Say What? Could Netflix Really Be Worth $75 Billion Soon?

Shares of Netflix (NASDAQ: NFLX  ) have rallied to a new series of all-time highs this week, driven in large part by a big price target increase by MKM Partners. On Tuesday, MKM moved its Netflix price target up from $285 to $370, giving it the highest target among Wall Street firms. Moreover, analyst Rob Sanderson stated that Netflix could be worth $75 billion within five to seven years -- well above today's valuation of approximately $20 billion!

While I am highly skeptical that Netflix is even worth $20 billion, there is a plausible case to be made for why the company could be worth that amount. If Netflix can really capture much of the addressable market within the U.S. -- currently around 88 million households with broadband Internet -- and replicate that success in other countries, it could grow into its $20 billion valuation.

By contrast, a $75 billion valuation for Netflix is absurd today, and will be absurd in 2020 as well. It implies that subscriber growth will explode within the next few years and continue despite big price increases, while content cost growth drops off. Based on Netflix's recent history, there is no reason to believe this can or will happen.

Some perspective
A good way to assess the plausibility of valuation estimates is to compare the company you are interested in to its most comparable competitors. In Netflix's case, this means comparing it to other media companies. Netflix executives have clearly stated that they envision making the service more like premium cable channels such as HBO and Showtime over time.

Media companies, such as Time Warner (NYSE: TWX  ) (the parent of HBO, TNT, TBS, and other properties) and CBS (NYSE: CBS  ) (the parent of the top-rated TV network and the Showtime cable network), are currently valued at a little more than two times sales.

If Netflix can eventually achieve a margin profile similar to those of similar companies -- it has never come close before -- it would still need to grow revenue to around $30 billion by 2020 to be worth $75 billion. This assumes that Netflix could achieve somewhat higher sales and earnings multiples than CBS and Time Warner have today.

Based on its current pricing, Netflix would need to grow its global streaming subscriber base from 37.6 million as of June 30 to around 300 million by 2020 to reach that level. Even if Netflix doubles prices, it would need to grow to 150 million subscribers by 2020 to meet a $30 billion revenue target! That implies adding more than 15 million subscribers per year on average (while raising prices, no less). By contrast, Netflix has added around 10 million streaming subscribers in the last year.

Cost creep
Some Netflix bulls might argue that Netflix will generate a significantly higher profit margin than other media companies over time due to operating leverage. In other words, Netflix can boost its margin simply by adding subscribers faster than it increases content spending. As a result, bulls might argue that Netflix could be worth $75 billion by 2020 even if revenue only hits $15 billion or so by then.

However, Netflix's content costs are likely to rise too quickly to allow the 50%-plus long-term profit margin that some investors seem to expect. Netflix's streaming cost of goods sold -- a good proxy for content costs -- reached an annual run-rate of around $2.5 billion in the second quarter, up 30% year over year.

Furthermore, Netflix management signaled that it will be stepping up content spending beginning in the fourth quarter. Indeed, if Netflix wants to grow quickly, its best bet is to keep prices low while adding lots of new content and adding new markets (which also increases content costs, since Netflix primarily pays for content on a country-by-country basis).

If content expense continues growing at 30% annually for the next seven years, it would reach around $16 billion by 2020! Even at a 20% compound annual growth rate -- which is probably more realistic -- content expense would still increase from $2.5 billion to $9 billion by 2020. In other words, even if Netflix more than quadruples its streaming revenue by the end of the decade, it will not lead to the other-worldly profit margins that some bulls hope for.

Let's be realistic
If MKM's analysis is correct, and Netflix could really be worth $75 billion by the end of the decade, the stock would be a great buy today. However, there are no plausible scenarios that could justify that kind of valuation. Either Netflix would need to step up its rate of subscriber growth while also raising prices significantly, or it would need to grow its subscriber base rapidly without adding much content.

Even megabulls like Carl Icahn -- a top Netflix shareholder -- have admitted that Netflix is no longer a "no-brainer" at its current stock price. Personally, I think the stock is already priced for perfection. That said, it's plausible that Netflix could eventually grow into this valuation.

By contrast, MKM's $75 billion market cap target for 2020 does not seem plausible whatsoever. The scenarios that would justify such a valuation are not just rosy -- they're ridiculous.

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Read/Post Comments (11) | Recommend This Article (7)

Comments from our Foolish Readers

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  • Report this Comment On October 03, 2013, at 7:12 PM, AceInMySleeve wrote:

    50M domestic is plausible. 100M international is plausible. 15$\month is plausible *IF* Netflix continues to spend 65% on content, and this is apparent in the amount of content they provide to the customer. That is, twice the content, twice the price.

    Margins in the last 12 months have expanded rapidly. Contracts are fixed price and so increasing subscribers dilutes the cost of any given piece of content. This is particularly obvious for their own purchased content i.e. Originals.

    HBO charges 15$ now, of which half goes to cable. They also take giant profit margins. Therefore, the amount spend on actual content is substantially less than Netflix. So who outbids Netflix for content in the future? If no one can, then margins expand for them as well.

    75B is a challenging call to make now. They have a lot of maturing to even get to the 2B$\year profits required to support a 20B$ market cap. That's not to say it's impossible.

    Fortunately, as an investor you don't need to forecast 75B$, you only need to expect it to have room to go up from here.

  • Report this Comment On October 03, 2013, at 10:11 PM, avcilar1 wrote:

    netflix is going up like hbo,hulu time warner,amazon prime REDBOX,APPLE etc ,all going out of business and netflix going to be only DISTRIBUTER.And no body talk about how many subscriber amazon prime,or hulu has ? HULU plus has 4 million statistic show 38 million person watch at list once a year hulu standard .HBO and stars,apple i believe they are not stupid just they dont wanna jump in the streaming business because whoever says they are losing business still they making good profit they gonna watch closely whats going on in the market and jump in the streaming when is the right time.

    bulls for netflix says content is the king so if you are realistic who loves to watch game of throne , or sopranos etc they gonna quit hbo andgo with netflix? best bet they will sign up for both

    Most important if streaming is the future why movie studio need middle man(distributor) . Streaming its make distribution easy i believe if the future is streaming ,movie studio is the best bet .WHICH ONE IS EASIER OR NEED TO INVEST MORE . NETFLIX BECOME A MOVIE STUDIO OR STUDIO DISTRIBUTE THEM SELF?

  • Report this Comment On October 03, 2013, at 11:14 PM, TMFGemHunter wrote:

    @aceinmysleeve: I agree that 50M domestic is very plausible, but 100M international seems a lot harder, esp. @ $15/month. Netflix's current model works in anglophone countries, or countries with significant english-speaking populations. It would be expensive, and a lot harder to get good penetration of markets like germany, france, japan, etc. Even Latin America has been a tough nut to crack.

    It seems like there's so many more people outside the U.S. that it should be easy to have 100M international if 50M domestic is reasonable. But you shouldn't underestimate the challenges of scaling out Netflix internationally.

    Adam

  • Report this Comment On October 04, 2013, at 7:41 AM, assisgnmeaname wrote:

    Most content is US TV and that won't fly much in Europe.

  • Report this Comment On October 04, 2013, at 9:09 AM, pauldeba wrote:

    "or countries with significant english-speaking populations. "

    Bingo. They will never accomplish anything in Latin america, except perhaps Mexico, and the lack of DVD will prevent the same level of penetration. Also, outside Canada few places have the couch potato/bingewatch culture. and when they do it is soap operas and sports, neither of which play well on netflix as soap operas become obsolete a day or week after airing.

    The fact that they already expanded to marginal markets like Scandinavia and the Netherlands tells you what they think of France, Germany, Italy and Spain. Especially after they announced Spain a few years back and got gun-shy after the Latin america disaster.

    15 million International and 35 million domestic is where they stop growing. They have added 7 million subs in the past 2 years, I don't see how they get to 50 million domestic, growth will not "speed up" and even if it stays the same we're talking 6 years to get to 50 million, especially when churn becomes greater than new signups, the growth disappears. Somehow, these bulls forget about churn. it's always 14% and new signups are between 4.5-6 million, neither changes, and at 35 million the formula - zero growth. So, either chrun drops significantly for some reason or signups increase. Most likely, it won't be both. It may be churn dropping and signups dropping.

    So, 50 million * $10 *12 = $6 billion 33% margin = $2 billion less $450 million marketing and $240 million R&D and $240 million G&A and $400 million taxes leaves $10 a share maximum when growth has stopped. That is a $100 stock. And that is with perfect execution.

  • Report this Comment On October 04, 2013, at 9:10 AM, TMFGemHunter wrote:

    I don't know what you mean by "most content". Do you mean most content that Netflix currently licenses?

    There's nothing that would prevent Netflix from licensing lots of local content in Europe. But it would be expensive and take many years to build out. That's why I think it will be fairly tough to drive the international business past the domestic business in terms of customer count, profitability, etc.

    Adam

  • Report this Comment On October 04, 2013, at 9:18 AM, TMFGemHunter wrote:

    @pauldeba: you're overstating your case by looking at the last 2 years rather than the last year. Netflix added 5.87 million subs in the year ending June 30. Furthermore, for the last three quarters, Netflix has added more domestic subs than in the same quarter of the prior year. (i.e. growth is speeding up, so far)

    That said, I do think Netflix's domestic growth will start slowing down noticeably within the next year. After that, each quarter will show lower growth than the prior year quarter. Even so, I think that 50M domestic subs is achievable in 5-7 years. It still doesn't make for a $300+ stock.

    Adam

  • Report this Comment On October 04, 2013, at 11:32 AM, goldrimtang wrote:

    The article is very good, but it focuses only on what Netflix does today: one single price for everybody. This makes sense today, when all it matters is getting subscribers and grow.

    But how about having different prices depending on the the type of content? Or pay-per-view? Events, premium moves? Even music... There a lot to do and profit from once everybody tunes your service every evening.

    Fool on!

  • Report this Comment On October 04, 2013, at 1:26 PM, AceInMySleeve wrote:

    According to wikipedia, HBO has 30M domestic subscribers and 114M international subscribers.

    The default guess is that Netflix can match that ratio.

  • Report this Comment On October 05, 2013, at 9:49 AM, jb757 wrote:

    The article doesn't even mention subscriber fee increases over the next few years which would seem likely, and which would increase revenue and earnings to further propel the stock price.

  • Report this Comment On October 05, 2013, at 9:59 AM, jb757 wrote:

    @pauldeba: The US is the premier movie making country of blockbusters that humans can't get enough of. Plus Netflix has been working hard on subtitles or captions for foreign viewers. Your ideas are short sighted. Movie attendance thru out the globe is huge and always growing. Broadband - huge and growing dramatically. Stilll time to buy the stock before it exceeds $400.

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