Analysts Debate: Is Netflix a Top Stock Once Again?

The Motley Fool has been making successful stock picks for many years, but we don't always agree on what a great stock looks like. That's what makes us "motley," and it's one of our core values. We can disagree respectfully, as we often do. Investors do better when they share their knowledge.

In that spirit, we three Fools have banded together to find the market's best and worst stocks, which we'll rate on The Motley Fool's CAPS system as outperformers or underperformers. We'll be accountable for every pick based on the sum of our knowledge and the balance of our decisions. Today, we'll be discussing DVD and streaming content king, Netflix (NFLX 2.16%).

Netflix by the numbers
Here's a quick snapshot of the company's most important numbers:

Sources: Netflix investor relations, Yahoo! Finance, and Morningstar.
*Does not include debt offering announcement on Jan. 29, 2013.

Sean's take
"It's up. It's down, It's dead. It's not, but DVD subscriptions are down. No, wait, streaming subs are way up." And that's just the past three months for Netflix! It's a company that can give investors indigestion and movie-seekers pleasure all at the same time. The question must be asked, "What's next for Netflix: $300 or $50?"

To answer that question, I think we need to look at how Netflix got here and what it'll have to contend with moving forward.

On the plus side, Netflix clawed itself back from the threat of ignominy by striking a movie-licensing deal with Disney (DIS 0.54%) that'll give it exclusive access to Disney, Pixar Animation Studio, and Marvel Studio production and allow direct-to-video Disney releases beginning this year. With content costs rising, this was a key win for Netflix and is sure to keep its foothold strong in family households with children.

Another turning point for Netflix was its push overseas and its renewed focus on its streaming business. By spending big on popular movies and shows, Netflix has been able to offer consumers a best-in-class digital library for a very reasonable price (now that its PR gaffe is in the rearview mirror). The result was the addition of 9.74 million streaming subscriptions in 2012, with a big push internationally, where subs more than tripled to 6.12 million.

On the other hand, there are a number of troubling trends that could weigh Netflix down. With content costs rising, Netflix's cash position is nowhere near as optimal as Amazon.com. In fact, Netflix actually had a free cash outflow of $58 million. If it's unable to generate sufficient cash flow from operations, it'll need to issue debt and shares to cover its large content deals.

The slow death of its DVD business is another concern. Although the trend of subscription losses has leveled off a bit, Netflix nonetheless lost 26% of its DVD subs in 2012. I know what you're thinking: "DVD subs are so 2009!" And you're right. The problem is that DVDs were an extremely high-margin business for Netflix, so while streaming subs are booming, they're not replacing the high-margin losses from the DVD side of the business. In addition, Coinstar's RedBox DVD rental machines and its partnership with Verizon in streaming, as well as DISH Network's Blockbuster stores, are further challenges to Netflix's already sagging DVD business.

Finally, international subs jumped 229%, but the company still lost money on this segment! Not only did Netflix lose $105 million overseas in the fourth-quarter, but that figure was 75% higher than in the year-ago period. Furthermore, international streaming losses are expected to continue for the immediate future, with only "modest sequential improvements" moving forward. 

Weighing these two sides, I can't help seeing big yellow flags from a valuation standpoint, given all of these potential negatives. With the stock at 13 times book value and a ludicrous 66 times forward sales, I believe investors are discounting the impact of future competition and negating Netflix's inability to generate cash from operations given the rising cost of acquiring content. In short, sign me up for a CAPScall of underperform.

Alex's take
We should have done this a year ago. I still remember watching Netflix peak and then crater during my first few months as a Foolish writer. It seemed like an overreaction then, and I could have mustered plenty of arguments in support of an outperform call for early February 2012. Its subscriber base was still growing rapidly -- more than 6.2 million subscribers joined Netflix in 2011, despite the price increases that will live in infamy. Netflix's net margin was also roughly in line with its past two years, and its P/E was near its lowest levels ever after peaking near 80 at the stock's 2011 heights . It seemed reasonable to expect a rebound from that point onward.

However, we're not talking about 2012. We're late to what's undoubtedly been a wicked party for Netflix shareholders. The problem with wicked parties is that staying too long will leave you with a wicked hangover. No matter how hard we party with you happy shareholders right now, there's no way that we're going to capture similar gains out of a stock that's gone up 80% in less than three weeks. We'll just wind up with a hangover and no great memories to show for it.

Sean already pointed out valuation concerns, but I'd like to further highlight the rising costs of Netflix's streaming business from year to year, as discussed in its annual reports:

• In 2008, content acquisition expenses increased by $24.0 million.
• In 2009, that expense increased by another $46.6 million.
• In 2010, content acquisition and licensing spending jumped another $267.8 million.
• In 2011, that expense shot up another $674.4 million.
• In 2012, content and licensing costs were up another $397.7 million.

In five years, Netflix's gross margin has declined from 33.3% to 27.3% while operating expenses as a percent of revenue have grown 1.5%. That's not a good trajectory. It's possible that this will reverse as Netflix locks in more agreeable licensing deals, but that's not going to happen in the near future. If Amazon is serious about mastering this market (and Amazon is serious about mastering everything, apparently), the competition will only encourage content providers to jack up their licensing fees.

Producing costly series like House of Cards helps differentiate Netflix, but putting that series together cost $100 million, and it would be silly to think that subscribers are going to be happy with just a few new shows per year. A Forbes feature on Time Warner's (TWX) HBO, which Netflix CEO Reed Hastings clearly sees as a mortal enemy, cites a figure of $75,000 per minute in production costs for a high-quality scripted drama like the blockbuster Game of Thrones. That lines up with House of Cards' cost for two seasons. A five-series lineup will cost Netflix about $250 million a year. In the long run, that's a good investment when annual revenue is approaching $4 billion, but not if it eats into already-dwindling margins.

The kicker, for me, is this: To get back to a P/E of 30, which is where it was in early 2012, Netflix would need to earn $330 million this year while its stock goes nowhere. Netflix's purportedly "strong" earnings report that just came out shows a net income of $7.9 million for the fourth quarter. Annualized out, that's less than a tenth of what's necessary. If Netflix grows its revenue another 13% this year, as it did in 2012, and its net margin rebounds to 2011 levels, it still only manages to net $283 million. With no forward guidance to parse, we can only assume that Netflix's leadership doesn't expect to hit such targets, either.

I want to like Netflix. Six months ago, I would have suggested buying it. However, when even a highly optimistic scenario doesn't come close to returning Netflix to reasonably priced territory, I have to consider it overvalued and will make my call accordingly. This one gets an underperform call from me. Let's revisit this after the market comes to its senses.

Travis' take
Let's start with the good news. Netflix is attracting new customers like crazy, adding 5.48 million subscribers during the year. Margins are also improving in both the domestic streaming and DVD business, which allowed Netflix to be (slightly) profitable over the past three quarters.

The bad news is that none of that allowed Netflix to build a substantial or sustainable profit. Revenue keeps going up, but so does the cost of content, as Alex pointed out, a problem that will only get worse once the Disney deal kicks into high gear.

Netflix may be able to offset some of this additional cost by raising prices on consumers, but Netflix customers have already proved to be a fickle bunch. When Netflix went through its Qwikster debacle, it quickly lost 2.5 million subscribers, proving that Netflix doesn't have inelastic demand. Customers are free to come and go as they please and have no problem doing so. But margins, content costs, and customers aren't the reason I'm seriously worried about Netflix.  

Here's the most telling question I can ask about Netflix: What does Netflix do that Disney or HBO can't do themselves?

The answer is easy -- nothing. Both ESPN and HBO have two of the best streaming apps available. Disney is working on a service called Disney Movies Anywhere, which still has plenty of content to offer consumers despite the Netflix deal. Network television stations all have streaming apps in some form, so is what Netflix does novel in any way? Netflix has shown the way, but it doesn't bring any sort of long-term competitive advantage to the table. It doesn't provide the wire to our house like cable does or the dish on our roof like current cable providers do. If any content provider wants to leave (see Starz), it can build its own app and offer its content to consumers with any number of revenue streams.

What we haven't seen, yet, is a content owner creating an independent distribution system by pricing its content for direct sale to consumers, but I think that's the wave of the future. Take Disney, for example. If Netflix doesn't offer enough revenue for their rights, they can go on their own. Even if Netflix can gain control of a plethora of content, the cost will continue to eat into margins, creating a spiral that requires user growth to continue or, worse yet, price increases. We know consumers don't have the appetite for that -- at least not yet.

At the current price, I'm perfectly comfortable with an underperform call. I just don't see how Netflix can make a sustainable profit long-term, and eventually that will come back to bite investors.

Final call
Don't fall over, but that's two consecutive weeks that we've come to a unanimous decision -- no easy feat given our history of disagreements. After carefully examining Netflix, we've decided to make a CAPScall of underperform on the company. What's most interesting is our unanimous call was made from three different angles yet still came to the same conclusion, by focusing on Netflix's valuation, its rising costs, and it's lack of competitive differentiation.

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