For months the financial press harped that online DVD rental service Netflix (NASDAQ:NFLX) was overvalued. Perhaps that explains why the punishment was so swift a few weeks back when Netflix warned of lower earnings, citing higher marketing costs. If you ask me, people were looking for an excuse to sell.
As an avid reader and active member of Tom Gardner's Motley Fool Hidden Gems, I know that great stocks become "hidden" for any number of reasons. Granted, like another Tom Gardner favorite, Papa John's (NASDAQ:PZZA), it's a bit tricky spinning Netflix as truly hidden. But even as the earnings warning made it harder for Netflix to hide, the subsequent sell-off made it more of a gem.
What price growth?
Disclosure: I took advantage of the temporary insanity and added to my position at around $30 per share. That press release didn't faze me at all. CEO Reed Hastings gave plenty of warning that marketing costs would increase as the company resorted more to TV ads to attract new subscribers. At least partly the result, Netflix now looks to surpass $1 billion in revenue by 2006, a year earlier than previously expected. Because management has a history of lowballing, I am confident that Netflix will meet and probably beat its guidance.
What about the competition, you say? What about Wal-Mart (NYSE:WMT)? What about Blockbuster (NYSE:BBI)? What about video-on-demand (VOD), lower DVD retail prices, and the end of the world? Sure looks like the online movie rental market is getting awfully crowded.
People said the same thing in 1997 about the market for online booksellers when Borders (NYSE:BGP) and Barnes & Noble (NYSE:BKS) launched websites to compete with Amazon.com (NASDAQ:AMZN). Fast-forward a few years. Amazon now runs Borders.com, and barnesandnoble.com is still the redheaded stepchild of online booksellers. No one questions Amazon's dominance in this market.
It may be presumptuous to compare Netflix to Amazon, but I believe we can learn from precedents. Businesses that carve out attractive niches for themselves tend to be great investments because they do one thing better than anyone else. And while companies like Amazon and even Dell (NASDAQ:DELL) were once Davids of their respective industries, fighting Goliaths like Borders or Compaq, they managed to prevail because they are the best at what they do.
Casting a wide Netflix
I believe the same will happen with Netflix. Competition from Wal-Mart and Blockbuster's FilmCaddy so far has been marginal and laughable, respectively. Netflix captured a beachhead by being the first-mover, and has a four-year head start on its competition and a brand that becomes stronger with each passing day. Ironically, it will become harder for big-name Wal-Mart and Blockbuster to compete going forward. Time is on Netflix's side.
But what about VOD and cheaper DVDs? Both will gradually chip away at the DVD rental market. I contend, however, that Netflix can still grow in a shrinking market by stealing share from Blockbuster. Look at how Dell has managed to perform in an extremely difficult PC environment at the expense of its competitors.
I haven't even mentioned Hastings' plan to make movies available for download off the company's website. I find it hard to believe that Netflix will be able to compete effectively with cable companies in the VOD market, but that doesn't worry me. Here's why: To achieve $1 billion in revenue by 2006, the company needs a mere 5% nationwide household penetration.
So what if VOD takes off? Unless VOD reaches 96% penetration in this country, there is still plenty of room for Netflix to grow. And here's the best part: The company has already achieved over 5% penetration in its first market, San Francisco. Subscriber growth in its newer markets is tracking historical growth in San Francisco almost perfectly. I am convinced that Netflix's success in the foreseeable future is as inevitable as anything in business ever is. With the company targeting only 5% penetration to reach its medium-term goals, there's more than enough room for both VOD and online DVD rental in this market.
Undervalued, you say?
A gem's not a gem without the value. So fasten your seat belts as I attempt to debunk the Netflix overvaluation myth. In 2006, management expects to generate $100 million to $200 million of free cash flow (FCF). Let's take the low end of that guidance and project $100 million in free cash flow in 2006. Hastings expects the company to be growing at least 50% annually at least until 2007 or 2008.
What's a fair multiple to pay for this kind of growth? I'm going to be very conservative and assume the market will pay just 30 times FCF for 50% growth. So in 2006, the company will be worth $3 billion in the worst-case scenario. Accounting for 5% share dilution, that represents a 19% annual return from a recent price of $30 per share. In the best-case scenario, with 2006 FCF of $200 million, the company will be worth $6 billion, or more than three times what it is worth today. Granted, this is a very wide range, but even at the bottom end we are looking at market-beating returns.
There's a bigger lesson here. If a company's accrual earnings understate its cash flow, and if the company is growing fast enough, then a stock that looks to all the world to be rich can be undervalued. Netflix is a great example of how, when taken out of context, traditional valuation metrics like the trusty P/E are sometimes meaningless and even misleading. Don't be fooled again.
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Fool contributor Daniel Hong owns shares of Netflix. The Motley Fool is investors writing for investors.
