2 Ways Bulls Are Wrong About Netflix

Netflix (NASDAQ: NFLX  ) is one of the most hotly contested stocks in the market today. Bulls like my colleague Anders Bylund think the sky is the limit and that Netflix stock could go to $600 within a few years. By contrast, prominent bears like TheStreet's Rocco Pendola believe it's only a matter of time before Netflix comes crashing back to earth.

Both sides have some good points to make. However, Netflix bulls and bears alike tend to overstate their cases with flawed or exaggerated arguments. With dubious cases being tossed around on both sides, it can be difficult for investors to sort out what's really happening. Today, I'll look at two flaws in bulls' arguments. Check back this weekend to see how the bears may also be pulling your leg!

What earnings growth?
Netflix stock is now trading for about 200 times projected 2013 earnings. That valuation implies investors consider Netflix a big-time growth company. Indeed, bulls (and the media) often get sucked into calculating Netflix's year-over-year earnings growth to justify the stock's high valuation. For example, in the first half of 2013, Netflix saw pre-tax income (excluding a debt refinancing charge) grow 20-fold year over year, from $3.6 million to more than $72 million!

However, while it's true Netflix is posting rapid year-over-year earnings growth, its earnings are still well below peak levels. In fact, Netflix's pre-tax income in the first half of 2013 was 65% below what it produced in the same period of 2011 ! Analysts don't expect Netflix to regain its 2011 profit level until at least 2015.

Bulls might point out that Netflix has greatly increased its investment in international markets in the past two years. Indeed, higher international losses do account for the majority of Netflix's decline in pre-tax profit.

Still, even if you exclude international losses from the calculation, Netflix's pre-tax income was about 7% below 2011 levels in the first half of 2013. Meanwhile, the share count has grown by more than 10%, so each shareholder is entitled to a smaller percentage of that profit.

Margins can go both ways
Netflix bulls are also very impressed by growth in the company's contribution margin for the domestic streaming segment. This statistic represents the percentage of streaming revenue that remains after Netflix pays for content acquisition and delivery costs and advertising expenses.

Domestic streaming contribution margin has jumped from 14.3% in the first quarter of 2012 to 22.5% last quarter. The midpoint of Netflix's guidance calls for an increase to 23.8% for the current quarter. Management's goal is to grow this contribution margin by 400 basis points per year.

Bulls therefore believe Netflix's domestic streaming contribution margin will continue growing at this rate for a long time. This is a dangerous assumption. To be clear, Netflix's "long term view" states, "As long as we continue to grow as we have been, we are likely to be able to continue this margin expansion." In other words, Netflix needs to continue adding about 6 million domestic streaming subscribers annually to maintain this contribution margin growth rate.

However, Netflix's domestic subscriber growth is likely to taper off beginning within the next few quarters. First, market saturation will become an increasingly important barrier to domestic growth. Netflix's U.S. streaming subscriber base already totals more than one-third of the 88 million U.S. households with high-speed Internet.

Since some people are not interested in Internet TV, and others are satisfied with competing services such as Hulu and Amazon.com's (NASDAQ: AMZN  ) Prime Instant Video, the pool of potential new Netflix subscribers is shrinking.

Second, Netflix recently lost several high-profile series to Amazon, including Downton Abbey, SpongeBob SquarePants, and Dora the Explorer. This boosted margins in the near-term, since Netflix is no longer paying for that content. However, as subscribers begin to notice that this content is missing, some attrition is likely.

Netflix's foray into original content may offset these losses, but original content is very expensive. If Netflix has to step up original content investment to maintain its subscriber growth rate, that will just as surely put a damper on margin growth.

Bulls overlook trouble spots
Netflix bulls tend to exaggerate Netflix's earnings growth prospects for two reasons. First, they have focused on the company's year-over-year earnings growth, which is merely an artifact of the company's dreadful 2012 performance. A longer look backward reveals that Netflix's pre-tax income has dropped by 65% over the past two years.

Second, bulls expect significant long-term expansion in Netflix's domestic streaming contribution margin. However, even Netflix executives have carefully hedged their goal of achieving 400 basis points of improvement each year. There are good reasons to believe subscriber growth will slow soon, ending the period of rapid margin expansion.

Still, while there are some major gaps in the bull case, Netflix bears' arguments aren't always up to snuff either. Check back this weekend for the other side of this story!

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Read/Post Comments (5) | Recommend This Article (13)

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  • Report this Comment On September 20, 2013, at 9:04 AM, 24penny wrote:

    Another big question mark is the international streaming biz. They can add as many subs as possible but it seems to be an issue of scale. If each international market requires its own content licensing agreement then each market must have a big enough sub pool to support the costs for that market. Hence large population markets can be profitable while the smaller ones will be more challenging.

  • Report this Comment On September 20, 2013, at 9:18 AM, jb757 wrote:

    "Netflix's pre-tax income in the first half of 2013 was 65% below what it produced in the same period of 2011 !" Really? The company was riding high until later that year when the new fee plan and Qwickster emerged to ruin the income flow with more than 600,000 subscribers leaving. It's taken over a year to recover from that. Upcoming earnings reports will confirm the health of Netflix and justify its valuation.

  • Report this Comment On September 20, 2013, at 11:43 AM, TMFGemHunter wrote:

    @jb57: I don't really understand your comment. My point is that the big "improvement" Netflix has been showing in the last year is just getting the company back to where it was two years ago, before the whole Qwikster thing. There's a big difference between a turnaround/earnings recovery and rapid growth, though.

    If Netflix is just a "normal" growth company that will have a 15%-20% revenue growth rate for the next few years, as well as some margin expansion, then it might deserve a 40X-50X forward P/E. That works out to a fair value of about $130-$160. You have to believe that earnings are going to continue growing like wildfire to get to a number beyond $300. As one bullish analyst put it earlier this month: $5 in EPS in two years, $10 two years after that, and so on.

    I wouldn't be surprised to see Netflix hit EPS of $5 by 2015: that would be roughly the EPS run-rate it had achieved in 2011. But $10 and beyond won't be so easy to achieve, in my opinion.

    Adam

  • Report this Comment On September 22, 2013, at 10:03 AM, jb757 wrote:

    When you say "Netflix has been showing in the last year it is just getting the company back to where it was two years ago", it is very misleading. It implies that the company, e.g., assuming it was a manufacturer, was producing 2 million LCD displays, while now, two years later, they're almost back with production at 1.8 million.

    Two years ago, Netflix had about 25 million total subscribers. Since then they've added 10 global million subscribers and have taken on high international startup costs, while at the same time, recovered from the Qwickster disaster. This perspective is important because yes, the financial figures are as you say, but it's the achievements in growth and recovery that bears ignore when they state the financial comparisons.

    I agree the 2015 $5 appears likely. Still I don't see the company slowing with the current growth in international broadband, and the tremendous value that their newer TV series have added to the service, further helping to retain subscribers.

  • Report this Comment On September 28, 2013, at 10:25 AM, DavidGomm wrote:

    As a Netflix consumer, I look at there value from a costumer service standpoint. For getting new releases of movies they are pretty good, if you don't mind waiting a month or longer after release in stores. They used to get their movies the same day as stores but now have some dumbed down, so extras, slow release deals with some production companies. That's okay now that we expect it, but it's a chink in their customer satisfaction armor.

    The streaming issue that is so enthusiastically talked about by financial gurus is very disappointing. The shows you can watch are getting fewer and I often feel that the little I can see readily are documentaries that I wouldn't view if I had better choices. I often load up my que go to watch and watch a minute or two of as many as a dozen titles and finding that they are substandard films that no one in their right mind would care for.

    So, the debate isn't whether Netflix has dvds mailed out or provides streaming, It's will their content problems continue to make them less valuable. I've changed my 4 discs at a time membership to a 2 disc at a time one and may drop even lower.

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