What Is Netflix Really Worth?

Hi, my name is Anders. I'm a Netflix (NASDAQ: NFLX  ) bull, and not the least bit ashamed of it.

I've been known to compare the digital video expert's current stock prices with Apple (NASDAQ: AAPL  ) , circa 2003. Skeptics point to Netflix's expectation of negative cash flows in 2013 and say the company is doomed. Well, Apple's cash ran red in 2003, too, as the iPod/iTunes business found its feet and Steve Jobs was cooking up the iPhone. Five years later, the stock had jumped 2,700% as Apple's early investments paid off in spades.

Yes, I see a similar story shaping up for Netflix. The company is building a fantastic future right now. It's expensive, but you gotta spend money to make money.

I'd like to walk you through three possible versions of the next five years. In one, CEO Reed Hastings achieves everything he ever dreamed of. In another, pretty much everything goes wrong. The third tale balances risks against opportunity, and is the most likely scenario in my opinion.

And then I'll tell you what Netflix is worth under each of these scenarios.

Three possible profit futures for Netflix. The author suggests sticking close to the yellow line.

Dream a little dream
Hastings learned his lesson from the Qwikster debacle and plays his cards to perfection from now on. House of Cards is an Emmy-winning hit that launches a 10-year franchise, followed by other top-quality shows in every genre that matters. Whether you like witty sitcoms, science fiction drama, or gory horror, Netflix has you covered with exclusive content. Only the best scribes, helmers, and thespians need apply, because this is high-budget, high-quality stuff that can stand up to HBO's finest.

On the strength of a generally well-rounded content portfolio with the added spice of award-winning exclusive shows, subscribers sign up and stick around like never before. By 2018, Netflix reaches 84 million American households.

The same factors accelerate the company's overseas growth as well. All this extra money in the bank enables quicker rollouts in new markets. Netflix blankets Europe by 2014, turns a reliable profit on international operations by 2015, and jumps to Southeast Asia the same year. In 2018, the company has 78 million international accounts and 162 million total subscribers.

The result? Streaming operations generate something like $7.4 billion in operating profit just five years from now. The company will be a fully mature media giant by then, equally adept at content distribution, production, and technology. Hastings might start running video-on-demand operations for cable companies by then. Movie-themed theme parks, maybe.

It would be a bit early to call Netflix a threat to Walt Disney (NYSE: DIS  ) at this point, but check again in 2023. The company will eventually have more money than it could deploy in its current business model and would simply have to diversify into a complete media package, just like the House of Mouse. If you're going to copy anybody, might as well stick with the industry's best.

Oh, but everything cannot possibly go as planned. What if absolutely nothing works instead?

Nightmare in Los Gatos
Uh-oh. House of Cards is a critical success (already proven) but doesn't do diddly-squat for Netflix's subscriber hunt. Every original show bombs or slips away, and Hastings stops making them as soon as the existing commitments have been filled. If anything, the grand experiment only increases subscriber churn.

Bidding wars with Hulu and Amazon.com (NASDAQ: AMZN  ) limit what movies and TV shows Netflix can get its hands on, and every important deal falls into the enemy's hands. Amazon is bigger and richer, after all. Hulu is owned by three Hollywood studios. One little DVD-powered upstart can't possibly put up a fight. Hastings expects to get at least 60 million subscribers in the long run but misses that goal with just 54 million accounts in 2018.

The same story plays out in South America and Western Europe. Growth is slow and painful, not to mention expensive. Operating costs balloon, and Netflix would be lucky to reach France and Germany by 2016. Local rivals and some more Amazon resistance further limit overseas growth. That's 41 million non-U.S. subscribers in 2018, or 95 million overall.

This time, costs escalate out of control and the entire operation in still unprofitable in five years. Revenues may be booming in comparison with 2013, but at what cost? Forget about diversification and world domination -- at this point, Netflix should count itself lucky if Coinstar (NASDAQ: OUTR  ) would buy its DVD business for a quick cash infusion. Amazon is beating Netflix in every streaming market is cares to enter, Coinstar (now simply renamed Redbox) owns the physical media market worldwide, and Netflix has nothing going for it.

Busted, broken, dead.

That's not going to happen, either. Let's get real.

The real world
Some of those original shows work out, and some don't. A handful become lasting franchises with repeatable business value, and they make a measurable difference to subscriber acquisition and loyalty. But some sink without a trace and are never seen again. Just like in the traditional cable TV world, failure is the norm. But the hits are at least worth the trouble.

Bidding wars and rivalries turn out to be healthy for the newborn streaming industry overall. Amazon wins some deals, Hulu others, new entrants grab a few tasty morsels. But Netflix finds enough quality stuff to get by and is not forced to overbid on potentially irrelevant items. When the price rises too high, Hastings will walk away, like he did from Starz and Downton Abbey. The studios love having a healthy second market and are not shy about offering an even-handed selection of exclusives to keep the bidders bidding.

That's enough to reach 74 million American subscribers in 2018.

Elsewhere, Netflix continues to invest in new geographic markets with a steadily growing cash inflow setting the pace. Add a handful of Western European countries next year, and then cover that continent two years later. The existing territories mature in a solid but not explosive manner. And so Netflix reaches 59 million overseas subscribers in 2018, or 133 million including the United States.

Costs increase but don't run out of control. In five years, Netflix makes $3.2 billion in operating profit from streaming operations.

This is the most likely scenario in my eyes.

What does it all mean?
Note that I kept this discussion simple. I'm not counting on seeing Netflix raise prices along the way, even though the company could probably get away with adjusting its price tags for inflation. Neither do I expect the company to sell any new products, like game rentals or pay-per-view premium movies. The ultra-high-definition and 3D services are treated as freebies with a regular $8 subscription. The profitable but shrinking DVD service is given no value at all, even though it certainly isn't worthless. I've chosen to err on the side of caution. These estimates are conservative, except for that pie-in-the-sky 100% success scenario.

A discounted cash flow analysis of the worst-case scenario would put a $7.1 billion total price tag on the company, or $126 per share. The stock trades 45% above that level today. I see this level as a fundamental long-term support. Assuming that Hastings doesn't do anything crazy to break the company in ways I haven't thought of yet, I would absolutely buy more Netflix shares below $126. There's no reasonable justification for prices lower than that. None at all.

The super-duper future is equally unlikely to materialize, but it's a useful exercise anyhow. The intrinsic value of the stock would be $118 billion, or $2,114 per share. That's an easy 10-bagger in five years, in the same ballpark as Apple's mid-2000s run to the stars.

But yeah, the middle-of-the-road outcome is the real deal. If you forced me to do a Monte Carlo analysis of Netflix, I'd give this track an 80% probability, with 10% to each of the other cases.

Here, the company's intrinsic value is $538 per share for a $30 billion market cap. Share prices need to triple before hitting that level, or you could see it as a 66% margin of safety. Even if I assume that the growth story will hit a brick wall in five years, it's still a $306 stock. That's with all the conservative caveats above. Any (reasonably handled, unlike Qwikster) subscription price increases, new product ideas, or even a DVD revival would just add more value on top.

So this is why I see Netflix as the next Apple-style hypergrowth stock. It's already one the most successful picks in CAPS, and the largest individual holding in my personal real-money accounts. I plan to ride Netflix over the next few years like early fans rode Apple 10 years ago.

You've seen my bullish analysis of Netflix, but don't stop there. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These are must-know issues for investors, which is why we've released a brand-new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. We're also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.


Read/Post Comments (8) | Recommend This Article (5)

Comments from our Foolish Readers

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  • Report this Comment On February 28, 2013, at 12:06 AM, tom2727 wrote:

    How do you get that Netflix is still worth $126 in your worst case scenario? If it can't manage to turn a profit with streaming, then $0 seems like worst case downside to me (though likely they get bought out by someone well before zero).

    And 95 million worldwide subscribers seems to me to be far from the worst possible outcome 5 years from now. They've only got like 33 million today.

    And how do you figure they get $7.8 billion in operating profit if they do manage to get 165 million subscribers. How do you estimate what their content costs will be 5 years from now?

    What if they have you pay up bigtime for content to hit those subscriber numbers? Theoretically they could have that many subscribers and still be losing money if their content costs were high enough.

    The reason I don't like Netflix as an investment is because the content owners have them by the short curlies. I don't see how they're ever going to make money when they have no leverage to push back on content costs.

  • Report this Comment On February 28, 2013, at 8:45 AM, TMFZahrim wrote:

    The studios aren't stupid, Tom. Netflix and other streaming channels open a new source of syndication-style income. Ask AMC Networks how that's working out for them. Heck, even former Netflix hater Jeff Bewkes, CEO of Time Warner, now admits that Netflix adds a significant source of extra sales.

    Price the content too high, and the studios get nothing instead of something. They'r not going to leave money on the table like that. And this is where the competition comes in: Bidding against Hulu, HBO, Amazon, et cetera helps the free market set a fair price. None of these guys are stupid either, though some may be desperate from time to time (see: Starz renewing Sony). And that's where the rational players fold their cards and move on to the next table. No single item (film, TV series, studio contract, whatever) is crucial to Netflix, just various levels of "nice to have." So you get fair prices through open competition.

    My estimates above are just that: estimates. I set up reasonable ranges for high and low cost escalation, applied them to my three scenarios accordingly, and the "yellow line" shows my honest-to-goodness most likely prediction.

    Yes, my pessimistic scenario still shows some subscriber growth. The company is still investing in new markets, promoting its services through advertising, word of mouth is difficult to judge but obviously not Qwikster-style horrible. And the streaming market is still in its infancy, not a declining empire like the DVD world.

    That's why you simply cannot assume that growth will suddenly stop. This is not AOL dialup in the broadband era. Netflix is the cable modem. Sure, the model will peak and reverse eventually, but only when someone comes up with a better tool than the Internet to distribute video content. That certainly won't happen in the next 5 years, and maybe not the next 50.

    Anders

  • Report this Comment On February 28, 2013, at 10:05 AM, TMFGemHunter wrote:

    Anders: I'd be interested to see your DCF figures. Send me an e-mail: (alevineweinberg@fool.com). I think your article just might require a bearish response!

    I agree that the studios like having Netflix, Amazon, Hulu, etc. out there as an additional income source. However, I still think all the power is in the content owners' hands. What does Netflix really bring to the table? In my opinion, super-successful original series are the only way for Netflix to actually differentiate itself and earn more than a ~10% long term operating margin. Otherwise, content owners will just raise prices as fast as Netflix boosts its revenue.

  • Report this Comment On February 28, 2013, at 10:23 AM, tom2727 wrote:

    I think maybe you forget that many of the biggest content owners are also competing with Netflix. Yeah the little guys like AMC may love Netflix, but the big boys don't. They hate their guts.

    If they get 165 million subscribers worldwide, you think that might put a little dent into cable subscriber numbers? Not something that makes you well liked among the Time Warner / Viacom / Disney crowd.

    And if Netflix has 165 million subscribers instead of 33 million, that's now 130 million extra people that you are giving your content away to when you do a deal with Netflix. People who presumably won't buy the DVD set or watch the rerun in syndication or do pay per view on demand. People who might cancel their cable subscriptions too. Maybe they will ask much more for the same content, knowing that Netflix can afford it? Kind of like Starz did?

    If Netflix wants to get exclusive deals for shows that are newer than 5 years old, they will be paying up for it. How much? I don't know. But I don't think you do either. Netflix has been very cagey about exactly what they have been paying for content until now.

    Don't forget that Netflix is not the only option content owners have for these kind of deals. If Netflix walks away, they don't need to take their content and go straight home. They go to Amazon or Hulu or whoever and get their offer. It's not like Netflix is the only company that can stream content over the net. Nor will they ever be.

  • Report this Comment On February 28, 2013, at 12:14 PM, pastaguy1 wrote:

    Where do you get off with saying nflx will be in 84 million US households? That would be in about 75% of US households. Some houses don't have tv's some don't have internet and some won't pay for anything.

  • Report this Comment On February 28, 2013, at 12:46 PM, pastaguy1 wrote:

    Not to mention how is NFLX going to be in 84million US houselholds...About 75% of all of them when AMZN prime for a lot less money will compete and take away many subscribers from nflx....How well has any company done competing against amzn?

  • Report this Comment On February 28, 2013, at 1:21 PM, verylargelarry wrote:

    Pastaguy1: Still waiting for Amazon to become real competition to Netflix; some years now. How well has any other company done competing against NFLX?? Open thy eyes....

  • Report this Comment On March 30, 2013, at 1:26 PM, MFMotleyStool wrote:

    It's funny how this wrath of bullish articles comes out as this momentum stock is on the verge of breaking out. I wonder if you actually believe any of the numbers you have posted above or have convinced yourself to believe them so you can sell the stock as it breaks to more ridiculous highs. Your worst case scenario won't even come to fruition but that won't stop the short term momentum of the stock. In what world is 54M US households a worst case scenario by 2018 when there are only 132m household units today? So let's just say by 2018 that there are 162M household units by 2018. You think a worst case is that 1/3 of the population is using Netflix. Think about how ridiculous that statement is. Let's use this analogy. There are many supermarkets out there. I go to one mainly that is near me and cheap and maybe 2 others on occasion. They sell food and water, things I actually need and they are a commodity business which this is already lining up to be as more companies joining this space. I don't see any supermarket with a 33% share and everyone goes to supermarkets. They have to. Granted NFLX business is much less of a commodity but over time it will become more of one and not less and not every single household will be using any of these services, this isn't food and water.

    Competition drives prices lower. Is that figured into your model, if you can call it that?

    I'm sorry your worst case scenario is much closer to your best case scenario IMHO and I think all these positive baloney articles coming out in unison are either group think or a concerted effort to add more air to what is already a bubble, drawing in greater fools who are ultimately left holding the NFLX bag.

    That's what I believe reality is now let's see what plays out over time.

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