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Netflix Just Had a Great Q1. Is the Stock Getting Too Expensive?

By Royston Yang – Apr 29, 2020 at 1:39PM

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The coronavirus pandemic may cause people to permanently alter their TV-watching habits.

The COVID-19 pandemic has altered habits and routines like never before. With strict lockdowns in place all across the world and air travel severely curtailed, most people are stuck at home hunkering down while authorities scramble to contain the virus.

For companies such as Netflix (NFLX 0.91%), the current crisis has been a boon for business. The video-streaming, subscription-based media company reported a record 15.77 million net additions during its first-quarter fiscal year 2020 earnings report, significantly higher than the 9.6 million added in the same period last year. Revenue grew 27.6% year over year while net income more than doubled from $344 million to $709 million.

It seems Netflix is on a roll as it adds a whole new chunk of subscribers who are forced to stay home and have nothing better to do than binge-watch television. The stock is up nearly 29% year to date.

The question now is: Is the stock getting too expensive?

Family sitting on sofa watching television

Image source: Getty Images.

Consistent subscriber growth

Netflix Subscriber Numbers and Additions

Sources: Netflix 2019 10-K Report; Q1 2020 Shareholder Letter. Chart by the author.

If we take a look at the paid membership growth over the last five years, a pattern emerges. Netflix has consistently been enjoying higher net additions of members since 2015, with the numbers flattening somewhat from 2018 to 2019. This observation not only tells us that Netflix is effective in constantly adding subscribers, but that it has also managed to accelerate the pace of its additions as it builds up its library of content.

At a glance, it's obvious that the Q1 2020 net additions of 15.77 million seem like an anomaly. Total net additions for the whole of 2019 came up to 27.8 million, so the huge jump in additions for Q1 2020 was almost exclusively due to the lockdowns imposed both in the U.S. and globally due to the coronavirus. The earnings commentary did mention that membership growth has temporarily accelerated due to home confinement. However, it remains to be seen if this new batch of members will continue to stick with Netflix after the confinement period is over, or if they will drop the subscription.

The problem with habits

Human behavior is such that habits can be easy to form but tough to break. For people who have signed up for streaming services, whether it be Netflix, Disney+ by Disney, or Apple TV by Apple, they may find that the convenience and ease of streaming entertainment offers them an additional option for leisure and relaxation. Even when the lockdowns are lifted, this habit may still stick around as it opens up a new lifestyle option.

Furthermore, the cost of a streaming subscription is quite manageable for most households, and there is also history showing that people suffer from inertia when it comes to opting out of subscriptions. This is why many countries have an "opt-out" policy for organ donation rather than opt-in -- most people will just accept the status quo and not bother to actively opt out when it comes to donating their organs (upon death), thus significantly increasing donation rates. When applied to subscriptions, this logic also holds as many may not bother to actively cancel their subscriptions, especially if they view the content as being entertaining and desirable.

Valuation seems high in the short term

Netflix's valuation may seem high, as it is trading at a trailing 12-month price-to-earnings ratio of around 86. However, as the above evidence suggests, the subscriber growth that has fueled the stock price surge and high valuation may not be ending anytime soon for Netflix. Netflix has already demonstrated a strong track record of subscriber growth. The pandemic may permanently push more people to sign up for live streaming services -- a situation where all the streaming players benefit.

There are a couple of caveats to factor into any assessment. Government lockdowns have meant that most of Netflix's new content production has been paused around the world. As no one knows when physical production can restart again, it will eventually cause some disruption for the company's content production cycle and limit its library of original programming. Though this may mean less new content to attract and retain more members in the near-term, many other streaming players are in the same predicament.

Also, with lower capital expenditure needs in the near-term, the company has also started generating free cash flow, with close to $160 million generated in the current quarter alone. But investors should note that Netflix's debt burden is expected to remain high as it needs to continue to spend on new content and other expenses. The company may need to borrow more to fund this spending, but I see this as a positive as it helps Netflix can stay ahead of its competition.

Expect net subscription additions to taper off in the next few quarters after this one-off surge, but consider that they could remain above average pre-pandemic levels as people's habits change. With more original programming always being planned, the growth in membership should continue to power Netflix's earnings. With more "sticky" customers, the company also has the option of raising its fees gradually. The price-to-earnings ratio is elevated as earnings take time to catch up with the stock's valuation, but I am confident that Netflix's continued long-term growth prospects justify purchasing the stock right now, even at its high valuation.

Royston Yang has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple, Netflix, and Walt Disney and recommends the following options: long January 2021 $60 calls on Walt Disney. The Motley Fool has a disclosure policy.

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Netflix, Inc. Stock Quote
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Apple Inc.
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The Walt Disney Company Stock Quote
The Walt Disney Company
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