector head at Hedgeye, makes his Real Vision debut in style with a pairs trade on Netflix and Disney. He discusses why Netflix’s subscriber growth is hitting a wall, explains how Disney’s DisneyPlus could be a Netflix killer, and breaks down his price targets for both stocks, in this interview with Jake Merl. Filmed on July 29, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl, sitting down with Andrew Freedman, Communication Sector Head at Hedgeye. Andrew, it's great to have you on the show.
ANDREW FREEDMAN: Great to be here.
JAKE MERL: So today, we're going to be talking about Netflix. The company just reported the largest paid subscriber miss in company's history as a streaming service. I believe they were expecting 5 million or so subscribers, they only got 2.7. What's going on, Andrew? Should investors be worried?
ANDREW FREEDMAN: Yeah. Look, what we've been saying for the good part of this entire year is that growth is going to slow across the board. We've been tracking data that tracks that number of subscriber additions for Netflix for a long period of time now, and the growth rate has just continued to slow and should investors be concerned? Yeah, I think this is the beginning of the end for the Netflix growth story.
Now, could they have a couple more good quarters in them? Sure. But I think as we look at increased competition and going to 2020 and beyond, investors that are running million net new US sub add models and 30 million international sub add models to 25 ARPU, they're really going to have to start stress testing their assumptions and that doesn't support the ARPU valuation whatsoever.
JAKE MERL: So, I know there are a lot of different moving parts to this bear case. Why, specifically, do you think Netflix is a good short?
ANDREW FREEDMAN: Look, we can talk about valuation all we want. I think what it comes down to is that growth is going to slow meaningfully that the addressable market that the bulls are putting this huge multiple on just doesn't exist. They're trying to expand their investment market growth, accelerate growth by cutting pricing in India. We'll see if that actually works, but I don't think they're going to be able to make any money.
When we look at the US market in particular, they're 65% penetrated. We've done primary research that suggests that there's just not enough new subscribers left for them to go after. And in that scenario where maybe they do flatline at 60 to 65 million US subs a year, that would be really bad for the financial model and for the stock. In that scenario, it's really hard to model how they ever get to free cash flow breakeven, and mind you, this is a company that cannot fund itself, that burns anywhere from three to 4 billion cash a year, so completely relying on the capital markets.
And so, I'm sitting here looking at the longer term model, looking at my growth estimates or what the consensus is and I'm like, man, if they just miss by a little- there's so much downside here. At the same time, we're at peak leverage, peak growth and investor sentiment, I was having conversations with investors, and a lot of them were last three months, it's a completely consensus long. Short interest is at an all-time low, sell side sentiment is at all-time high. So as far as I see it, it's a really great setup on the short side. So, I think that this is just the first of many, big misses to come for the company as the whole narrative shifts.
JAKE MERL: So, the company has slowing growth, and they consistently burn through cash. But what about competition? What does that look like for the company?
ANDREW FREEDMAN: It's getting worse. The bears, those who've been short the name for years have always talked about competition, whether it's from Prime, Hulu, what have you. And they've lost content on the platform before, we've seen the Fox content slowly come off going to Hulu. But I think why this time is different than in the past is that those services didn't have 30 million subs like they do today. They were fairly underpenetrated.
Also, Netflix was underpenetrated too. They had 2030 million subs as well. And so when you think about modeling out the future growth of the company, they're following an S curve. You have this whole shift from over the top of linear to streaming. And it's following this natural progression that you see both growth stories follow. And in that period, you can have a rising tide that lifts all both scenario.
Reed Hastings has talked about it on their conference calls for years, saying that look, we're doing well, so as HBO, everyone's growing. But what we're seeing now is that we're hitting the point of unit saturation in the market. Everybody has Netflix, and the folks that don't have Netflix are probably not going to subscribe if they haven't subscribed to it at this point, especially in the US. And with increased competition, that's when you actually start to see the negative effects start to impact Netflix as a model.
So when we look at Disney launching, there's competing streaming service, November 12th, all those very popular movie titles coming off the Netflix service going on to Disney. That is the first time we're seeing big box office type stuff being transferred and launched on a competing service. At the same time, we got news this last quarter that Friends is leaving, The Office is leaving, albeit over the next couple years. But still, content is what matters. Real Vision, Hedgeye we create content. Hopefully, I'm not sitting here and boring everybody that's listening to this right now.
JAKE MERL: Not at all., Andrew.
ANDREW FREEDMAN: Yeah, but that's the point. We're all here because we're trying to create great content. So if all of a sudden, you're losing that content that everybody loves, and then they're raising price aggressively, then the relative value just goes away. And then people start to question, why am I paying $15 a month for this? Why am I paying $17 a month for this if Disney's only charging me $7 a month?
So as you face unit saturation, that part of the growth curve, Netflix has 90% of market share. It's not surprising, they are the first ones to be in this space. And it's just math. You throw more entrants into the market with great content, their share on a unit basis declines, and so does their share of viewership. And then all of a sudden, a model that was usually used to be driven by sub adds, now, has to be driven by price, which becomes challenged. At the same time, they have massive content obligations that are fixed.
So this isn't the Netflix of 2011-2012 when Reed made the big pivot to streaming. I've said this all the time, but it's like they were Ferrari going on the highway, and they're able to just weave in between cars. Now with all the content obligations that they have that are largely fixed and committed to in advance, it's like more like a Mack truck. So it's not surprising for me to sit here, Reed in the management team saying, look, we're doubling down on our strategy, because the alternative is really just not feasible, at least in the very short term, maybe over a multiyear period. But we're all dead in the long run, and Netflix could be $100 stock. That's completely realistic.
JAKE MERL: Over what time horizon do you expect that?
ANDREW FREEDMAN: Look, so you asked about competition. It's great question. There are surveys that suggests that 28%, 30% of Netflix subscribers would cancel their service if they lost The Office, Friends and Disney. Now, those surveys tend to be overinflated. But even if you have 10%, 15% incremental churn and they lose six to 10 million subscribers and I'm talking about in the US, not even the international side, forget it. You're talking down sub growth for a stock that has no cash flow. Those growth investors are going to hit the doors all at once.
So, it could get really ugly really fast. So it depends. I'm not going to pull the fire alarm and say it's going to be $100 stock tomorrow. But if the setup exits, where they did put out these aggressive sub targets for the back half of the year, if they do not hit them, or they miss them like they did this last quarter, and they had a takedown guidance for the year, at the same time, they have to raise capital, and you have a ton of competing streaming services launching, like you can't own stock, you just can't. So I think there's a lot of people that are hoping that this was just a blip. But I think it's really shot across the bow.
JAKE MERL: So Andrew, you're painting a pretty bearish picture here. But what could Netflix do to salvage the situation?
ANDREW FREEDMAN: Yeah. That's been the pushback, a lot of pushback I've gotten is that I trust the management. Reed's a genius. I've heard that narrative a lot. I'm not sitting here and saying that's a bad management team. But at the end of the day, it doesn't matter who you are. Reed, he's going to have a hard time coming up with the limitations of stressing the market.
So what could they do? They could launch an ad supported service. And when we think about our process, and how we think about our short thesis, you lay out the risks. And you always ask yourself, you're always very paranoid, especially as a short seller, where could I be wrong? And if they do launch an ad sponsored tier, I think that would unlock a lot of incremental subscriber growth, just because they could charge 599 a month, make up the rest on ads, the implications for the rest of legacy media I think would be really devastating. Because you have to think about what the lifeblood is that's funding all they're competing, competing content, which is a lot of it's ad dollars, it's 100% margin stuff.
So as they suck that away by launching the ad service, it impairs their competitor's ability to create content and on-launch streaming services. So it keeps the whole Netflix bull case, the whole content flywheel going at a very, very fast rate. So I've always thought that if they launched an ad sponsored tier, that would help fund their growth, tap into an incremental subscriber they could do without being cannibalizing the existing. And then it would also help them on the international side as well, to really crack markets like India, which don't have a consumer base that's used to paying for premium video subscriptions. That's use services like Hotstar that Disney owns that is all ad supported.
So, I think that's one thing. Maybe they can get into sports and live news. But I think that's neither here nor there. I don't think that's a big deal. As far as I see it, like where I get blown up on the short side, that can keep the growth going for another three to five years like that really solid is if they launch an ad sponsored option.
JAKE MERL: And would you have a stop loss on the upside, just in case any of these things do play out?
ANDREW FREEDMAN: So part of the process and I mentioned, like not getting blown up is how can I track my thesis and close to real time. So, we build out longer term adoption models, we have the S curve, we look at how many subscribers are left in the market for them to go after. So it's looking at a combination of pricing studies, demand models, adoption curves, primary research, survey work, as well as high frequency alternative data that we can use to make sure that the key metric that matters which are your subs isn't going against us.
So throughout the quarter, we track app downloads, we saw the growth rate just completely just roll over. And we flagged that. And that gave us conviction that, look, there's either going to be a big problem, they're either going to miss the quarter, or they're going to miss the guy, like something bad's going to happened, like some time, like very soon, and it ended up playing out. So when I think about stop loss, I don't really think about that in terms of valuation. I just think about it in terms of where the trend and the fundamentals are going.
If the data that we're tracking suggests that, look, India, they're cutting price in India. And we look at India app downloads, they're launching a mobile only service, if that starts to accelerate or hockey stick above and beyond what I'm currently expecting, I may cover the short because they're going to crush the number. But that's so far, the danger's not doing that. So I'm okay. And I also don't think management did themselves any favors by setting expectations so high for the back half of the year. So even if they do hit the number, it's questionable whether the stock even performs well to begin with.
So that's how I think about it. As long as the data and the fundamentals continue to trend in my direction, I'll stay short, because valuation is always the last thing I look at because stocks go crazy. Valuations make no sense and you can make a lot of money being long names where growth is accelerating and it's working, and vice versa on the downside, especially if you put leverage on it,
JAKE MERL: So Andrew, I'd like to back up a bit and hit on a point you mentioned earlier, and that's competition, specifically DisneyPlus that's coming online in a few months. And I'm just curious, people are calling it content wars. How important is original content? And are you bullish on Disney?
ANDREW FREEDMAN: Yeah, we're wildly- as bearish as we are Netflix, we're equally as bullish on Disney. And we think that the DisneyPlus launch along with Hulu and the ESPN Plus altogether starts to look a lot like a Netflix killer. And it's not that anyone standalone service is going to take them out- and when I say take them out, I mean Netflix. But the amount of content, the complimentary offerings that they have, is a really superior value driver. So you think about Netflix charging 1299 a month, you put Hulu, ESPN, and DisneyPlus together, and you can get to a price point, maybe if it's bundled, almost the equivalent of Netflix, maybe a couple dollars more, and you're really catering to all people in the household, people that love sports, you get the Disney movies as well as the adult entertainment on Hulu.
So, we're really bullish on the launch there. We think that in year one, they could probably get at least 20 million subs in the US. Haven't seen anyone else talk about how many subs they can get but we think that they can get to 20 million plus. Throw on the international launch as well, it probably gets to a number closer to 30 million when we get to call it December of 2020. And what, do you want to pay for that? Look, we'll see. I can't sit here and say, oh, let's take an EV per subscriber of Netflix and apply that to Disney, because we're short Netflix and I think the valuation is absurd.
So it'd be a little like intellectually dishonest to me to do that. But I do think that can the DTC offering combined be worth $100 billion in two or three years? Can they get 90 million DisneyPlus subs, 160 million in total worldwide when you factor in all of their three DTC offerings? Yeah, absolutely. And Disney has incredible brand infinity. Most people are aware of it. I think it's about- the survey where 65% are already aware that DisneyPlus is coming to market.
So I think that growth is going to accelerate while Netflix's growth decelerates. And so it's like it's really a simple thesis. But so far, the pair trades worked. And I think when we roll the calendar forward into 2020, I absolutely want to be long Disney into that launch.
JAKE MERL: So, Disney has a few different parts of their business model, how important is a streaming service to the overall business?
ANDREW FREEDMAN: So DTC or streaming is the future. This is the future, they're betting the whole company on it. So, it's extremely important. And I think that's what's going to drive the stock ultimately. Now, there are some legacy parts of the business where you have to be a little concerned about. ESPN, what happens to ABC, what happens to the cable and broadcast networks? What happens to that revenue stream? Because that's where all the profits are.
And look, my top down view is that you're going to start to see an accelerating decline or deacceleration and cord cutting across the industry. I think 5%, your clients reasonable. I've heard people talk about 10%. We'll see. My bet here is that the rest of the Disney legacy media business stabilizes or just doesn't get that bad while the DTC launch takes off, because I think that's what's going to drive the stock.
And in the long run, look, you have to worry about affiliate fees but you also have to think about what happens to the ad revenue. And when you look at a platform like Hulu, which is commanding very high CPMs, which is the unit metric that goes at how much it costs to reach a certain segment of your user base, I think Hulu could probably be larger in terms of ad revenue than ESPN and ABC combined in five years, I don't think that's crazy. And so in terms of future-proofing the platform and reaccelerating growth, and also just the synergy, being able to maybe drive more merchandise sales by having a direct to consumer offering, their existing distribution is tremendous.
So there's just so many levers that this provides, and it is the future of the company. I'm not just saying that Iger said it. And we'll see how successful they are. But it's a massive bet. And if they fail, it's going to be a disaster. Obviously, we don't think they're going to fail. We can see it being a $200 stock as growth accelerates, I think it's going to be big bang. This isn't like Netflix, four to 5 million subs a year in the US, this is going to be like 10 million subs out of the gate type of an adoption curve. It's going to be very quick.
JAKE MERL: And over what time horizon do you think it will reach that $200 target?
ANDREW FREEDMAN: It could be next year, could be next year.
JAKE MERL: The stock does look pretty expensive, though, right now just on normal valuation metrics. What do you say to that?
ANDREW FREEDMAN: Yeah, look, the stock went sideways for four to five years, for a good reason, everyone was afraid of what was happening in the cable business. And I think that if you look at estimate revisions on the out year, they've come down because they're investing in original content. And to your point before, original content is going to be very important. So they're investing billions of dollars to support growth of their DTC offering.
So they have things like the main DeLorean, they're coming out with a bunch of original $80 million bigger budget movies that are going to be made exclusively available on the DisneyPlus service. And all that's going to take ahead of earnings. But what we've seen time and time again, at least in this market, is that investors are willing to subsidize losses in the short term if it means future growth in some out year type of earnings story that you're going to get to. And so I think Disney is really not going to be any different in that respect. And so, that's how we're thinking about is I'm not too worried about earnings in the very near term, as long as they're putting up incredible sub growth, I'm okay with that.
JAKE MERL: So, what about the theme parks and the hotels aspects of the business? Because I know that's at peak margins right now. And it's a very cyclical business. Does that worry you at all?
ANDREW FREEDMAN: Totally. Yeah, remember how I said before, you're always paranoid in this business. At Hedgeye, we tend to be a little bit louder than most. But when you're trying to make big calls and you have conviction in, you got to swing for the fences when you can and when the data supports it. And yeah, I am worried. Because if we do go into recession, or going to some downturn, it's going to be negative.
When we look at the data, it's actually not surprising, but interesting that the highest correlation to the theme parks business is the housing market. And so when I think about where we are in the housing cycle, we're not as late cycle in the housing market as we are in the broader market. And the other thing, too, is things can go on for a pretty long time. And my duration on the $200 target is over the next 12 months. So as long as the parks business doesn't- as long