I hate to say, "I told you so," but it does feel good to be right.
In its third-quarter report last night, Netflix (Nasdaq: NFLX) seemed to go out of its way to show how closely management's thinking aligns with my theories of how the company is managed. Let's walk through the evidence, point by point:
- "By every measure, we are now a streaming company that also offers DVD-by-mail," said CEO Reed Hastings. Streaming is not only a top priority for Netflix now, but also the majority of what it does for a living. This outcome was only a question of time ever since the company was started.
- "Earnings is a managed outcome," said CFO Barry McCarthy. When I tell you that earnings figures don't mean anything for Netflix investors, I'm often rebuffed with reminders of the dot-com bust, of how Sirius XM Radio (Nasdaq: SIRI) justify their investments despite a lack of earnings, and similar counter-arguments. But the reality is that Netflix can and does control exactly where its earnings are going to land in every quarter, and it's done by adjusting the twin levers of marketing and content acquisition.
- Streaming licenses are a fixed cost, albeit one that gets higher every time expiration dates and renegotiations come up. Hence, subscriber growth is how Netflix builds its business, not in terms of a cash hoard but rather in more compelling content that leads to even more subscribers down the road.
- This phenomenon plays out in the updated guidance: Netflix upped the expected subscriber count and the concomitant revenues, but kept the earnings targets constant. Why? Because any superfluous monies left over toward the end of the income statement will go toward some combination of more marketing and more streaming licenses before hitting the bottom line.
Bigger and bigger
According to network equipment provider Sandvine, Netflix video streams already account for 20% of all Internet bandwidth in America at peak entertainment hours. I bet content delivery providers Akamai Technologies (Nasdaq: AKAM), Level 3 Communications (Nasdaq: LVLT), and Limelight Networks (Nasdaq: LLNW) are all ecstatic to serve Netflix given those heavy flows, and are likely to do whatever they can to steal each others' slices of the Netflix pie as the streaming service keeps on growing in volume and importance.
Despite adding 52% more customers over the last year, Netflix is actually spending less on new DVDs and Blu-ray discs that it used to. The DVD era is slowly grinding to a halt, set to be replaced by digital streams in an ever more dominant proportion. Others will try to replicate the Netflix model, and it's not a very hard problem in technical terms -- anybody can start a video-streaming site. Amazon.com (Nasdaq: AMZN) and Apple (Nasdaq: AAPL) might try their very capable hands at a subscription-based rental model before too long, and will probably carve out their own niches in the market. But how big of a head start can they give to Netflix if they really want to make a difference -- or for that matter, if they want to actually hurt Netflix?
What's next?
You've seen why I fully expect Netflix to triple in five years, and company leaders just stepped in to underscore nearly every one of my assumptions. Yes, the stock looks expensive by traditional metrics, but that's only because nobody has bothered to develop a valuation model based on price to millions of subscribers, or perhaps enterprise value over revenue growth. That's the kind of metric you would need in order to put a fair price on Netflix, and I've done my best to come up with an approximation of such a model. And by those figures, Netflix still looks like a steal.
The Gardner brothers have recommended this stock to Stock Advisor subscribers for six years, multiplying early investments by as much as 12 times the starting price. What more do you need to hear before taking a position in this trailblazer of the digital entertainment era? Share your skepticism in the comments below, if you still have any.
