Long ViacomCBS/Short Netflix

I thought I could talk about my investing philosophy through the lens of two businesses the market perceives as very different. One is a boring, disrupted, old world media producer and distributor and the other is a sexy, Silicon Valley, disrupting media producer and distributor (I don't own either, for the record).

One has a long history of free cash flow and profits, while the other has negative free cash flow and only shows profits due to some generous and misleading accounting assumptions.

The most interesting part is that one sells for a low single digit multiples of these current earnings, while the other is priced at egregious multiples of promised future profits. It's growing quite fast, but will need to keep this up, and then some, for investors to come out ahead.

ViacomCBS is an American media powerhouse, with a 70 year operating history. Its assets include Paramount Pictures (owner of Dreamworks), the CBS Entertainment network, popular cable programming, like MTV and Nickelodeon, international networks and an enormous library of TV content including iconic shows like Seinfeld and the Star Trek franchise.

Viacom and CBS have recently re-merged after a decade apart in an attempt to gain scale to compete in the current global media environment. Today VIAC sports a $10 billion market cap, which is dwarfed by some of it's peers, with Disney, AT&T (owners of Warner Bros.) and Netflix all around $200 billion. The media space is a tough battlefield at the moment, with those with access to quality, enduring content holding a large advantage.

So, we know that VIAC is a middling legacy business, in a competitive field. It also has little competitive moat to speak of, other than a large existing network and a reasonable content library. Not sounding too enticing yet.

However, clearly, you can't have a discussion about the attractiveness of any asset without first knowing the price and this is where ViacomCBS starts to look interesting to a deep value investor (this one anyway).

In February, the company guided to $1.8-2 billion in free cash flow for 2020. This was pre-Covid 19, however it gives an idea of the normalised cash generation within the business. This will be a challenging period for all companies and this years profitability will be hard to gauge, but let us conservatively carve 33% off the lower end of this number and assume $1.2 billion for 2021 (VIAC is mostly traditional programming- it's most significant sports exposure is shared rights to the NFL, which doesn't kick off until September).

Even in our base case scenario, the business is selling an for 2x EV/EBITDA and 8x free cash flow, or a cash yield of 12%. These is quite an appealing number in a world of US Treasuries yielding 1%.

The business is currently planning to launch a streaming service of its own, which would incorporate CBS All Access with Paramount movies and some of their popular cable channels. VIAC is definitely late to the streaming market, but streaming is an extremely low moat business. I believe there is very little impediment to customers changing their provider/s, due to price point or quality of programming. Billing is done on a month-by-month, credit card basis and customers demand a steady flow of quality content to maintain their loyalty.

This is where VIAC is not as weak as it appears. Decent media is extremely expensive to create and having a proven back library is a bonus (Disney+ is undoubtedly best placed in this regard, but you won't buy Disney at VIAC multiples either). Much of this legacy content has been long expensed and depreciated from the income statement and is now very low cost for the company to distribute.

Let's turn to NFLX now. The Silicon Valley-based streaming juggernaut was founded in 1997, by Reed Hastings, who is still at the helm. It has seen phenomenal growth, as the first-mover in the online streaming space, and has gained enough scale to throw its weight around the media landscape.

The bulls like to claim that Netflix is under-monetizing its platform while it builds marketshare and expands globally. But now that formidable competition is arriving in streaming, I think materially raising subscription pricing will prove to be a fantasy. Additionally, much of Netflix's growth from here will be in emerging markets, where monthly rates will be lower and content specific to local markets will need to be produced.

Netflix has very little legacy content of its own and must choose between buying the rights off others in an increasingly competitive environment and producing its own content with the risks and expense this entails. Netflix was dealt a blow last year, when it lost the streaming rights to The Office and Friends in quick succession, in a clear sign that buying streaming rights only gets more expensive at each negotiation and there is no loyalty shown to the incumbents.

Consequently, Netflix has been producing more and more of its own content in recent years and, in my opinion, is a long way from any content that people will be watching a decade from now. The Irishman proved to be an expensive flop and saw popular criticism for its lack of female characters or dialogue. House of Cards was vastly popular, but suffered the x-factor of Kevin Spacey's rapid fall from grace, resulting from the #metoo movement.

This speaks to the survivorship bias we observe in the media world. In reality, there are a vast number of flops and has-beens for every show that gains the cash-cow status of Star Trek or Seinfeld. Netflix is currently building its library, in the hope that it will develop enough hits to give it some long term cash flow traction. There must obviously be a lot of misses in this process, but Netflix's accounting seems oblivious to this fact.

Netflix has been depreciating the cost of producing its content over 10 years, despite base rates informing us that most programs will be virtually worthless after year one, thereby accounting all their programming as if it was the next enduring hit.

This has the large advantage for Netflix of allowing it to show a small adjusted profit, by pushing these expenses out to future accounting years. Another handy tweak, which is popular among disruptors and Silicon Valley types, is to remove share based compensation from the P&L.

This gives earnings another handy boost, even though these are very real costs to any shareholder in the company (share based comp. was $1 billion for 2019). NFLX depreciated and amortised $20 billion dollars for 2019, and if this figure was more realistic it would easily wipe out the reported net income of $1.89 billion.

So Netflix is a successful, fast growing creator and distributor of media content, however finds itself in a suddenly more competitive environment with very little in the way of moat to keep its customer base sticky.

So what's the price? Well you can't value it using Price/Free Cash Flow, because NFLX burned $3.3 billion in cash last year and has never produced positive cash flow. If we accept their reported net income, despite its obvious flaws, we end up with a PE of 102x and an EV/EBITDA of 67x 2019 numbers.

When you pay prices like this for a stock the rosy future painted by the bulls needs to be your base case. Anything other than a perfect threading of the needle will be a disaster for shareholders. Can you conceive of circumstances where increasing competition or lack of access to unlimited capital prevent NFLX from growing enough to justify 100x earnings? I could imagine quite a few possibilities and believe a NFLX shareholder today is investing without any margin of safety, whatsoever.

A huge part of my investing philosophy is based around mean reversion. This could be in the form of asset valuation, asset returns, sentiment or company profitability. With ViacomCBS priced for the scrapheap, any improvement in mood, profitability, a takeover offer or a successful move to a streaming presence could see the stock move significantly higher.

If the toxic is priced in, merely awful can give a great outcome and passable can give stellar results. So let's check back in in 5 years.

Or as Benjamin Graham quoted Horace- "Many shall be restored that are now fallen, and many shall fall that are now in honor."

17/4/20 VIAC-$14.63, NFLX-$439.17

Guy