Is Netflix Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Netflix (NASDAQ: NFLX  ) fit the bill? Let's look at what its recent results tell us about its potential for future gains.

What we're looking for
The graphs you're about to see tell Netflix's story, and we'll be grading the quality of that story in several ways:

  • Growth: Are profits, margins, and free cash flow all increasing?
  • Valuation: Is share price growing in line with earnings per share?
  • Opportunities: Is return on equity increasing while debt to equity declines?
  • Dividends: Are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let's take a look at Netflix's key statistics:

NFLX Total Return Price Chart

NFLX Total Return Price data by YCharts

Passing Criteria

3-Year* Change

Grade

Revenue growth > 30%

109.6%

Pass

Improving profit margin

(83.4%)

Fail

Free cash flow growth > Net income growth

(577.2%) vs. (65.1%)

Fail

Improving EPS

(67.3%)

Fail

Stock growth (+ 15%) < EPS growth

171.8% vs. (67.3%)

Fail

Source: YCharts.
*Period begins at end of Q2 2010.

NFLX Return on Equity Chart

NFLX Return on Equity data by YCharts

Passing Criteria

3-Year* Change

Grade

Improving return on equity

(90.8%)

Fail

Declining debt to equity

(60.1%)

Pass

Source: YCharts.
*Period begins at end of Q2 2010.

How we got here and where we're going
Things don't look too good for Netflix today, as the streaming video kingpin has earned only two out of seven passing grades. Both net income and free cash flow have tanked in recent quarters as Netflix spends itself into losses (in free cash flow terms, at least) to build out its library of licensed and original content. Despite this weakness, Netflix's shares have made an impressive comeback since its late-2011 debacle. Is this surge sustainable, or will Netflix's fundamental weaknesses catch up it to the end? Let's dig a little deeper to figure things out

Netflix and Amazon.com (NASDAQ: AMZN  ) have both looking into advertising opportunities as a means of expanding the market for their streaming-video services. This has long been Netflix's territory, as neither Amazon nor TV-focused streamer Hulu expended anything close to Netflix's $160 million in 2012 ad costs. Should Amazon decide to open its ad wallet for Prime, millions of consumers who have been on the fence about subscribing to this service may decide to take the plunge. Amazon's Prime Instant Video service already offers the immense secondary benefit of free Amazon shipping, something Netflix can never hope to match. Amazon may have to hike prices to build out a comparably deep streaming library, but Jeff Bezos has never had a problem driving Amazon's margins to the floor as long as the company can seize market share in the end.

Fool contributor Robert Hanley notes that DVD-rental competitor Redbox, a subsidiary of Outerwall (NASDAQ: OUTR  ) , recently entered into a partnership with Verizon Communications (NYSE: VZ  ) to launch online streaming service Redbox Instant, which offers unlimited streaming of movies and four free monthly DVD rentals at a lower monthly subscription fee than Netflix, which is already pretty darn cheap when you think about it. This might be concerning if Verizon throws its marketing and financial muscle behind Outerwall, but until that happens, Redbox Instant is likely to remain in a distant third place in the subscription-streaming war -- fourth, if you count Hulu.

Netflix's unique content strategy of providing full seasons of original programs to its subscribers all at once may also come under threat. Time Warner's (NYSE: TWX  ) HBO app, HBOGO, is currently quite restrictive compared to Netflix, and a proper push for this cable alternative would undermine Netflix's dominance of online original programming. Is that likely? Not in the immediate future, but if cable providers feel threatened, they might start looking more seriously at providing online-only options.

Netflix, thus far, remains far in the lead in terms of content breadth and depth. The company recently signed a multi-year content agreement with the Weinstein Company, which is expected to begin in 2016. Lions Gate Entertainment (NYSE: LGF  ) also signed an agreement that allows Netflix to show any of The Hunger Games episodes on a pay-per-view format, and Lionsgate's deal to produce future seasons of Orange Is the New Black for Netflix is all but certain to continue given the new show's popularity and critical acclaim.

Putting the pieces together
Today, Netflix has few of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

Americans reportedly spend nearly 34 hours a week watching television! With TV viewing taking up almost as much time as the average work week, the potential for profits in the space is enormous. The Motley Fool's top experts have created a new free report titled "Will Netflix Own the Future of Television?" The report not only outlines where the future of television is heading, but offers top ideas for how to profit. To get your free report, just click here!


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