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Netflix will be the star of the recovery

Will record new subscriptions outlast a return to normal?

I woke up on Tuesday morning and assumed there was an error with the oil price I was seeing on my screens. Front month West Texas Intermediate Oil (WTI.OIL) was showing -300% at minus -$33.00.

However, I quickly worked out it wasn’t an error and that traders who didn’t want to take physical delivery of spot oil were paying others $33 to take it off their hands.

I would have to say in my 25 years in markets this is actually the most stunning thing I have seen.

Firstly, I actually didn’t know a commodity futures contract could trade at a negative price, and secondly this is the most important commodity in the world. A true black swan liquidity event based off what is an unprecedented demand collapse for oil products.

However, as scary and unprecedented as the sight of negative spot oil prices are, today I want to explore whether the path of least resistance in equity markets is actually higher from here (albeit with volatility).

Equity markets rarely go where consensus positioning wants them to go (remember record highs in February). Right now, the consensus view is that equity markets will most likely re-test the March lows.

On that basis institutional investor cash holdings are the highest since the GFC, while hedge fund positioning is equally conservative in terms of gross and net positions.

That’s all understandable and even I have around 15% cash in my fund now, using the recent bounce to take some profits and look for better risk adjusted entry prices.

However, the old adage says “don’t fight the Fed” and the Fed is effectively all-in using tools they didn’t even use in the GFC. The Fed’s response has been unprecedented in time and scale.

Similarly, the fiscal spending response has been unprecedented in time and scale, leading to unprecedented liquidity sloshing around the global financial system to attempt to counteract an unprecedented problem.

What this leads to is the much larger “pain trade” for professional investors in equity, where they continue to grind higher, not re-test the lows of March. If they keep rallying, the vast bulk of professional investors will be underperforming their benchmarks, potentially severely so.

Following one of the biggest bear market recoveries on record, we have hit another crossroad. The question now is will the unprecedented stimulus be enough to bridge the gap through what will be the worst 2Q on record?  As we all know, the market is forward looking; it quickly priced in the negatives and is now pricing in a recovery. The risk is what shifts the narrative which is supported by – stimulus, rising expectations for COVID -19 treatment/testing, and return to work. Should any of these legs give out, the downside becomes more interesting but right now the pain trade seems higher.

Sentiment is important right now. After a +25% rally in S&P500, consensus has shifted toward cautious view, while at the same time positioning has been reset (lower).

Equity long/short funds (funds that can hold both long and short positions) followed as they flipped back to de-grossing across both the long and short side.  As of Tuesday, “Long/Short (L/S) funds have sold longs for 8 of the past 9 days.  US L/S weighted gross leverage dropped slightly DoD to 181%, which is the 10th percentile over last 12 months and 48th percentile since 2010.  Nets also dropped modestly to 41%, which is the 10th percentile over last 12 months and 4th percentile since 2010.”

Can the market look through the worst unemployment shock? Time will tell. But for comparison’s sake, when you look back to 2001-2003 and 2007-2009 bear markets, stocks bottomed before peak jobless claims.  As a reminder, we expect unemployment rates will rise to a higher peak but will also recover faster in the Great Covid-19 Recession as compared to the GFC, as the initial shock is more akin to a natural disaster than a financial shock. In the G4 economies, the aggregate unemployment rate should peak at 11.1% in 2Q20 (2% points higher than the GFC peak).

All I know is the markets will (actually already have) bottomed well before the peak of COVID-19 deaths and peak of unemployment. They will attempt to look through the valley and into what the world looks like as we slowly reopen the global economy.

If the markets do take the path of least resistance, which is higher, then companies like Netflix will most likely continue to lead them.

I thought I’d finish today with a quick high[level summary of the Netflix result from Morgan Stanley Research. Netflix has been a major beneficiary of COVID-19 lockdowns and my personal view is those subscribers won’t prove transitory.

Netflix (NFLX) crushed subs with +15.8M net adds in 1Q (vs expects of +9-10M) and are guiding to +7.5M for 2Q which would get them to190M subs (vs expects of +5-6M, which they say is mostly guess work on confinement timing) for 1H20 implied of >23M (vs expects in the +15-16M range).

Unsurprisingly, they are expecting 2H net adds to be lower y/y based on pull-in / content delays / higher churn when people go back outside. They reiterated their target of 16% EBIT margins in ‘20, which is impacted by FX headwinds.

Free Cash Flow (FCF) guidance is improved by ~$1.5B for FY20 with burn now expected to be -$1B or better (vs. MSe (Morgan Stanley estimate) of -$2B and prior guide of -$2.5B) due to content timing with spend moving into ‘21, while they reiterated path to FCF profitability unchanged.

Here is the line in the letter that is dampening the after-hours action despite the massive sub beat and improved FCF burn guide (although it is likely prudent conservatism):

“Intuitively, the person who didn’t join Netflix during the entire confinement is not likely to join soon after the confinement…plus, last year we had new seasons of Money Heist and Stranger Things in Q3, which were not planned for this year’s Q3. Therefore, we currently guess that Q3’20 and Q4’20 will have lower net additions than last year due to these effects.”

NFLX outlined 3 primary effects on their financial performance from the crisis

  1. Membership growth has temporarily accelerated due to home confinement,
  2. International revenue will be less than previously forecast due to the dollar rising sharply, and
  3. Cash spending on content will be delayed improving FCF due to the production shutdown and some title releases will be delayed, typically by a quarter.

Revenues were inline despite the sub beat on a bigger FX headwind, while ARPU (average revenue per user) grew +8% y/y ex-FX. Op Margin was 16.6% (vs. 10.2% in the prior year quarter) was lower than their 18% forecast (continue to look for 16% for FY20) on an incremental $218M in content costs due to paused productions and hardship fund commitments (a 3.8ppt impact).

The 1Q net adds were better globally in all regions vs MSe with the ~16M = +7M in EMEA (vs MSe +3.8M), +3.6M in AsiaPac (+vs MSe +1.9M), +3M in LatAm (vs MSe +1.8M) and +2.3M in the US and CAN (vs MSe +1.1M).

They are now expecting 2020 FCF of -$1B or better (compared with prior expectation of -$2.5B and -$3.3B actual in ‘19). This dynamic may result in more lumpiness in the path to sustained FCF profitability, however, there has been no material change to their overall time table to reach consistent annual positive FCF and believe that 2019 will still represent the peak in annual FCF burn.

In terms of 1Q content highlights, viewership numbers are staggering with Spenser Confidential at 85M, Money Heist at 65M, Tiger King at 64M, Love is Blind at 30M and Ozark S3 at 29M in first 4 weeks.

For the 2Q slate they call out their latest buzzy unscripted series Too Hot to Handle, and look forward to the launch of Space Force, which is the new original comedy series created by Greg Daniels (The Office) and Steve Carell.  They will also premiere Hollywood from Ryan Murphy, and, later this week, Extraction a large scale action film starring Chris Hemsworth.

They finished the quarter with cash of $5.2B, while their $750M unsecured credit facility remains undrawn and have more than 12 months of liquidity and substantial financial flexibility. Their financing strategy remains unchanged – their current plan is to continue to use debt to finance their investment needs.

I hope you and your families are safe and well. I also hope that brighter times are coming.