Streaming video veteran Netflix (NFLX 0.42%) has sent its investors on quite a ride recently. Just before July's second-quarter earnings report, share prices had soared an incredible 171% higher in 52 weeks. But the company fell short of its own subscriber addition targets, and market makers were quick to punish its stock. Today, Netflix is trading more than 20% below the all-time highs it set just three weeks ago.
Does this mean investors should flock to Netflix at a 20% discount, or is it time to cash in your still-impressive yearly gains to find better investments elsewhere?
Image source: Getty Images.
Incontrovertible proof of the coming crash!
At first glance, the bears must be right.
The stock has still provided an 82% one-year return, leaving investors to ponder some meaty valuation ratios. Today, Netflix shares are trading at 140 times its trailing earnings, or 77 times forward estimates, not to mention 10.7 times the company's annual sales, or 32 times its total book value. Don't ask me about cash flow ratios, because Netflix is running in the red when it comes to cash profits.
Moreover, bullish Netflix investors like yours truly often trot out skyrocketing subscriber gains as support for valuations that seem crazy from a financial point of view. So, what does it mean when even that last-ditch safety blanket comes up short? Surely, we're looking at the end times for Netflix's nosebleed valuations. The house of cards must tumble and fall.
Why that subscriber miss didn't change my mind
First glances rarely tell the whole story. In this case, Netflix bears are making a mountain out of a gentle slope.
Yes, Netflix missed its internal subscriber-growth targets in the second quarter. As a shareholder myself, I'm comfortable with this miss for three reasons:
- Management had expected to add a net of 6.2 million subscribers in the second quarter, but it stopped at 5.2 million instead. In an off-season period, while competing for consumer attention worldwide with the soccer World Cup, that's not too shabby in my book.
- Seen from a wider perspective, Netflix boosted its global subscriber base by 25.2% over the last year. Hitting the guidance target would have resulted in a 26.2% increase instead. That's the difference between the targeted 131.1 million users and the actual 130.1 million result. Hardly a deal-breaker, as the company's growth remains healthy and impressive even in this purported failure of a quarter.
- Some companies like to set their guidance targets low in order to impress investors with a big surprise. Netflix claims to do it differently by sharing its own internal target metrics instead. So, the company sets itself up for the occasional misfire, either above or below its stated goals. I'm OK with this.
Looking back, Netflix exceeded its guidance targets in each of the last four quarters before this report. The upside surprises ranged from 0.9 million to 2.03 million, totaling 5.99 million more subscriber additions than expected over that full-year span. Management got a bit ahead of itself this time, but the current four-quarter total still stands at 4 million new subscribers above the official guidance targets.
What about the silly financial metrics?
As for the profit-based valuation metrics, I'm convinced we will see them sink back to reasonable levels over the next few years. Netflix is already pushing its bottom-line earnings through the ceiling thanks to a 39% segment-level profit margin in the domestic division and maturing operations in key markets around the world.
NFLX Normalized Diluted EPS (TTM) data by YCharts.
Free cash flows will remain negative for a couple of years because Netflix is spending billions to create an award-winning portfolio of original content across basically every genre you could name. That comes with large cash costs up front but also with a couple of important benefits. Netflix is becoming less and less dependent on buying content licenses from other studios, inoculating itself to sudden price increases and other gamesmanship tactics.
These original shows and movies will remain Netflix's property for the long term, allowing the company to benefit from the brand loyalty that springs from a top-shelf content library -- and the cash bills are already paid. The idea is to see the balance between cash costs and revenue growth reverse in the early 2020s, and then the price-to-whatever ratios will start to make sense.
Long story short: Netflix is a no-brainer of a buy
No crystal ball is perfect (and if you have one of those, I've got some business ideas...). There is nothing wrong with this stock or the underlying company, and the skyrocketing growth story continues.
All things considered, the conclusion is crystal-clear: Yes, Netflix is a buy today. New investors are buying into a long-lasting entertainment giant in the early years, and that 20% is just gravy on top.
