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Putting on a black turtleneck does not make one Steve Jobs

Tong Kooi Ong & Asia Analytica
Tong Kooi Ong & Asia Analytica8/30/2019 6:30 AM GMT+08  • 11 min read
Putting on a black turtleneck does not make one Steve Jobs
(Sept 2): The Walt Disney Co’s share price came under some selling pressure in recent weeks, after earnings in the latest quarter fell short of market expectations.
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(Sept 2): The Walt Disney Co’s share price came under some selling pressure in recent weeks, after earnings in the latest quarter fell short of market expectations.

Profits were hurt by the dilutive impact and integration costs from its US$71.3 billion ($99 billion) acquisition of 21st Century Fox, which was completed in March, that also include a larger share of losses for streaming service Hulu. Fox Studio’s latest movie, Dark Phoenix, flopped at the box office, partially offsetting a stellar performance from Disney’s own releases during the quarter.

Its direct-to-customer business incurred higher costs, including loss of licensing income for pulling content from other providers such as Netflix, as the company ramps up preparation for the launch of Disney+.

It was a difficult quarter for analysts to forecast, given all the moving parts. With clearer guidance from this set of results, the market has pared back on earnings expectations. No doubt, Disney’s pivot from traditional network media to the streaming business will weigh on earnings for the next few years.

Nevertheless, we remain confident in the company and this forward-looking strategy. Disney’s mistake was that, in the past, it literally gave away its most valuable asset — content — to Netflix. Many media companies likewise gave away their content to Google and Facebook in the hope of expanding their reach. Almost all these companies have suffered. These content creators were, without realising it, strengthening their enemies. We will write Part 4 to the series on Future of Media, which was printed in 2015. What has evolved is what we had expected and written on.

Disney+ will be launched in the US on Nov 12, followed closely by the global push to Canada and the Netherlands, Australia and New Zealand — and the rest of the world within two years.

Disney expects to secure about 12 million subscribers within the first year. If it gets off to a strong start, this will be the catalyst to lift the stock higher. The company aims to reach 60 million to 90 million subscribers worldwide by 2024, which is 40% to 60% of Netflix’s current base of 152 million (see Table 1).

The target is definitely achievable, given the quality and breadth of its library content, brand-name recognition and competitive pricing. Disney+ is priced at only US$6.99 a month and the bundling of Disney+, Hulu and ESPN+ costs the same as the standard Netflix package of US$12.99.

We live in an odd but interesting world. Sometimes, it is hard to comprehend the valuations that the market accords companies. Disney shares are now trading at a trailing price-to-earnings ratio of about 17.6 times, and the company has a total market capitalisation of just over US$245 billion.

On the other hand, the market is giving Netflix a lot more latitude. The stock is trading at a trailing PER of nearly 115 times and the company has a market cap of more than US$127 billion.

That is a huge valuation gap between the two stocks. Whether or not it is perceived as a tech company, Netflix is definitely not one. Its business has limited, if any, network effects. It is a media company. Shouldn’t it be valued as such?

Netflix reports a profit, as it amortises content costs over several years. But it has been burning cash since 2011. Negative free cash flow totalled US$7.7 billion for the past seven years, rising to US$2.9 billion in 2018 alone and estimated to hit US$3.5 billion this year. Disney, on the other hand, has consistently generated positive FCF, totalling US$62.2 billion in the past decade.

Based on the valuation gap, the market must believe that Netflix’s future growth prospects will far, far exceed Disney’s — and, indeed, the majority of listed stocks, given that Standard & Poor’s 500 companies are currently priced at roughly 20 times trailing earnings. Can it?

Without a doubt, Netflix is an excellent company that has had an excellent run. It successfully evolved from the mail order DVD business and practically created the market for streaming/subscription video on demand (SVOD).

It was the disruptor, capitalising on the cord-cutting trend (where customers switched from high-priced cable packages to relatively cheap SVOD through the internet), changing how entertainment is consumed and delivering it more efficiently through digital distribution.

The company was able to grow its subscriber base rapidly. Revenue expanded at a compound annual growth rate (CAGR) of 29.3% in the past five years and 27% in the trailing 12 months.

Netflix is no longer a disruptor but the incumbent, however, and must now defend its market share against a slew of new streaming service providers. As we have mentioned before, in the streaming war, content is king.

Netflix has years of catching-up to do to match the legacy content of Disney, Comcast Corp (NBCUniversal) and AT&T (WarnerMedia). That is why it is spending heavily to beef up its own intellectual property (IP) — some US$12 billion last year and up to US$15 billion this year — and to make up for the loss of its most popular licensed content. And, yes, the high valuations help Netflix raise cheap money.

The cash burn is funded by borrowings and Netflix does not expect to turn positive FCF for the foreseeable future. To do so, it would need to pull off a combination of strong subscriber adds, higher selling prices and reduced spending on content — no easy feat in an increasingly crowded market.

It may have to keep spending (not just on IP but also for marketing) just to retain, let alone grow, subscribers. In fact, the cost of subscriber acquisition is rising. Competitors such as Amazon.com and Apple have a lot more cash to burn.

Amazon Prime Video (packaged under Amazon Prime membership) is reportedly spending some US$7 billion on content this year. Apple has just upped its budget for original content to US$6 billion, and will launch Apple TV+ in November at a reported price of US$9.99 a month.

In addition, Netflix is disadvantaged in that it has only one source (for now) of income — subscription — whereas its competitors have synergistic businesses that allow them to monetise IP across different platforms.

We see the same valuation issues with WeWork, the next hotly anticipated IPO in the US, now rebranded and to be listed as The We Company.

In writing this article, we researched for views that make a bullish case for WeWork. The best was presented by Stratechery, which compared the company to Amazon Web Services (AWS) — in that its business model is based on co-sharing, where subscription is better than ownership. But here is where the similarities end.

WeWork positions itself as a tech company. It is being marketed with all the tech hype and “cool community vibes”. Its IPO filing is generously littered with the word “technology”. Yet, its business has neither scalability nor network effects. It holds no IP. Its marginal cost does not fall rapidly, certainly not near zero.

In short, it is far from the definition of a tech company. As such, it does not warrant tech-type valuations.

Yes, it does serve a purpose — fulfilling the demand that is being created by technological innovations, from the gig economy to sharing, subscription and remote working trends. WeWork leases office space for the long term (an average of 15 years) and sublets to start-ups, freelancers and enterprises on a flexible, short-term basis.

And, yes, we believe it is possible to make some money capturing this market. Theoretically, long-term leases are cheaper than short-term rental charges. WeWork makes a profit from this term mismatch and value-added services, including spiffy office design and furnishing as well as “hip” amenities such as coffee and snack bars. It will gain some economies of scale as it grows — having stronger negotiating positions with landlords and being more attractive to customers, with its brand name, wider offerings and less friction. At least in theory, it will.

WeWork has yet to report a profit in its nine years of history; so, most traditional valuation metrics are not applicable. Revenue rose strongly, from US$436 million in 2016 to US$1.82 billion in 2018 and US$1.54 billion in 1HFY2019. But so did losses, faster in fact. Net loss jumped from US$430 million in 2016 to a staggering US$1.93 billion last year and US$905 million in 1HFY2019, including one-off gains of US$486 million. Losses are expected to widen significantly in 2HFY2019.

Sceptics call it a real estate company, dressed up like a tech company. We would call it even less. A real estate company owns the properties it rents out. In the worst-case scenario, they can sell the properties and pay off debt.

WeWork owns few assets, but has US$47.2 billion worth of long-term lease obligations — commitments it has to pay, regardless of demand and occupancy rates — versus just about US$4 billion in committed revenue. It plans to keep expanding its business in much the same way.

It is selling itself as a branded, high-growth “space-as-a-service” company. Growing sales (or giving away free space) quickly is easy if one is willing to spend big money — WeWork aims to raise US$3 billion to US$4 billion cash from the IPO and has lined up US$6 billion in borrowings, contingent on the IPO money — and eat the losses.

WeWork does not know whether it will ever turn a profit. This cash-burn business model is especially risky, given that we might be looking at recession, when demand can drop off practically overnight. This being the case, the next obvious question for investors is this — does the risk-reward make sense?

We believe the answer is no, not unless WeWork expects to default on its obligations without repercussions. It has been noted that landlords have limited recourse since most of the leases are housed under special-purpose vehicles (although, in time, property owners will wise up and demand some form of guarantee for all the commitments).

Despite its lack of earnings-cash flow visibility, a path to profitability and the risks, the New York-based co-working company was privately valued at US$47 billion in January — based on the latest fundraising of US$2 billion (scaled down from the earlier reported US$16 billion) from SoftBank Corp.

Since SoftBank had already invested US$8.4 billion previously (for new shares and warrants and to buy out existing WeWork shareholders as well as stakes in three new companies to expand into China, Japan and Southeast Asia), the additional US$2 billion investment to raise WeWork’s valuations from US$21.1 billion to US$47 billion is terribly smart — assuming the market believes this valuation when WeWork goes to IPO.

Indeed, the entire private market is a fantastic money-making machine, where each additional $1 invested (new funds raised) results in a seven to 28 times increase in overall valuations, taking WeWork’s past fundraising and valuations as an example (see Table 2). How real is this valuation? Is it realisable?

Can one really throw enough money at a company to make the market believe in its implied valuations? WeWork’s upcoming IPO will be a big test to this playbook. If it fails, the money most at risk is that from SoftBank — which contributed US$10.4 billion of the total US$14.2 billion funds raised by WeWork, and at a relatively late stage.

For perspective, WeWork’s US$47 billion valuation is larger than the prevailing market caps of more established companies such as Dollar General Corp, Ford Motor Co, Delta Air Lines, FedEx Corp, Yum! Brands and Twitter and just slightly smaller than Target Corp.

Could it be that WeWork’s value proposition is so terrible that it, ironically, becomes a moat, in that no other competitor will be tempted or be able to raise financing to enter the business? Odd world, indeed. Or is it?

The Global Portfolio fell 1% for the week ended Thursday as global stocks were once again roiled by trade war uncertainties. The losses pared total portfolio returns to 8.1% since inception. Still, this portfolio continues to outperform the benchmark index, which is up 3.8% over the same period.

Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports

This story first appeared in The Edge Singapore (Issue 897, week of Sept 2) which is on sale now. Not a subscriber? Click here

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