Netflix, Inc. Gets a Big Upgrade: Analysis or Farce?

On Tuesday, Netflix  (NASDAQ: NFLX  ) got a big upgrade courtesy of Goldman Sachs. The Goldman analyst team increased its price target by more than 50%, from $380 to $590, and raised its rating on Netflix from hold to buy. However, the analysis behind this upgrade doesn't square with Netflix's track record.

Goldman Sachs' international subscriber growth assumptions are thoroughly unrealistic.

The recent trend toward Netflix bulls "piling on," even after the stock has rebounded by around 50% from its early May lows, is ominous. That's particularly true given that there hasn't been any real news about Netflix during that time. Bulls may be inflating another Netflix bubble that could lead to a lot of pain when it pops.

Goldman's bold call
While the Goldman Sachs analyst team likes Netflix's positioning in the U.S., their bullishness stems primarily from an assessment of its international growth trajectory. They believe that Netflix will grow rapidly outside the U.S. through a combination of adding new markets and increasing its penetration of each market.

Indeed, the analysts believe Netflix could have 61.7 million international subscribers by 2017, up from 10.9 million at the end of last year. This would drive the international contribution margin to more than 20%, from a loss today. In that scenario, Netflix would have a 29.7% penetration rate within a total addressable market of just over 200 million households by 2017.

This stands in sharp contrast to the expectations of other Netflix analysts -- even bulls. One recent bullish analyst estimated that Netflix might have just 53 million international subscribers in 2020. Another thought Netflix might reach 70 million international subscribers by then. Even that would be well below the trend being projected by Goldman Sachs.

Back to earth
While it's impossible to predict the future with any certainty, it is generally helpful to look to the past as a guide. With that in mind, Netflix's international growth in the last four years makes Goldman's projections look quite unrealistic.

At the end of Q1 -- when Netflix had been operating in its international markets for more than two years, on average -- it had 12.7 million international members. The addressable market in the countries launching this fall is smaller than in Netflix's existing international markets. Measured by broadband households, it is about two-thirds as large. Discounting the value of a Latin American household due to lower income and poor e-commerce infrastructure narrows the gap somewhat.

Netflix hasn't shown the ability to grow as quickly in international markets as Goldman Sachs expects.

There is no reason to expect Netflix to do better in its new markets than in its existing international markets. Based on the size of the addressable market, at the end of 2016 (more than two years from now), Netflix is likely to have fewer than 12.7 million subscribers in the markets being launched this fall.

Yet Goldman Sachs projects that Netflix will have 43.7 million international subscribers by the end of 2016 (and then gain another 18 million in 2017). These estimates would require much faster growth in Netflix's new markets -- or a dramatic acceleration in growth within its current international markets.

Into the clouds
To make matters worse, the Goldman Sachs analysts proceeded to conduct an analysis showing how profitable Netflix could be if it had the same economics as premium-cable titan HBO. This analysis "showed" that Netflix could be earning $57.83 per share by 2018 -- which could justify quite lofty price targets indeed.

There's just one problem. This analysis assumes that while investing heavily in new original programming, Netflix will spend approximately the same amount on licensed content in 2018 as it did in 2013.

Considering the general inflation in content costs and Netflix's entry into new markets, this implies a sharp cutback in the licensed content available on a per-country basis. For Goldman's model to work, Netflix would have to cut lots of content without slowing subscriber growth.

Foolish conclusion
It's clear that Netflix is on a strong growth trajectory. There is plenty of room for debate about just how strong that growth will be, and how long it will take Netflix to capitalize on its international growth opportunities.

Unfortunately, Goldman Sachs' recent note doesn't do much to further this debate. Without presenting much evidence, the firm assumes that Netflix will be much more successful in its new international markets than in its current ones.

If anything, Netflix will do somewhat worse in its newest markets than in previous international launches, as it is later to market and English fluency is lower there. Goldman's assumption that it will catch on much faster than ever before leads to highly unrealistic projections.

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Read/Post Comments (8) | Recommend This Article (3)

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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 July 06, 2014, at 11:13 AM, spwangsu wrote:

    At least, Icahn made a mistake by selling his shares at $330. He missed 43% more gain up to now. Whoever can predict so accurately? What if CEO get some new idea in the next 18months? Those are unpredictable. GS may not be 100% accurate. How about Barclay ? Not to mention your fools.

  • Report this Comment On July 06, 2014, at 11:32 AM, TomEarnest wrote:

    We need inexpensive, quality internet for these services to travel on and it is difficult to find in a small town. Cable is not going to give up their control and the phone system has not got the speed.

  • Report this Comment On July 06, 2014, at 12:09 PM, eticket wrote:
  • Report this Comment On July 06, 2014, at 12:09 PM, eticket wrote:

    Finally, some reality enters the picture regarding NFLX. To be mundane: most people would like to be movie stars, including those at GS. So, hype into NFLX. It was impossible to disregard the little fireworks show that NFLX placed on the charts at the closing moments on July 3rd.

    But like all Roman Candles, the debris eventually falls back to earth ( hopefully without causing damage). Perhaps NFLX recent arrogance - a desire to turn the UN Security Council chambers into a prop to boost its share price is an indication of things to come. Roman Candles coupled with arrogance makes for a risky situation. Perhaps this is what GS was really drawn to. Curious to know if any GS associates are shorting NFLX at this time.

  • Report this Comment On July 06, 2014, at 5:50 PM, wchildres wrote:

    I believe Icahn sold only 25% of his Netflix holdings. He still holds over 2 million shares.

  • Report this Comment On July 07, 2014, at 10:20 AM, AceInMySleeve wrote:

    "Netflix would have a 29.7% penetration rate within a total addressable market of just over 200 million households by 2017."

    just over 200M sounds low.

  • Report this Comment On July 07, 2014, at 6:00 PM, TMFGemHunter wrote:

    @Ace: that was just international, in case it wasn't clear. And addressable market just counts broadband households. That's going to be 150-160 million at the end of this year.

    What happens next depends on how aggressive Netflix is. I believe the Goldman analysis expects expansion into Southern Europe next year, and then Australia/New Zealand/South Korea in the 2016-2017 period. There is probably some upside there. Netflix could enter Japan, which is the only other big broadband market among wealthy countries. That seems to be the only way to get materially beyond a 200-210 million household TAM, unless Netflix cobbles together dozens of small markets.

    Adam

  • Report this Comment On July 07, 2014, at 6:54 PM, AceInMySleeve wrote:

    International will be higher than 160M this year as you are quoting typically older numbers and this is a rapidly growing number in Lat Am. Also, while it seems that analysts have converged on using wiki (or it's source) for fixed broadband lines that doesn't necessarily imply it's the best estimate. Mobile broadband (a much higher number) may be sufficient for some customers.

    But yes, I expect them to maintain a more substantial growth rate than 40M in 3 years following this one. There's a lot of world left out there.

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