Netflix (NFLX -3.92%) is a very particular stock. The video streaming leader is firing on all cylinders, and it seems truly unstoppable in its quest for world domination. On the other hand, it is facing rising competitive pressure in the middle term, and the stock is priced for aggressive expectations, which is always an important risk to watch. Let's take a look at what Netflix has to offer to investors in terms of risk versus potential reward in the years ahead.
The star of the show
The online streaming revolution is a well-established global phenomenon, and it will provide spectacular opportunities for growth over the coming years. Netflix is at the same time a major driving force behind this trend and also the leading beneficiary of it.
The company has 74.76 million streaming members around the world, gaining 5.59 million new members in the last quarter alone. International markets are powerful growth engines for Netflix, having added 4.04 million international members last quarter, and ending 2015 with 30.02 million international members versus 18.29 million in 2014.
Data source. SEC filings.
Netflix is now available everywhere in the world except China. It recently added 190 million broadband homes to its addressable market on top of the 360 million it counted at the end of 2015. With a total addressable market estimated at 550 million homes and nearly 75 million members, Netflix is still barely scratching the surface in terms of capitalizing on its long-term market potential.
The company is planning to release 600 hours of original programing in 2016, a major plus for Netflix. Original content has been particularly successful among subscribers, and it also differentiates Netflix from the competition, providing a tremendously valuable source of competitive advantage in a growing and dynamic business.
Netflix is solidly profitable in the U.S., where it reported a contribution margin of 34.3% of revenue last quarter. In global markets, however, it is operating in the red due to big investments to sustain growth, and this will probably continue weighing on overall financial performance over the middle term.
The risks
If Netflix proves that it can deliver both rapid revenue growth and expanding profit margins in the coming years, then the future looks brilliant for investors in the company. On the other hand, it is investing huge sums of money in international markets, and it's hard to tell at this stage what levels of profitability it can produce in these countries.
Success, of course, attracts competition. Netflix is already facing increasing competitive pressure, and it will only intensify in the future. Amazon.com (AMZN -1.64%) looks like a particularly important threat due to the quality of its original content and its ambitious growth strategy. Original productions from Amazon Studios have been acclaimed by both viewers and the critics. While Amazon does not disclose numbers for its streaming members, it said in its latest earnings release that Amazon Prime Video ended 2015 with nearly double the streaming customers it had in the fourth quarter of 2014.
Time Warner (TWX) is now offering HBO as a stand-alone streaming service via HBO Go. Needless to say, HBO is home to massively popular blockbusters such as Game of Thrones, so it has a solid chance of making big inroads in the streaming business. Time Warner is pricing HBO Go at a premium price of $15 per month, substantially higher than $9.99 standard Netflix plan, and this is probably related to the pricing power that HBO content provides for Time Warner.
Growing competition is not necessarily a good enough reason to stay away from Netflix. The online streaming industry should offer enough opportunities for multiple companies such as Netflix, Amazon, Time Warner, and several others to do well in the long term. Just like traditional TV has allowed many companies to succeed over the years, there is no reason to expect streaming to have only one winner. However, investors should not disregard the risk that increased competition could mean for an industry pioneer such as Netflix in the middle term.
Also, Netflix stock is priced for demanding expectations, and this makes the company vulnerable to any potential disappointment down the road. As a reference, Netflix stock trades at a price-to-sales ratio around 6 versus a price-to-sales ratio of around 2 for Time Warner. Netflix most certainly deserves a valuation premium because of its extraordinary growth potential, but this clearly represents a source of risk and volatility for investors.
Should you buy Netflix?
Wall Street analysts and the financial media typically have a simplistic approach to investing. Most stocks are generally characterized as "buy" or "sell," and this leaves several important variables out of the equation. A stock is not just a good or bad idea. It may be the right choice for one investor but the wrong one for someone else.
At the end of the day, it all depends on factors such as your risk tolerance, the kinds of returns you are looking for, your overall investment strategy, and what you think about Netflix as a business.
Some investors gravitate toward big and predictable corporations that consistently deliver free cash flow and reward shareholders with generous capital distributions via dividends and buybacks. In that case, you should stay away from Netflix. The company's earnings will be hard to predict over the coming years due to heavy investments for growth and most of its cash flows will be reinvested in areas like content and technology.
On the other hand, if you are willing to tolerate above-average volatility in order to invest in an explosive growth story with massive long-term potential and a world-class management team with a proven track record, then Netflix looks like a smart choice for your portfolio.
