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Netflix Analysis and Valuation
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By investorpoet
July 17, 2007

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I first bought Netflix (NASD: NFLX) in October 2003, and it has been quite a wild ride. The financials have only gone in one direction, that of constant improvement. The price of shares and the news reports, however, have been all over the place. I haven't taken a close look at the company since January of this year, but since then their growth has been impacted greatly by Blockbuster's (NYSE: BBI) Total Access program. As the second quarter results approach, it's time for me to take a closer look at the company and its prospects.

About the Company

Netflix is a fairly easy company to understand. Their business model is direct and straightforward. The industry in which they operate is a little more difficult. Netflix provides subscription DVD rental services. A customer pays a flat monthly fee and is then entitled to have a certain number of DVDs in their possession. When they mail one back, they receive their next disk. Netflix now offers a Watch Now feature that allows users to download streaming video of movies direct to their computer. Currently subscribers are allowed to view as many hours as dollars they pay per month. If you are on the $17.99 plan, you get to watch 18 hours of streaming video per month.

Netflix currently has 6.8 million subscribers to their service, and they have always reported solid customer satisfaction numbers. I have tried their service and was completely satisfied. The DVD selection is truly unmatched. If it has been published on DVD, they have it. One of the big questions surrounding the company has always been one of market potential. Is the total market for this service 10 million subscribers, 20 million, or 40 million? Blockbuster reported that at the end of the first quarter, they had 3 million Total Access customers. Combined the two companies have 10 million subscribers.

There are so many options for entertainment and only so many hours available. Do households watch cable? surf the internet? watch DVDs? use video-on-demand? Is there still growth in the by-mail DVD rental business? It is obvious now that there is no growth left in the video store model as Movie Gallery is on the verge of bankruptcy, and Blockbuster recently closed almost 300 stores. Netflix also faces competition from download services provided by Amazon and Apple. These are not rental services, but another delivery method for movies. Does the future hold another competitor for download-on-demand movie rental that can compete with Netflix on price? There are many questions facing Netflix, and it is reflected in their stock price.

The History

Netflix has shown tremendous revenue growth over the past several years, though it slowed a bit in 2006.

(in millions)           2006    2005    2004    2003    2002
Revenues               $996.7  $682.2 $500.6  $270.4  $150.8
Cost of GS             $627.0  $465.8 $331.7  $180.4   $97.5
Gross Profit           $369.7  $216.4 $168.9   $90.1   $53.4
Marketing              $225.5  $144.6 $100.5   $51.5   $37.4
Other Expenses          $63.8   $63.5  $46.6   $32.0   $36.9
Taxes                   $31.2  -$33.7   $0.2    $0.0    $0.0
Net Earnings            $49.1   $42.0  $21.6    $6.5  -$20.9
Dep & Amort            $157.1  $107.0  $88.2   $51.0   $26.5
Capital Expenditures    $27.9   $28.1  $15.7    $8.9    $2.8
DVD Library Acqu.      $156.7  $105.7  $94.5   $53.8   $22.1
Owner Earnings          $21.6   $15.2  -$0.4   -$5.2  -$19.3
Shareholder Equity     $414.2  $226.3 $156.3  $112.7   $89.4
Shares Outstanding       69.08   69.02  64.70   31.45   28.20
                                             
Owner Earn./Share      $0.31   $0.22   -$0.01  -$0.16  -$0.68
Gross Profit Margin    37.1%   31.7%    33.7%   33.3%   35.4%
Net Profit Margin       4.9%    6.2%     4.3%    2.4%  -13.9%
Return on Equity       21.7%   26.9%    19.2%    7.3%  
YOY Rev Growth:        46.1%   36.3%    85.1%   79.3%   


There are a couple of things that I like to focus on when looking at these statements. The first item is the marketing expense. The infrastructure that Netflix needs is in place, so the business should scale very well and require little investment going forward. The marketing expense that Netflix incurs is management's investment in the future of the company. It is largely a discretionary expense, and management has indicated that they spend marketing dollars to target an earnings number. There have been quarters where Netflix could not find cost-effective advertising, resulting in an inflated earnings per share number well above analyst estimates.

The second item I focus on here is the DVD Acquisition expense. This is treated as a capital expenditure on the cash flow statement. I'm always reluctant to penalize a company for investing in growth, and I think a certain percentage of these DVD acquisitions are to service their growing subscriber base. Every year new DVD titles are added to the library that Netflix offers. This will be an ongoing "maintenance" capital expenditure. A smaller percentage of these DVD acquisitions are "growth" capital expenditures. There needs to be some methodology for determining what is growth and what is maintenance. I had been assuming that 25% of this total is related to growth, and backing this out to yield a more representative owner earnings number. Little growth is expected over the next couple of quarters, so I may have a chance to pin this number down a bit more.

After adjusting for subscriber growth DVD acquisitions, I get the following owner earnings numbers:

(in millions)     2006     2005     2004     2003     2002
DVD Lib. Acq.   $156.7   $105.7    $94.5    $53.8    $22.1
Owner Earnings   $21.6    $15.2    -$0.4    -$5.2   -$19.3
% Growth Capex     25%      25%      25%      25%      25%
Growth Capex     $39.2    $26.4    $23.6    $13.4     $5.5
Adj. OE          $60.7    $41.6    $23.2     $8.3   -$13.8
Adj. OE/Share    $0.88    $0.60    $0.36    $0.26   -$0.49


As an investor, I will happily take the marketing expenses at a reasonable price and the growth related DVD acquisitions provided that they yield additional growth in the future. Netflix management has been effective in leveraging their DVD and marketing expenses into new subscribers so far in their history.

Netflix Quarterly Guidance and Seasonality

Netflix management has indicated that there is some seasonality to their growth. I looked back to find out if this was the case. See below:

2005               Q1      Q2       Q3        Q4
Subscribers     3.018   3.196    3.592     4.179
Revenue        $154.0  $164.5   $174.3    $195.0
QoQSubs           16%      6%      12%       16%
YoYSubs           56%     53%      61%       60%
QoQRev             7%      7%       6%       12%
YoYRev            54%     37%      23%       36%
                                    
2006               Q1       Q2      Q3        Q4
Subscribers    4.866     5.169    5.662     6.316
Revenue        $224.1   $239.4   $256.0    $277.2
QoQSubs           16%       6%      10%       12%
YoYSubs           61%      62%      58%       51%
QoQRev            15%       7%       7%        8%
YoYRev            47%      47%      47%       42%
Market/GP         59%      53%      61%       61%
                                    
2007               Q1     Q2G      Q3E       Q4E
Subscribers    6.797    6.800    7.100      7.400
Revenue        $305.3  $303.0   $305.0     $307.0
QoQSubs            8%       0%       4%        4%
YoYSubs           40%      32%      25%       17%
QoQRev            10%     m-1%       1%        1%
YoYRev            36%      27%      19%       11%
Market/GP         70% 


I have also included Netflix second quarter guidance in this table and estimated the third and fourth quarters based on full year guidance. You can see that Blockbuster's Total Access program is really doing some damage to the growth of Netflix. Reed Hastings, CEO of Netflix, has indicated that he believes that Blockbuster's program is unsustainable, but he has reduced guidance based on the assumption that Blockbuster will not raise their prices for the remainder of the year.

An analysis of Netflix really necessitates an analysis of Blockbuster's balance sheet and cash flow statement. I am not going to provide that here, but I will provide several scenarios in my valuations.

Netflix Valuation

As a starting point, I plan to use my adjusted owner earnings number of $67.7 million as noted above. If Blockbuster can sustain their prices, they may well outpace Netflix. This is a big IF here as Netflix has almost $400 million in cash, no debt, and a light business model. Blockbuster has $182 million in cash, $887 million in debt, and about 4,000 stores to pay for. I will grow Netflix's owner earnings at 5% for the first five years, 3% for five more years, and then use a reversionary P/E of 12. This results in a value of $13.50 per share. Add back their cash of $5.70 per share and the total value is $19.20 per share.

Based on the guidance that Netflix has given, their year over year growth this year will be approximately 11%. Keeping the same assumptions as above yields a total value of $20 per share. These seem to be the assumptions that the market is using to price Netflix shares.

If Netflix can keep up a growth rate of 12% for five years followed by 5% for five years and a reversionary P/E of 20, their total value is equal to $31 per share. None of these valuations take into account the large amount of free cash that could be moved from marketing to the bottom line. Netflix spent $225 million on marketing last year.

Conclusion

Netflix is currently priced as if their competition with Blockbuster will result in a permanent stalemate. With Movie Gallery's impending demise, Blockbuster may have more customers to draw in to Total Access, and more cash to continue their marketing push. I'm more skeptical of Blockbuster's longevity as a serious competitor. Beyond Blockbuster, though, there remains more competition for Netflix.

Netflix has shown some tremendous growth over the past five years, and they have a very light business model. Watch Now is just getting up and running, but showing some signs of success. There could be quite a bit of upside to Netflix shares.

I'm ambivalent about adding more shares for now. I want to see a couple more quarters from both Blockbuster and Netflix before I do anything. It feels too speculative right now. Maybe it is a calculated bet based on the cash Netflix has on hand. We may not know until the end of the year.

All my pretty tables are at: http://www.odysseyroad.com/weblog/?p=43
Other Stock Research: http://www.odysseyroad.com/weblog/?cat=15


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