Netflix Expensive? Give Me a Break!

Every time I write a positive story about Netflix (Nasdaq: NFLX  ) , the same question always pops up in the comments: "Isn't the stock way too expensive already?"

Say what?
Netflix is in a high-growth phase of its history today -- a mode the company hasn't left despite more than a decade on the market. Management is pulling a couple of levers to adjust that growth on an ongoing basis, both of which directly affect both earnings and cash flow results: marketing expenses and licenses for streaming digital content.

Nearly every last penny of surplus cash is going into content deals, which is how Netflix keeps its library fresh and interesting while building the foundation for a DVD-less era. You can see how this strategy makes earnings figures nearly meaningless: Management picks a target, then spends or saves whatever it takes to get there. Blowout earnings aren't in the cards, and neither are total misses. And it doesn't matter anyway.

What's the story?
Subscriber growth and gross margin trends tell the real story here. The company is currently adding about a million new subscribers per quarter, giving lots of credit to the pull of digital content. With 15 million customers under its belt already, Netflix is as big as Time Warner Cable (NYSE: TWC  ) and set to pass cable leader Comcast (Nasdaq: CMCSA  ) in about two years. That's a serious changing of the entertainment guard.

Meanwhile, Netflix is enjoying the widest gross margins in company history at 39.4% last quarter, and that metric has been on an upward trend for more than two years. Digital deals like the Epix contract may look expensive up front, but I'm convinced that it's a fixed cost that doesn't scale with the number of subscribers, so the profits come along with economies of scale. If you look at Netflix's annual income statements over time, you'll notice a marked flattening of the cost of its services ever since the digital platform launched. DVD mailing is expensive and streaming is cheap, even with markedly higher subscriber counts to serve.

Best of all, when Netflix finally meets its growth targets and turns down the rocket boosters to a slow boil, profits and cash flows will suddenly skyrocket and make these old valuation calculations look irrelevant. But that day is still several years away.

I want a second opinion!
Fine, don't take my word for it. Piper Jaffray's senior media analyst, Mike Olson, sees Netflix being worth about $180 per share today. That's 45 times Olson's own earnings estimate for calendar year 2011, a figure he arrives at through an "improving content and device ecosystem" and high barriers to entry -- nobody else has the head start in digital media that Netflix has built over the years.

Do you still think Netflix is expensive?

Netflix is a Motley Fool Stock Advisor selection. 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. The Motley Fool has a disclosure policy.

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 (13) | Recommend This Article (21)

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 08, 2010, at 3:54 PM, investintexas wrote:

    I agree wholeheartedly, I won't however carry more than 10% in my portfolio. I also don't blame anyone for selling off at $160 recently as I was tempted as well. The market is going to take time to really figure out Netflix & it's current grip on the lead, I would be extremely comfortable with taking an additional position at $130 or even $140 possibly. A recent friend recently argued with me on this stock & said he knew 5 guys & that when he brought up Netflix they didn't even know what that was as a reason why it was overvalued. I said now consider what you just said & what even an additional 25% saturation & international coverage will mean. He shut up.

  • Report this Comment On October 08, 2010, at 4:11 PM, CFischer wrote:

    Subscriber growth and gross margin trends tell the real story here.

    > Heard that about XM/SIRI too. Heard the "earnings don't matter" speech a lot as well.

    Digital deals like the Epix contract may look expensive up front, but I'm convinced that it's a fixed cost that doesn't scale with the number of subscribers

    > You couldn't be any more wrong about this if you tried. When the contract expires and gets re-negotiated, the number of subscribers is the key metric the content companies use when negotiating! Look at the $ number they're talking about for the Starz renewal - why do you think it's 4-5X what they're currently paying? Rampant inflation?

    Best of all, when Netflix finally meets its growth targets and turns down the rocket boosters to a slow boil, profits and cash flows will suddenly skyrocket and make these old valuation calculations look irrelevant.

    > Huh? Besides some direct marketing costs, what expenses can they turn off?

    Fine, don't take my word for it. Piper Jaffray's senior media analyst, Mike Olson, sees Netflix being worth about $180 per share toda

    > Haha, really? Cherry pick the one analyst that has a price target higher than the current share price, and ignore the other dozen that have lower prices and/or outright sells against the stock?

    Still waiting to see any kind of numerical analysis behind all your anecdotes. This stock is outragously overvalued, they have no competitive advantage in digital distribution.

  • Report this Comment On October 08, 2010, at 4:54 PM, joshpritchard wrote:

    I feel like I read this article already, several times...same author, same point, still no real argument. This is cheerleading, plain and simple. Maybe a rhyming version next time?

  • Report this Comment On October 08, 2010, at 7:52 PM, maximus9 wrote:

    CFischer- It is obvious that you are short Netflix !

  • Report this Comment On October 08, 2010, at 8:16 PM, TMFZahrim wrote:

    @joshpritchard, you mean kind of like this?

    http://www.fool.com/investing/value/2007/04/20/amds-prosodic...

    Don't tempt me until next April :)

    Anders

  • Report this Comment On October 08, 2010, at 10:54 PM, jm7700229 wrote:

    "Do you still think Netflix is expensive?"

    Yes.

  • Report this Comment On October 09, 2010, at 5:19 PM, JakilaTheHun wrote:

    The problem that every positive analyst ignores is that while NFLX can make huge margins on digital content, SO CAN EVERYONE ELSE! And basic economics suggests that other companies will move into this sphere in order to take advantage. Amazon is already doing so; others may follow.

    This isn't to say that NFLX doesn't have a head start --- they do. They are a well run company and may continue to be the best of class. But, at the very least, I think they will find themselves facing more competition 2-3 years down the line and those enormous gross margins will start to shrink.

    The other thing here is that NFLX has a moat on DVD-by-mail. No one else can get into that game because the high capital costs and economies of scale associated with it.

    Even though a lot of these streaming deals are 'fixed-price', they don't create quite the barriers to entry that NFLX's DVD-by-mail model does. This is because the "fixed costs" involved are not all that large investments, comparatively speaking.

  • Report this Comment On October 09, 2010, at 9:27 PM, sagi17 wrote:

    I remember when Iomega and Enron were the next big thing, only to dominate for a brief time. DVDs will go the way of the zip drive. To get a better perspective of Netflix financail situation, I look at the balance sheet.

    1. Shares outstanding have gone down 28% from 2007 to 2009 which adds 28% to EPS growth.

    2. 200MM of debt was taken on. Investors need to be careful that with such low interest rates companies would issue cheap debt and buy back stock to raise eps. Any firm could double their eps by halving the outstanding amount of shares.

    3. Netflix owns an ever-growing amount of fast-depreciating DVDs. Does Netflix expense its DVD purchases or capitalize them? When NFLX writes off its obsolete PPE it will take a huge hit to earnings.

  • Report this Comment On October 10, 2010, at 1:46 AM, maximus9 wrote:

    Any big player can start an e-commerce site, but can they beat Amazon ? Similarly anyone can get into digital streaming - but can they build the same brand identity as Netflix ?

    The challenge here is to beat the wide reach of NFLX in terms of subscription numbers, DVD-rental infrastructure, the content partnerships, studio licenses, world-class customer service and a low/affordable monthly cost to the consumer.

    I don't believe that any of the competitors can reach the subscriber numbers even remotely

    matching Netflix. No wonder, Apple and Google have selected Netflix as a partner of choice.

    It is really naive to say that Netflix has no competitive advantage. In fact I believe

    they have a wide moat. According to the Census Current Population Survey data, 63.5 percent (75.8 million) of U.S. households used a high-speed Internet:

    http://www.ntia.doc.gov/reports/2010/NTIA_internet_use_repor...

    The subscriber base of Netflix reflects a deep, fast growing penetration in the digital streaming market. Streaming is the wave of the future in consumer entertainment and Netflix is at the forefront of this wave. Considering the huge untapped market potential, I see nothing

    but a very bright future ahead for Netflix.

  • Report this Comment On October 11, 2010, at 7:44 AM, afamiii wrote:

    The critical questions are:

    i) do Netflix content deal give them an advantage in subscriber aquisition and retention (I don't know the answer, but my suspicion is that they do - I recall BSkyB (now Sky in Europe))

    ii) does its DVD Brand recognition (which has no long term potential) and customer base give it an advantage in acquisition and retention. (again my suspicion is that it helps in aquisiton but not retention.)

    iii) Will it enjoy economies of scale with its distibution infrastructure (I doubt it) or with its content deals (my suspicion is yes.)

    If it can enjoy any or all of these advantages, then it is a great business (great margins, and RoE, low debt vs. free cash flow), at a fair price (given its growth trajectory).

    On a technical side it is trending well, it is being accumulated, the current correction is healthy (and with low volume) and should result in a good buying opportunity.

    The debt issues brought up by another reader is a none issue, it is well covered by free cash flow (even if one argues that the 50% equity leverage is high)

  • Report this Comment On October 11, 2010, at 8:26 AM, nickolassc wrote:

    Netflix is too expensive and could be in the start of a downtrend for the next several months. I wouldn't buy into it at a P/E over 20 myself. Valuation metrics have nearly always been proven winners over the story based investing model. For example, in tech I"m liking microsoft right now.

  • Report this Comment On October 11, 2010, at 3:06 PM, pstoimenov wrote:

    Of course NFLX is way too expensive. For how long this 1 milion subscribers/quarter will last? Couple of years? They have 15 million subscribers which is more like 15 million households. If you average the number of people per household it appears that anybody who cares for Netflix already has it. After all the number of people in this country is quite limited.

    'You can see how this strategy makes earnings figures nearly meaningless: Management picks a target, then spends or saves whatever it takes to get there. Blowout earnings aren't in the cards, and neither are total misses. And it doesn't matter anyway.' Is this a joke? NFLX does not have an option to stop keeping their library fresh otherwise their business will go stale. Earnings are not meaningless- for an investor they are important because it is the real money they make.

    I do not have a NFLX position.

  • Report this Comment On October 15, 2010, at 6:09 PM, diogenes001 wrote:

    Your analysis is too fluffy and totally misses the point about margins by glossing on past margins instead of future. The reality is that Netflix got a sweet deal with Starz for $30MM/y through Sep-11 and got the leverage upfront with users due to PSP, XBox and iphone penetration. The content cost is going to go up exponentially in future quarters to create negative leverage. Here is the proof:

    1) Signed Epix for $200MM/y kicking in 4Q 10

    2) Signed Relativity for $75MM/y kicking in 1Q 11

    3) Will hike Starz to $250-300MM/y starting 4Q 11

    Bake it all in, divide by incremental 25MM subs to be added in next 3 years and you are looking at gross margins going below 30% by 1Q 2012. I expect investors to focus on this after 3Q 10 results are released because the first evidence i.e. 1 month of $16MM payment to Epix will create the first dent in Gross profit / sub

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1326956, ~/Articles/ArticleHandler.aspx, 10/25/2014 12:22:21 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement