NFLX still Undervalued

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By daniel1202
October 13, 2003

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I'm going to go out on a limb here and make the argument that Netflix is still undervalued, despite its almost 100% appreciation since David's recommendation in the Motley Fool Stock Advisor.

Here's my reasoning. Netflix management has said on several occasions that their long-term goal is 5% market penetration, $1 billion in revenue, and $200 million in FCF. They think they can achieve this in the next 5 years, by 2009 or so. So far, management has lived up to and in fact exceeded all of its projections. As long as the business model remains viable (and I think it will for the foreseeable future), I am inclined to believe that management can at the very least meet its projection for $200 million in FCF by 2009.

I am also going to use a fairly low discount rate for my DCF model: 12%. Why? Because so far, I have every reason to believe that Netflix's business model will succeed for the foreseeable future (which I define as 5 years or so). Competition from and Blockbuster's so far has been unworrying and laughable, respectively. Video on demand is still very limited in its current form. VOD offers 100 titles at most, and most of these are new releases. Netflix targets a slightly different market (I remember reading somewhere that 80% of Netflix's rentals come from 2000 titles, while 80% of Blockbuster's rentals come from 200 titles; I'll try to dig it up for you guys), and VOD can never hope to compete with Netflix on its breadth of selections. Basically, I see relatively little risk in Netflix's business model, and I'm comfortable applying a 12% discount rate.

Over the last 6 months, NFLX has generated $36.4 mm in operating cash flow and incurred $26.4 mm in capital expenditures (including DVD acquisition costs). Projecting the same trend over the full year gets us $20 mm in FCF for 2003.

Here's my DCF model:

($ in millions)
This model assumes that cash flows come at the end of the year.

                     2003   2004   2005   2006   2007   2008   2009
FCF                   $20    $29    $43    $63    $93   $136   $200
1st Year Adj. (1)    -$15
Adj. FCF               $5    $29    $43    $63    $93   $136   $200
Discount Time        0.25   1.25   2.25   3.25   4.25   5.25   6.25
Discount Factor     0.972  0.868  0.775  0.692  0.618  0.552  0.493
PV of FCF              $5    $26    $33    $44    $57    $75    $99
Sum of PVs of FCF                         $339
Terminal Multiple of FCF = 15 x
Implied Terminal Growth Rate (2)= 5%
Terminal Value = $3,000
PV of Terminal Value                    $1,477
Enterprise Value                        $1,816
Plus Cash                                  $71
Equity Value                            $1,887
Shares Outstanding                          24
Equity Value per Share                  $78.62
Current Price                           $44.65
% of Intrinsic Value                        57%

(1) 1st Year Adjustment subtracts cash flows that have already been realized by shareholders. Of the $20 million in FCF Netflix is expected to generate in 2003, $15 million have already been realized in the first 9 months of the year. In the remaining three months, shareholders can expect to earn the remaining $5 million in FCF.

(2) The implied terminal growth rate is the rate at which Netflix would have to grow FCF in perpetuity to justify a 15x exit multiple. 5% is a reasonable terminal growth rate, making 15x a reasonable exit multiple.

I've been a shareholder of Netflix since $22 a share. I'm very seriously considering buying some more even at these prices.

Any thoughts?


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