The Best Stock of 2013 Still Has Room to Run

Netflix (NASDAQ: NFLX  ) had the best-performing stock in the S&P 500 in 2013. Its shares rose 298%, making it a four-bagger for the year. You would think that CEO Reed Hastings would be pretty happy with that result.

In reality, his reaction wasn't quite what you might expect. Back in October, he said:

Every time I read a story about Netflix is the highest appreciating stock in the S&P 500 it worries me because that was the exact headline that we used to see in 2003.

Hastings is understandably leery of the run-up given the historical volatility of Netflix's share price. Despite those concerns, I'm actually very optimistic about the stock for 2014 and beyond.

The formula for success
So what was responsible for those dramatic returns in 2013? It was simple. The actual business made a big turnaround, and the market fell in love with the stock again as a result.

A bit of recent history provides some context. Knowing that its DVD rental business was about to be disrupted by streaming video, management made a difficult decision in 2011 to split Netflix into two parts. One part, which they called Qwickster, would house the DVD-by-mail segment. The streaming video segment would keep the Netflix brand. As everyone knows, it didn't go well. Customers started canceling, revenue growth declined, and the stock price fell far and fast.

Management eventually decided to reverse course, keeping everything under the Netflix umbrella, while investing heavily to grow its streaming business. And that plan is working beautifully.

Subscriber growth picked back up and marched higher in 2013. More importantly, Netflix's contribution margin reversed course in 2013 and is back on the rise. Contribution margin measures how well a company is covering its fixed costs. For Netflix, content acquisitions act as a fixed cost. So a rising contribution margin means that each additional subscriber is contributing more and more profit, which is exactly what investors want to see.

Seeing more subscribers and higher profits, investors got excited and began buying the stock again with tremendous zeal. And it's easy to understand why. Netflix has a huge advantage over the competition in streaming movies and TV shows over the Internet. Investors appear to be confident that Netflix will use that advantage to continue growing its subscribers and cash flow. I think they're right.

Let the good times roll
History shows that companies with sustainable competitive advantages do two things. They deliver more sales growth and earn higher returns on invested capital than the competition for longer periods of time. Those two things usually translate into excellent shareholder returns. 

Netflix has a clear competitive advantage that is bolstered by the following factors:

  1. Netflix provides the best entertainment value out there.
  2. Netflix is everywhere you want to use it.
  3. It benefits from huge amounts of data.

With a price tag of as little as $8 a month, it's easy to understand why people keep signing up for the service. That is an incredible price to access a big (and growing) library of content, ranging from TV shows to movies to original programming. And to make things even better, Netflix is available on a wide variety of devices: smartphones, tablets, smart TVs, gaming consoles, etc., etc. That enables viewers to watch what they want, when they want, without breaking the bank.

Netflix ended the third quarter of 2013 with 40.3 million total streaming members, who logged almost 5 billion hours of viewing. On the surface, both of those numbers show that its business is very strong. But it's the data underneath those numbers that set the stage for the future. Because Netflix knows what people watch, when they watch it, and for how long, it's able to optimize its library of content. In addition, when it's time to negotiate for the price of the content, Netflix knows exactly how much it can pay and still earn a healthy return. And as we've seen in the past, Netflix is willing to walk away from deals if they don't meet management's requirements.

Over the years, Netflix has used its advantage to become one of the most recognizable brands in the United States. And now the company is going global. Although there are still plenty of challenges ahead, and I am sure there will be bumps along the way, Netflix offers plenty of promise to long-term investors. Analysts expect $8.55 billion in sales five years from now and $1.82 billion in EBITDA -- 14.4% and 39.7% annual increases, respectively. That type of continued growth will translate into excellent returns in 2014 and beyond.

The Foolish bottom line
I don't expect Netflix to generate 298% returns again in 2014. But it doesn't have to. Reed Hastings and Co. are running the business for the long term. People can stream entertainment with just about any device they want without paying an arm and a leg. And by offering a wide selection of titles, along with a great viewing experience, Netflix will be able to attract new members in the coming years and keep them coming back month after month. And as the company grows, its financial performance will continue to improve.

As someone who looks to own shares of outstanding companies for the long term, I think Netflix is an excellent opportunity for like-minded investors. When I recommended buying shares of Netflix in the summer of 2012, I was really excited about the company's new direction as a streaming video provider. I'm still excited today, and believe it has a lot of growth ahead of it in the future.

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Read/Post Comments (11) | Recommend This Article (32)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 21, 2014, at 1:17 PM, AceInMySleeve wrote:

    A lot of people drew the wrong conclusions from the price changes. What it proved is that people weren't nearly as attracted to DVD as streaming. When forced to pay fully for them both, it was the DVD numbers that dropped rapidly, streaming dipped but recovered within 6 months. Netflix already knew this because almost nobody was signing up for DVD by itself at that point. The damage to Netflix's brand wasn't nearly as severe as Wall Street thought because the average consumer was not nearly as exposed to the media and stock news surrounding the whole episode.

  • Report this Comment On January 21, 2014, at 8:33 PM, notleyfool wrote:

    changing net neutrality laws make me skeptical netflix can continue with the same optimistic outlook from 2013.

  • Report this Comment On January 21, 2014, at 10:59 PM, enginear wrote:

    Sadly, Netflix is not anywhere you want to use it. I'm in Hong Kong, and its a noshow (at this point).

    I miss it terribly - Great company though.

    I think the market did overreact to the (admittedly) botched streaming/DVD split and pricing debacle, and don't think those type of gains are available again, but its a solid company and should do well.

  • Report this Comment On January 22, 2014, at 5:54 AM, The1MAGE wrote:

    The market way overreacted to Qwickster, and the price change, and the lack of profits due to growth.

    I joined right about the time they split the service. I really wasn't interested in renting DVD's.

    I thought that was a great time to buy more, but I just wish I had bought more then I did. (Hindsight. Don't we all wish we could invest retroactively?)

    The stock came back like I expected, but it was quicker then I thought it would be.

    Right now it looks like it is dropping. It broke it's upward trend at the beginning of the year.

    I could see it dropping further, but I can't guess how much. If it drops too much, I will buy back what I sold some, mostly because it had become too large a portion of my portfolio.

    I can see this stock quadrupling from where it is right now, in the next 5 years, as the new markets it has entered, and will enter, become profitable.

  • Report this Comment On January 22, 2014, at 1:40 PM, 407rotorhead wrote:

    I understand and am excited about going global. Does the content go with subtitles or language specific? Or are we talking buying content from other sources specific to that culture.

    Also, what about connectivity? Is it better overseas or not?

    I understand that Amazon provides all the servers for NFLX. Is this a fixed cost or does it fluctuate? How will that work for overseas?

  • Report this Comment On January 22, 2014, at 2:44 PM, AceInMySleeve wrote:

    rotorhead, a few answers. I am also excited about global. However, Netflix has progressed slower there than I expected and I think it's because UK was tough, and Latin America was ridiculously tough.

    Netflix mixes in local and American content. I think it's a 20/80 mix or so, but I might have made that up. I've always assumed they subtitle it to local languages, would be silly not to of course.

    International licensing is typically completely seperately negotiated. I believe that the smaller the studio the more likely Netflix is to obtain a license across geographies. The larger the studio, the more likely they negotiate per region.

    Netflix doesn't use Amazon's servers internationally. I think you can pretty much ignore anything technical like that in analyzing the company (it's a small cost and easily engineered). On the other hand, internet quality to consumers matters a lot. How many have broadband, what's the bandwidth, do they have download caps, etc. Canada has severe download caps. Broadband penetration isn't so hot in Latin America, and so on..

    I think 15 months after they launch in Germany and France they could have a combine 6.5M subscribers. In 5 years, I hope they exceed 50M total international. And in 10 years, I would think they could be near 70% of their total subscribers from international.

  • Report this Comment On January 22, 2014, at 4:36 PM, The1MAGE wrote:

    I believe Amazon is used more as a backup, not the main server, but that info may be out of date.

    I expect the buying for both America, and international could be bundled in the deals, leading to more income for the studios, yet a savings for Netflix over purchasing them separately.

    I see the internet growing abroad rapidly. I can see it being more like how phones grew overseas. Many countries simply skipped the land line, and went straight to cell. As a result people went from no phone, to cell phones in a very short period of time. I expect in some countries that Netflix will be some people's first cable like experience. The last place to get technology usually starts off with the best technology.

    But I am referring to less developed countries above. Many countries have, or exceed the broadband in America.

  • Report this Comment On January 23, 2014, at 3:13 AM, p3tar wrote:

    If average american is watching TV for 4 hours a day, 5 billion hours for 40.3 million subscribers is 290 days of watching.

    "Because Netflix knows what people watch, ..." - having all that data does not tell you want people wanted to watch. I spend most of my time trying to find something that's current...

    I think Netflix has big problem with their on-line content (compare DVD with what you can play now) althought their own content Orange is New Black, House Of Cards are pretty good.

    Overall I like Netflix but their stock price is scary...

  • Report this Comment On January 24, 2014, at 7:04 PM, BentMike wrote:

    p3tar, you are making the mistake of thinking you represent the benchmark for viewing preference. it is a bias you should avoid if it is holding you back from a good investment. A bunch of people take your view, but it is a narrow, self centered view. I don't intend that in a pejorative way, just an observation.

    Here's the fact to factor: A bunch of people who have different viewing habits than you do, and NFLX knows all about what they are watching. A bunch of them are children, a bunch of the adults are very different than you assume.

    There are plenty of things in the catalog that I have no interest in. But, I can take a peek at them anytime I like to see. It costs me no extra. $8 a month is very inexpensive.

    I actually think NFLX knows better what I will like than I can possibly know from looking at the stock image and single paragraph blurb. But, I spent a little time setting up my taste preferences, I have a lot of history with NFLX viewing, and have rated the ones I liked. I have been willing to try their recs, and find that they are often things I do like, but had no preconceptions about them at all. I now trust their recs, but am not expecting them to all be right.

    None of that is as easy or even possible with the closest competition AMZN and Hulu. On cable, Comcast actually is in the game a little, it is VOD, but it is very irritating to use. And the cost is quite a lot more.

    They really have no competition at just what they do, and their product is popular. Despite your protestations. If I wasn't already scraping the limits of portfolio portion I would be buying more.

  • Report this Comment On January 25, 2014, at 11:46 PM, Nanobot wrote:

    P3tar , I agree with you about content that is current. No more current movies. I am watching reruns of popular TV shows and miss the movies I enjoyed.

    I also subscribe to Amazon Prime and there movies are occasionally current (last year ) but selection very limited. You pay extra to view rerun TV and popular movies. But maybe it is worth it to see newer material.

    Yes the bottom investment line is profitability and Netflix has been amazingly profitable and probably continue to grow .

  • Report this Comment On January 29, 2014, at 10:39 AM, BishopD521 wrote:

    I am disappointed that you are currently bombarding me with requests to upgrade to SuperNova . Why would you even list the original Motley Fools Subscription if it is less of a bargain than you advertised initially.

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