What's The Deal With Netflix?

After the close on Oct. 21, Netflix (NASDAQ: NFLX  ) shook the market. In addition to rising more than 6% before the company's earnings announcement in the afternoon, the company's share price skyrocketed more than 11% after the close as it reported earnings that were much better than expected. However, Mr. Market just can't seem to make up his mind about where Netflix belongs, as demonstrated by the company's 5.5% drop the next day.

Summary of Netflix's earnings
In an attempt to understand why Netflix's shares ultimately fell after reporting such good numbers, it would be best to go over what it reported.

For the quarter, the company reported revenue of $1.11 billion compared to the $905 million it reported in the same quarter a year ago (a 22.7% increase). This topped the $1 billion in revenue expected by analysts by 11%. The primary driver behind this tremendous rise was the company's significant increase in subscribers, which rose to around 40.3 million globally (and over 31 million in the United States). This increase allowed Netflix to narrow the distance between it and one of its largest competitors, Time Warner Inc. (NYSE: TWX  ) (NYSE: TWX  ) , owner of the HBO subsidiary, which has an estimated 41 million customers in the United States and 117 million across the globe.

Admittedly, Netflix has grown much more rapidly than Time Warner's HBO subsidiary in wooing more customers to its side, but it still has a long way to go (190.3% growth) before catching up to the company in terms of size.  Moving forward, this could prove to be a concern for Netflix, as Time Warner's market capitalization of $64.46 billion is far larger than Netflix's $19.34 billion.  Despite this, as well as Time Warner's larger cash hoard of $2.1 billion, compared to the $1.14 billion reported by Netflix, Netflix does have relatively stronger financial flexibility, as demonstrated by its $500 million in long-term debt compared to Time Warner's $19.1 billion.

In addition to reporting blowout revenue growth, the company also outperformed on the bottom line. Its earnings per share came in at $0.52. This was 6.1% higher than analysts' expectations of $0.49, and 300% higher than the $0.13 it reported in the same quarter a year ago. There were two reasons underlying this substantial rise in earnings per share. First, Netflix's higher-than-expected revenue helped increase its bottom line. Second, the company has been better able to control its costs, which has helped increase its operating margin from 1.8% a year ago to 5.2% this quarter, while causing its net profit margin to increase from 0.8% to 2.9%.

Certainly, these better-than-anticipated metrics warrant a positive investor reaction. However, what we've seen is the exact opposite, as investors have been dumping the stock. The big question here is why? Why, when every number forecasted by analysts was completely crushed by the company, has the market pushed its shares down so much? Was there some hidden detail delegated to footnote status that foretells a bleak outlook for the company?

The answer to this is not really. Although the company did report that it expects international subscriber additions to remain flat for the following quarter as it pushes through its "low quality" free trials in Latin America, there wasn't any news that should strike an investor as "bad" necessarily. Instead, the rationale behind the company's decline is likely one underlying factor: valuation.

Netflix is wonderful but expensive
Throughout the past few years, management has shown what kind of growth engine Netflix can be. This has been amazing for the company as well as its shareholders. However, sometimes Mr. Market gets a little carried away. Instead of focusing on how much an investor is paying for a company's growth, investors begin to focus on the growth itself. This is dangerous thinking because the concentration toward growth as the reason for investing can sometimes overshadow the company's true fundamental health.

In another article I wrote on the topic, I discussed how Netflix is a fast-growing company but that investors are paying a lot for a piece of it. One example that I gave illustrates that an investor acquiring shares of Netflix would be paying $442.05 per customer (though now that number works out to around $439.48 given its current market capitalization of $19.17 billion and the 43.62 million subscribers the company expects to have by the end of the year).

In return, each customer generates around $99.50 in revenue (using this year's estimated revenue of $4.34 billion). The ratio of these two metrics boils down to about 4.42, which is far higher than the five-year average of 1.99. This may indicate that the company's shares are significantly overvalued even after factoring in its growth prospects.

I'm not the only one who thinks so
Now, if I was the only person who said that Netflix is unbelievably expensive, you could simply conclude that I'm crazy (you wouldn't be the only one to arrive at that conclusion). However, the company's CEO, Reed Hastings, also believes that the market is getting carried away with the company.

According to this source, Hastings indicated that the market is becoming euphoric about Netflix, a sign that those passionate about it may be getting over their heads. Others have also come out to voice their concern. Analysts at firms like Jefferies and Pacific Crest claim that it is difficult to justify the company's current valuation and that its fair value is likely in the range of $160 to $230, which would be a significant haircut from current quotes.

Foolish Takeaway
I cannot state enough how impressive of a growth engine Netflix has become. It has done (and will likely continue to do) so much to revolutionize the entertainment industry. Fortunately for those who realized this early enough, the company has paid off immeasurably. However, the general market has also come to the same conclusion and, as a result, pushed its share price sky high--possibly too high.

Will Netflix rule the future of TV?
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