To some of us market watchers, Netflix (NASDAQ:NFLX) looks like a rocket stock for the ages. For others, it's an unsustainable fairy tale that can't have a happy ending. Analyst firm Bernstein recently started coverage of the streaming media stock, noting that it's a tremendously polarizing ticker.
Quoth Bernstein analyst Todd Juenger:
A wise investor once remarked to us: "If Jesus were a stock, he'd be Netflix. You either believe or you don't."
We think that analogy perfectly captures investor attitudes on this stock. In fact, we would take it even farther.
Like any belief based on faith, we don't think there are any arguments based on currently observable, factual evidence that could be made to convert believers into non-believers, or vice-versa. There is no new mathematical algorithm we can put forth, no new way of looking at churn or forecasting content spend or ARPU, that will incontrovertibly solve the debate.
Juenger lands firmly on the side of the believers, setting an outperform rating on Netflix shares with a Street-high price target.
He's right, you know. Netflix has almost single-handedly created a global market for digital video streaming services, complete with a well-managed domestic market around all other efforts can be designed to emulate. The pure media licensing business has evolved into a big play on original content. Plenty of competitors have followed suit, both in America and overseas, but none have come close to matching Netflix's massive first-mover advantage.
How could Netflix grow into that $62 billion market cap?
Like Juenger and all the other Netflix believers, I am convinced that Netflix will do more than simply living up to its current market value. Let me show you how.
Netflix is burning through a lot of cash these days. Streaming content licenses and in-house productions can be expensive, and those cash costs reached billion-dollar territory back in 2011. Operating cash flows turned negative in 2015, and will continue sinking deeper into the red for a few more years. Management is financing this costly habit by raising debt as needed. All of this works out to a major deal breaker for many Netflix critics.
Not for me, because I see this as Netflix investing in its long-term future.
The company is spending money now in order to make it back with plenty of interest a few years down the road. The growing portion of in-house productions is important here, because those are immediate cash expenses that produce company-owned content with lasting value.
Think of it like building an apartment complex with cash and mortgage loans, and making that investment back with generous long-term returns by renting the apartments out. Netflix is producing head-turning content to bring in now subscribers and keep the current customer list interested. No apartment complex, no rental revenue. No Orange Is the New Black and Stranger Things, no committed viewers willing to pay a global average of $8.80 per month for Netflix streaming services.
The strategy is particularly effective if the company can create stuff that appeals to a global audience, since the current headcount of 93.8 million subscribers works out to less than 6% of the global TV market. There's a ton of growth potential ahead of the company in a market that it largely created and defined.
Netflix also has lots of pricing power. The average monthly subscription fee per customer rose 12% in 2016 to $8.80. That included a 15% domestic boost and 11% higher international fees. And yet, the subscriber counts marched 25% higher. Higher prices did not result in lower or slower customer additions.
A snapshot of Netflix in 2027
Keep in mind that the streaming service has only existed for 10 years, and became a separate business unit in 2011. Introducing that service took guts, as it eventually made the old DVD-mailer business obsolete. DVD revenue amounted to just 7.7% of total sales in 2016, down from 31% in 2012 and all of it in 2010.
In other words, Netflix has already confronted the notorious innovator's dilemma and lived to tell the tale. This could happen again, if someone comes up with an even better way to distribute and consume video content. And Netflix would most likely stand ready to embrace the new entertainment paradigm, and may even have started the next revolution as well.
Assuming that the next disruptive upheaval is more than a decade away, Netflix of 2027 would have turned the negative cash flows upside down a while ago as the early content investments turned into revenue-producing eyeball magnets with near-zero maintenance costs. The company will still be producing new stuff and additional seasons for older hits, of course, but the overall balance between content costs and the top-line benefits they unlock will have swung over to the profitable side.
Many consumers will think of Netflix as a studio first and a streaming service second, with profitable side businesses in royalty-bearing jammies and lunch boxes as well as some syndication revenue from Netflix shows presented in what's left of the traditional cable TV model. If Netflix hasn't started building a theme park and brand-heavy hotel resorts yet, it must at least be planning to copy that page from the Walt Disney playbook.
The addressable market will only grow as people in developing nations get their hands on broadband services capable of Netflix-style video streaming. Netflix will raise prices to keep up with inflation -- and to boost its profit margins, too. Analysts have come up with various future subscriber counts, ranging from 140 million to 230 million in 2025 and 291 million by 2030.
These estimates inevitably lead to 2027 revenue in the neighborhood of $30 billion, with generous profit margins. Domestic streaming margins already stand at 34%, and management sees no reason why international margins wouldn't eventually follow suit.
Setting my crystal ball at the conservative side of those projections, I end up with a $150 billion market cap in 2027, or 9.5% compound annual returns for the next decade. If anything, my estimates are erring on the timid side, and Netflix could end up much larger and more profitable than that.
So that's why I agree when Bernstein's Netflix analyst says that the company's market value is "absurdly low" today. I'm preaching to the choir and don't expect any skeptics to change sides on my behalf, but Netflix is just getting started, and you really should make sure to get a piece of that long-term action.