Is Netflix Really Cheap or Terribly Expensive?

Last week, I called digital media expert Dan Rayburn out for missing the boat on how Netflix (Nasdaq: NFLX  ) will fare in the ongoing digital media revolution. Dan sees Netflix stock as way overvalued because its digital media streams are nowhere near replacing DVD discs or cable TV packages. I see a fixed cost structure supporting a rapidly rising number of customers, which will lead to outsized profits in due time, and if anything, Netflix is still too cheap.

Dan still doesn't think I make sense, taking the time to respond in person right here on The Fool:

The bottom line is that the consumption of digital media is growing, it's affecting multiple media industries, and it's very exciting. But one service is not replacing another anytime soon. Even with the positive balance sheets that Apple, Akamai, and Netflix have, one can't let the excitement around streaming movies and TV shows be the major catalyst for valuing them more highly.

In Dan's view, Netflix has proven that it can't replace cable by offering a streaming video model for three years without killing anybody. "75% of all U.S. consumers did not stream or download any multimedia content of any kind," he points out. Moreover, comparing streaming versus DVD to the DVD-versus-VHS battle is unfair because this time, we're asking consumers to shift between two fundamentally different delivery models while the last format war was fought over rival physical media.

You don't bet against a winning horse
OK. Netflix itself provides some key evidence of the rapid changes that are going on. As its customers either sign up just for the streaming services, or else shift down to a cheaper delivery plan that still gives them full streaming privileges, the average monthly revenue per customer slipped from $13.29 to $12.29 over the past four quarters. Moreover, you might think that lower average plan prices would hurt Netflix, but its customers are also requesting fewer mailed DVDs and thus widening the company's profit margins. I'd be worried if video streams didn't play a part in this movement, but I don't see how that can be the case.

In short, Netflix is not just a frontrunner in the digital entertainment race – it is the horse to beat. Apple (Nasdaq: AAPL  ) would be plain stupid to release its Apple TV box without Netflix support and even touts Netflix streams as a key feature of the iPad. The same goes for Google (Nasdaq: GOOG  ) and its Google TV, where Netflix support features prominently in the user interface. That's just a couple of the many delivery channels available to a Netflix subscriber today, showing broad industry support for the platform.

And Akamai Technologies (Nasdaq: AKAM  ) , itself a leader in the field of highly efficient content delivery, couldn't be happier than landing Netflix as a customer to keep its network pipes full of flowing video bits.

Anecdotal evidence and hard numbers
I'm in the process of dumping my expensive full-featured cable package for a bare-bones alternative and supplement it with the one-disk Netflix plan myself. That setup will cover more than 90% of my family's media needs in a very affordable one-two punch, and I know I'm not the only one to consider a move like this. It may take many years to kill Comcast (Nasdaq: CMCSA  ) or Time Warner Cable (NYSE: TWC  ) this way, mainly because the cable guys have the advantage of owning live sports and local news broadcasts.

But the Time Warner family will surely feel the burn when Netflix streams start cutting into the conglomerate's crucial HBO division's sales and subscriber counts. An independent study by Credit Suisse indicates that as many as one-third of Netflix subscribers in the prized demographic between 25 and 34 are already turning to Netflix rather than pay TV channels like HBO or Cinemax.

Final words
The growth is there, the shifting customer loyalties are there, and we're only three years into this seismic shift. You might be able to convince me that Amazon.com (Nasdaq: AMZN  ) is overvalued relative to its importance in the fully digital media landscape, and Blockbuster is clearly overvalued at any price today. But Dan, I'll have to continue to disagree with your conclusion that the Netflix growth story doesn't match up to the stock's valuation.

Google is a Motley Fool Inside Value choice. Akamai Technologies and Google are Motley Fool Rule Breakers recommendations. Apple, Amazon.com, and Netflix are Motley Fool Stock Advisor picks. The Fool owns shares of Apple and Google. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Anders Bylund holds no position in any of the companies discussed here. You can check out Anders' holdings and a concise bio if you like, and The Motley Fool is investors writing for investors.


Read/Post Comments (16) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 04, 2010, at 4:42 PM, maximus9 wrote:

    I agree that NFLX is the horse to beat here. We are talking about disruptive technology leaders who tend to operate outside standard definitions of value. It will perhaps make lot more sense for Apple or Google to ride this horse while it is still cheap. Acquiring a company like Netflix will be like an adrenaline shot to any player who wants to dominate the digital media world. At $8.5 blln it is a steal !!

  • Report this Comment On October 04, 2010, at 4:52 PM, CFischer wrote:

    Anders,

    I don't understand how the premise of your article is "Netflix is cheap right now" but again, you don't list any numbers to back it up. Yes, Netflix is growing, we get it. So at what price, or price range, do you consider these rosy growth prospects to equal it's current valuation?

    Maybe you can answer some questions for me:

    1) What effect will content deals have on NFLX's margins? How many incremental subscribers will it take to pay for the 1 Billion over 5 years to Epix?

    2) How much do you think NFLX will have to pay to Starz to renew their contract in a year?

    3) If the growth expectations don't turn out to be a rosy as planned, how much downside do you see there being in the stock (Margin of safety, per Warren Buffett?)

    4) What competitive advantages does NFLX have over Cable companies that own the tranmission medium and can provide the sports content, etc? What can Netflix do that Comcast, Time Warner, etc, can't, if they chose to enter the market at a price point comperable with Netflix?

    5) It says in the disclosure statement that you have no position in Netflix. Why not? If you're so adamant about the stock being cheap, why don't you own any?

    Also, in the Interview in your bio, it has

    The Fool: What's been your best investment to date, and how did you discover it?

    TMFZahrim: Netflix, oh sweet Netflix. Rick Munarriz basically talked me into that one through a Foolish series of articles. Thanks a lot!

    So it looks like you owned the stock at one point. When did you sell, and why?

    6) Blockbuster is overvalued at any price? Can you please explain? I understand the business is no longer growing, but after restructuring, if it still throws off cash, how is it overvalued at any price?

  • Report this Comment On October 04, 2010, at 4:55 PM, BioBat wrote:

    I cancelled cable months ago in favor of just watching Netflix. There are certainly times when I miss cable but those times are few and far between. At $9 a month, the value can't be beat and the content is more than enough for me and my family to be happy with for years on end - even if they add nothing new.

    Like you say, sports is the only thing keeping that pony going and with online offerings like MLB stream, NHL Game Center, it's not going to be long before the cable monopoly of live sports is distant thing of the past.

  • Report this Comment On October 04, 2010, at 5:40 PM, TMFZahrim wrote:

    CFischer, the NFLX-specific questions reads like fodder for another article; thanks for that.

    As for the rest:

    5) I recently had to sell every stock I own because of a personal financial crisis. I'd rather not go deeper into that if it's all the same to you. Now I can buy stocks again but it's really hard to squeeze in stocks like NFLX and GOOG that I would love to own but keep writing about all the time. Foolish disclosure policies are real.

    6) Blockbuster has filed for bankruptcy, most likely giving shareholders nothing at all while debtholders get all of the company's equity. Meant to link to this article but forgot:

    http://www.fool.com/investing/general/2010/09/23/this-stock-...

    Anders

  • Report this Comment On October 04, 2010, at 6:57 PM, CFischer wrote:

    Anders,

    Thanks for the reply. Fodder for another piece is fine, but I think this analysis is crucial to justify your claim the NFLX is "still too cheap." This is the same request Dan Rayburn just made to you, which you sort of sidestepped.

    If it's still too cheap now, at what point ISN'T it too cheap? I'm sorry, but I reject the "Great Growth + Great Business Model + Future Technology = No Price Too High" philsophy, which you seem to be putting forth.

    The other points:

    5) I'm sorry to hear that, and I wasn't insinuating the Fool's policy wasn't real. What do you mean it's "hard to squeeze into stocks like NFLX and GOOG"?

    6) Yes I'm aware that BBI's common equity is likely to get wiped out, but if I thought there was a real opportunity there, and had a lot of time and thought I had an edge over other distressed debt investors(I have neither) I could purchase some of their debt for eventually equity ownership.

  • Report this Comment On October 04, 2010, at 7:28 PM, TMFZahrim wrote:

    5) I can't buy or sell a stock I have mentioned in an article in the last 10 calendar days. Then I can't mention it for 10 days after the trading action. This policy is meant to ensure that we Fools don't get tempted to pump and dump and such nonsense; it also makes it dang hard to actually trade in the stocks I cover the most. Netflix is one of them.

    6) Fair point. I simply don't know enough about buying and selling debt papers to consider it an investment option. What I'm talking about is common stock owners getting wiped out.

    Anders

  • Report this Comment On October 04, 2010, at 11:18 PM, dav22white wrote:

    Yahoo Finance cites the book value per share of NFLX as $3.37/share. The price of a share is $156.39 as of the close today. If AMZN wants to, it has the retail experience and the money to take significant market share away from NFLX. The last I heard it intends to start its own subscription movie service. This is supposed to be available for the holidays. Much of AMZN's retail sales set up could be used for providing a subscription selection service with only some relatively minor changes. If the book value per share of NFLX is only $3.37, there is zero chance of AMZN paying anywhere near $156.39 to buy NFLX. It is not a buy out target. According to NFLX guidance its EPS will be flat to down Q-o-Q for Q3, and Q4. There's a lot of emotional speculation about this stock based largely on past performance and a currently #1 position in its field. However, it gets even a reasonable amount of the new competition that seems to be coming its way, growth could stop or even reverse. It could continue to grow if everything goes perfectly, but there is substantial risk to that. With the almost total lack of book value, any slowing in EPS will send this stock plummeting. Peter Lynch calls this type of stock a "nose bleed stock". It will likely give you one if you chase it at this point. If there were no competition risk, there would be enough risk just from pressure on margins going forward. With growing major player competition, this stock is truly a "FOOLISH" risk.

  • Report this Comment On October 05, 2010, at 5:45 AM, quaternion2 wrote:

    Although I am a Netflix subscriber and have literally canceled the word cable TV from the dictionary,two pesky points have deterred me from buying Netflix stocks.

    First I feel Netflix business is easy to be copied. The question is what is it that prevents anyone having enough money to invest in computers and streaming tech to jump in the field?

    Blockbuster couldn't because of those stores that had to be dealt with. In the long run, for a business to stay profitable, it must be able to protect itself from the inevitable competition. A difficult task unless something is intrinsically hard to make. Does anyone think some company in China, India or Europe would not be able to copy Netflix? I believe This poses a serious threat to Netflix potential.

    Second fast, reliable internet connections are required in order to enjoy the Netflix streaming service. Not all people have such good internet connections. Moreover Comcast and alike offer the internet connection along with cable TV. In order to fully exploit Netflix and its low costs this T.V. biased customers should make a bold switch by abandoning the whole package.

  • Report this Comment On October 05, 2010, at 8:57 AM, maximus9 wrote:

    More than calculations and analysis, it is the market sentiment that drives stocks. There is no perfect way to evaluate any stock’s valuation as being cheap or expensive. In retrospect, several expensive M&A deals bear witness to this fact.

    As for Netflix, where are the sellers ? The stock already has extremely high short interest relative to the float, which means everyone thinks price is too high and expects it to fall. That is precisely the situation that drives the stock in the opposite direction due to simple demand/supply equation. I wouldn’t be surprised if NFLX suddenly skyrockets 10-15% due to the short squeeze.

  • Report this Comment On October 05, 2010, at 8:57 AM, JakilaTheHun wrote:

    My view on this is that NFLX is the leader of the pack on digital streaming. Streaming will allow them to reduce costs and increase profits. However, the thing too many analysts are missing --- it will allow everyone else to do the same thing.

    NFLX's DVD-by-mail model had a moat. They had to build distribution centers all over America and they needed heavy volume to profit. No one else could get into that game.

    The new game is a bit different. It's much cheaper to get in. NFLX might still have a "moat", but it's a very, very small moat rather than the enormous one they had with DVD-by-mail.

  • Report this Comment On October 05, 2010, at 9:21 AM, BioBat wrote:

    I disagree. They still have a wide moat. The streaming business is the future and Netflix has the lead BUT only 30% of the 115m households in the US have broadband service - or rather, 35m households have broadband service capable of handing streaming. If you accept Netflix numbers that 65% of their 15m subscriber streamed video last quarter, that amounts to nearly 10m subscribers with an internet connection capable of streaming were doing so. So of 35m households with broadband connections, Netflix may be tapping into almost a third of them. Some will go for multiple services like AppleTV or Amazon VOD but many will not. To say Netflix is the leader is a vast understatement as to how much penetration they already have vs. the competitors.

    As for the 70% of households without a broadband connection, what can AppleTVs, GoogleTVs, Amazon VOD offer them? Absolutely nothing. What can Netflix offer them? Unlimited DVD rentals by mail, profits of which will go towards further improving their streaming service.

    If Netflix stood still and did nothing for the next year, I honestly don't believe any of the other services would be able to approach subscriber numbers remotely close to Netflix.

    This is without even getting into brand identity, something Netflix has been building over the past 5 years. Do people really think of Amazon, Google, or Apple for movies? No, of course not. They think of Netflix, Blockbuster and Redbox and only one of those companies has a clear and defined digital strategy that is consumer friendly.

  • Report this Comment On October 05, 2010, at 9:57 AM, maximus9 wrote:

    Very well said Biobat. Netflix indeed has a wide moat and it is way ahead of the pack. Besides none of the bigger players will be able to match their low cost model. It will be extremely difficult, costly and time consuming for the biggies to reach those subscription numbers.

  • Report this Comment On October 05, 2010, at 10:36 AM, masukomi wrote:

    With regards to Netflix not displacing anything with it's streaming services yet, you have to take into account the fact that the Movie industry has been very reluctant to allow them to stream the movies people want to see when they want to see they. Yes, their library is growing and there's lots to watch, but you can't stream new releases, and many of the successful movies users want to see simply aren't available for streaming because the content owners fear the impact on their pocketbooks.

    Eventually the movie industry will give in and accept the inevitable but until then...

  • Report this Comment On October 05, 2010, at 11:26 AM, Ambassadore wrote:

    Sorry to be off topic, but after reading Anders comment above regarding the 10-day before/after rule for Fools writers.... I appreciate that Fools has that policy in place :) I just lost a hefty amount due to a very recent Pump/Dump scam!

  • Report this Comment On October 05, 2010, at 3:14 PM, pstoimenov wrote:

    Neflix is horribly expensive. I would be interested in somebody to explain me at what growth rate Netflix has to move to justify its current valuation. Also the growth has its limits- the people who want Netflix already have it.

    I know that the movie delivery over the I-net is hot, however Netflix does not have exclusivity over it (so no moat). Any player with deep enough pockets can set it up and considering how price conscious people are they are not going to be loyal. The mail distribution is fine, however the profit is super slim. See here you pay 9$/month for the plan I use- they pay over 7$ in postage. When you count the man labor, wear and tear, royalty payments... Where is the profit coming from.

    Also I would like one of the Neflix stock fans to explain why is the CEO selling as soon as his options mature. He has been doing it since the stock exceeded 35$, where in my humble opinion lies the real price of the stock.

    I do not own position in Netflix.

  • Report this Comment On October 12, 2010, at 1:04 AM, ChrisBern wrote:

    The article I'm waiting to read is how NFLX's profits will look when you tack on $200M/year in extra expenses with the EPIX content deal. Netflix is an easy short because of this, though I enjoy the product as a customer.

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