Shares of Netflix (NASDAQ:NFLX) have rallied to a new series of all-time highs this week, driven in large part by a big price target increase by MKM Partners. On Tuesday, MKM moved its Netflix price target up from $285 to $370, giving it the highest target among Wall Street firms. Moreover, analyst Rob Sanderson stated that Netflix could be worth $75 billion within five to seven years -- well above today's valuation of approximately $20 billion!
While I am highly skeptical that Netflix is even worth $20 billion, there is a plausible case to be made for why the company could be worth that amount. If Netflix can really capture much of the addressable market within the U.S. -- currently around 88 million households with broadband Internet -- and replicate that success in other countries, it could grow into its $20 billion valuation.
By contrast, a $75 billion valuation for Netflix is absurd today, and will be absurd in 2020 as well. It implies that subscriber growth will explode within the next few years and continue despite big price increases, while content cost growth drops off. Based on Netflix's recent history, there is no reason to believe this can or will happen.
A good way to assess the plausibility of valuation estimates is to compare the company you are interested in to its most comparable competitors. In Netflix's case, this means comparing it to other media companies. Netflix executives have clearly stated that they envision making the service more like premium cable channels such as HBO and Showtime over time.
Media companies, such as Time Warner (NYSE:TWX.DL) (the parent of HBO, TNT, TBS, and other properties) and CBS (NYSE:CBS) (the parent of the top-rated TV network and the Showtime cable network), are currently valued at a little more than two times sales.
If Netflix can eventually achieve a margin profile similar to those of similar companies -- it has never come close before -- it would still need to grow revenue to around $30 billion by 2020 to be worth $75 billion. This assumes that Netflix could achieve somewhat higher sales and earnings multiples than CBS and Time Warner have today.
Based on its current pricing, Netflix would need to grow its global streaming subscriber base from 37.6 million as of June 30 to around 300 million by 2020 to reach that level. Even if Netflix doubles prices, it would need to grow to 150 million subscribers by 2020 to meet a $30 billion revenue target! That implies adding more than 15 million subscribers per year on average (while raising prices, no less). By contrast, Netflix has added around 10 million streaming subscribers in the last year.
Some Netflix bulls might argue that Netflix will generate a significantly higher profit margin than other media companies over time due to operating leverage. In other words, Netflix can boost its margin simply by adding subscribers faster than it increases content spending. As a result, bulls might argue that Netflix could be worth $75 billion by 2020 even if revenue only hits $15 billion or so by then.
However, Netflix's content costs are likely to rise too quickly to allow the 50%-plus long-term profit margin that some investors seem to expect. Netflix's streaming cost of goods sold -- a good proxy for content costs -- reached an annual run-rate of around $2.5 billion in the second quarter, up 30% year over year.
Furthermore, Netflix management signaled that it will be stepping up content spending beginning in the fourth quarter. Indeed, if Netflix wants to grow quickly, its best bet is to keep prices low while adding lots of new content and adding new markets (which also increases content costs, since Netflix primarily pays for content on a country-by-country basis).
If content expense continues growing at 30% annually for the next seven years, it would reach around $16 billion by 2020! Even at a 20% compound annual growth rate -- which is probably more realistic -- content expense would still increase from $2.5 billion to $9 billion by 2020. In other words, even if Netflix more than quadruples its streaming revenue by the end of the decade, it will not lead to the other-worldly profit margins that some bulls hope for.
Let's be realistic
If MKM's analysis is correct, and Netflix could really be worth $75 billion by the end of the decade, the stock would be a great buy today. However, there are no plausible scenarios that could justify that kind of valuation. Either Netflix would need to step up its rate of subscriber growth while also raising prices significantly, or it would need to grow its subscriber base rapidly without adding much content.
Even megabulls like Carl Icahn -- a top Netflix shareholder -- have admitted that Netflix is no longer a "no-brainer" at its current stock price. Personally, I think the stock is already priced for perfection. That said, it's plausible that Netflix could eventually grow into this valuation.
By contrast, MKM's $75 billion market cap target for 2020 does not seem plausible whatsoever. The scenarios that would justify such a valuation are not just rosy -- they're ridiculous.