In the battle between Netflix (NASDAQ: NFLX ) bulls and bears, hyperbole often overshadows the truth. Advocates on both sides like to make grandiose claims about Netflix's fate. Bulls think Netflix is destined to become ubiquitous and extremely profitable, while bears think it's a house of cards.
In all likelihood, the reality is somewhere in between. The true story of Netflix is not about the its dominance or implosion. Instead, Netflix's worth comes down to a rather pedestrian race between revenue growth and content cost inflation. Today, revenue growth is outpacing cost growth, but not by very much. To justify its sky-high valuation, Netflix will need to better leverage its existing content spending in the future.
A view from the bear side
Despite Netflix's strong rebound since the "Qwikster" fiasco in 2011, a surprisingly large number of investors think its business model is unsustainable. For example, TheStreet's Rocco Pendola has repeatedly argued that Netflix is all "smoke and mirrors." Pendola believes that big media companies such as Time Warner (NYSE: TWX ) and Disney (NYSE: DIS ) control the whole industry, and that Netflix can survive only as long as these competitors tolerate it.
However, while Netflix does buy content from big media companies (which rely on the pay-TV industry for most of the revenue), there's no real danger that these companies will cut Netflix off. There's too much money to be made by selling content to services like Netflix. Moreover, there are enough content owners out there that Netflix will always be able to find a few that are willing to play ball.
In short, Netflix's fate is in its own hands. If investors are overrating its prospects, it's not because Time Warner is going to "punkslap" Netflix -- as Pendola has colorfully put it on occasion. It's simply because Netflix won't be able to grow profit rapidly forever.
Bullish beyond belief
At the other end of the spectrum sit uber-bulls such as portfolio managers David Schechter and Brett Icahn of Icahn Enterprises (NASDAQ: IEP ) . While company Chairman Carl Icahn (Brett's father) decided to sell a large portion of the company's Netflix holdings in October, Schechter and Brett Icahn think Netflix is still massively undervalued.
The crux of Schechter and Icahn's argument is that Netflix is a superb bargain for consumers at $7.99 a month, and should eventually grow to serve 60 million to 90 million households. They also believe that the business model has massive operational leverage -- i.e., Netflix can grow revenue rapidly without adding much in the way of costs.
This scenario is just as far-fetched as Pendola's bearish one. First of all, while Schechter and Icahn say they "find it difficult to understand why a household would not subscribe to the service," the fact remains that most households do not subscribe to Netflix. Speaking from my own experience as a non-subscriber, I'd say Netflix would have to add a lot of content before it would be worth the price for me.
More broadly, the fact that tens of millions of U.S. households don't use Netflix today suggests that it isn't a "bargain" for them. Pretty much everybody in the U.S. knows what Netflix is -- even my 90-year-old grandmother, who doesn't use the Internet! -- so it's not as if lots of consumers have yet to discover Netflix. The only way Netflix will attract these holdouts (and get existing customers to pay more) is by adding more high-quality content to the service.
The real issue
What will really determine the scope of Netflix's success over the next five to 10 years is how fast content costs rise in relation to revenue. In the press release announcing Icahn Enterprises' sale of Netflix stock, Schechter and Icahn suggest that Netflix could boost domestic streaming revenue by $4.3 billion annually over the next five years. They believe Netflix can drive this growth while adding just $1 billion in content expense!
For some context, let's look at Netflix's revenue and cost growth this year. Through the first nine months of 2013, domestic streaming revenue grew 26% year over year. However, streaming content expense grew almost as quickly, increasing 19% year over year.
For Netflix to add $4.3 billion of domestic streaming revenue in the next five years, it would need to grow at a compound annual rate of 21%. Netflix would have to keep adding subscribers at its recent pace of 5 million to 6 million annually while also raising prices, with no sign of market saturation. At the same time, content cost growth would have to abruptly slow to 9% annually.
Instead, while revenue growth and content cost growth will both moderate on a percentage basis in the next few years, the two growth rates are more likely to converge than diverge. Revenue growth primarily depends upon subscriber growth, and sooner or later Netflix will start to saturate the market. Meanwhile, cost growth is unavoidable: even established slow-growth distributors such as Comcast (NASDAQ: CMCSA ) are contending with rapidly rising content costs.
Foolish bottom line
Netflix bulls and bears like to argue from extremes. Bears argue that Netflix is a house of cards with no control over its destiny, doomed to crumble because of skyrocketing content costs. Bulls view the situation through rose-colored glasses and expect revenue to grow rapidly without much of a content cost investment by Netflix.
Neither of these scenarios is likely. Revenue growth is modestly outpacing content cost growth today, leading to margin growth and earnings growth at Netflix today. However, today's revenue growth rate (at least domestically) is clearly unsustainable in the long run. The real question investors need to answer is whether Netflix can pull back on content cost growth fast enough to keep margins growing. Otherwise, earnings growth will never live up to bulls' expectations.
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