The gap between the projections of Netflix (NFLX 9.71%) analysts and the company's management continues to grow wider. As the Netflix stock price has skyrocketed in the past few months, analysts have raised their price targets to match. However, a closer look at their reports shows that they are not nearly as bullish about Netflix's business prospects as Netflix CEO Reed Hastings or other insiders.
This combination of low analyst expectations, high management expectations, and high analyst price targets could prove volatile. If Netflix performs up to management expectations in the next year or two, the stock could see another round of upgrades and raised price targets, as the company's fundamentals would be outperforming the analyst models. However, if analysts are right about Netflix's growth trajectory -- a scenario I believe to be more realistic -- the stock could drop precipitously in spite of their high price targets.
New week, new upgrade
On Tuesday, Netflix shares rose by as much as 6% after Pacific Crest analyst Andy Hargreaves raised his price target from $160, to $225. Hargreaves cited "increased margin and subscriber assumptions" for the move. However, his domestic subscriber growth assumptions are actually quite modest. Hargreaves now expects Netflix to grow from 27 million subscribers at the end of 2012, to 36 million domestic subscribers by 2015, with a plateau around 46 million domestic subscribers by 2021.
Hargreaves' analysis is very similar to a bullish call made by RBC analyst Mark Mahaney earlier this month. Mahaney expects the domestic subscriber base to reach 39 million by 2015, and derived a $210 price target from that analysis. These subscriber estimates dovetail well with my analysis of the market opportunity for Netflix. Premium video leader Time Warner boasts approximately 41 million U.S. subscribers between its HBO and Cinemax services. HBO can attract many subscribers, despite its high price, because it has very high-quality original programming. Netflix is trying to move in that direction with new series like House of Cards. With improving content quality and a low price tag, it seems reasonable to project that Netflix will reach a similar level of market penetration as Time Warner within a few years.
Watch the gap!
However, this is not what Netflix's management is projecting. Netflix CEO Reed Hastings has stated that the company's addressable market in the U.S. is 60 million-90 million households. . While I do not think that Netflix management seriously expects to reach the upper end of that range (which would be equivalent to roughly 100% of broadband households), Hastings talks about the 60 million figure as a target for the end of this decade.
To reach 60 million subscribers by 2020, Netflix would have to average more than 4 million net new domestic subscribers per year over the next eight years. By contrast, Tuesday's bullish call by Pacific Crest assumes just 3 million subscriber additions per year through 2015, and an end-of-decade target of just 46 million domestic subscribers. Clearly, there is a large disconnect between what analysts think Netflix can do, and what Netflix management has been telling the market.
Rapid subscriber growth is critical for Netflix's business model. In the short term, Netflix's content costs are fixed -- it pays the same amount for each piece of content regardless of how many streaming subscribers Netflix has. As a result, the revenue from each additional subscriber is almost pure profit. However, over the long term, growing competition from Amazon.com and other new streaming video services will increase content costs, while keeping a lid on potential price increases. Pacific Crest projects the domestic subscriber count to grow at a CAGR of just 6%-7% through the end of its forecast period in 2021; modest growth like this may not even be sufficient to offset rising content costs. By contrast, to meet management's goal of 60 million subscribers by the end of the decade, Netflix will need a much higher CAGR of 10%-12%.
So what?
Netflix will have to perform well above analyst expectations (and close to management's expectations) for the stock to be successful over the next few years. In other words, the analyst price targets we have seen recently will only be justified if Netflix significantly outperforms their expectations in terms of fundamentals, particularly domestic subscriber growth.
Today, Netflix trades at approximately $190, or more than 60 times the average analyst estimate for 2014 EPS. The company's fully diluted market capitalization is approaching $12 billion, or roughly three times annual revenue. In short, Netflix has a very aggressive valuation today, typical of a growth stock. If the company posts a CAGR of just 6%-7% in its core domestic streaming business for the next decade -- with improvements in the international streaming business largely offset by the declining DVD business -- severe multiple contraction seems nearly inevitable.
Conclusion
The growing disconnect between Netflix analysts and the company's management regarding long-term growth prospects could be setting the stock up for another crash. Analysts have provided encouraging price targets, but they do not seem to buy into management's bullish outlook. If investors sour on the stock because of Netflix's inability to hit Reed Hastings' optimistic projections, analysts could cut their price targets just as quickly, providing additional fuel for a significant drop in the stock price.
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