There's a word commonly used for analysts who think that a growth company is likely to see revenue growth quickly drop from 20% or more to the mid-single digits in just a few years. The word? "Permabear." But that's not the case among Morgan Stanley's new analyst team.
The firm just upgraded Netflix (NASDAQ:NFLX) this week to buy and set a $500 price target. Despite recommending Netflix stock and expecting it to reach a new all-time high of $500 within the next year, the Morgan Stanley analysts are surprisingly pessimistic about Netflix's growth prospects.
Netflix stock on the rise (again)
It is not even the midpoint of 2014 yet, and Netflix stock has already endured a roller-coaster ride. In the first two months of the year, Netflix shares soared to a new all-time high of $458 based on the momentum of strong Q4 results.
The stock proceeded to crash in the next two months, falling as low as $300. A new round of worries regarding competition from Amazon.com was one catalyst for this drop. In April, Amazon.com announced that it had purchased the streaming rights to a large number of popular titles from HBO's back catalog, such as The Sopranos and The Wire.
A month and a half later, those worries have apparently disappeared, and Netflix stock is approaching the $450 mark again.
The return of optimism regarding Netflix stock can be attributed to a few factors. Within the U.S., it has maintained a strong subscriber growth rate while steadily expanding its margins. Netflix's recent price increase -- which applies only to new customers now but will extend to all subscribers by 2016 -- could drive further margin expansion.
Meanwhile, outside the U.S., Netflix has made great strides toward reaching breakeven. This, in combination with the company's ambitious international expansion plans, is encouraging investors to anticipate big profits from international markets in the future.
The Morgan Stanley take
Morgan Stanley's analyst team thinks that investors should buy Netflix stock despite its recent run, and it projects that the company's global streaming subscriber base will reach 108.6 million by 2020. This is more than double last quarter's total of 48.35 million.
Nevertheless, this isn't a very bullish projection. Just a few weeks ago, analysts at Oppenheimer & Co. set the same $500 price target based on the expectation that Netflix will reach 70 million international subscribers by 2020 (vs. about 53 million according to Morgan Stanley).
On the domestic side, Morgan Stanley expects Netflix to have just 55 million subscribers by the end of the decade, compared to the 35.7 million it had at the end of March. This implies a compound annual growth rate of just 7% going forward, compared to 22% in the last 12 months.
If we assume that Netflix maintains a 20% domestic growth rate this year and that falls to 15% next year, Netflix would already have about 46 million domestic subscribers by the end of 2015. In this scenario, Netflix's domestic subscriber growth rate would have to plummet to less than 4% for the next five years to meet Morgan Stanley's projected 55 million subscriber base by 2020.
This doesn't make sense
Thus, to reach a 2020 domestic subscriber count of just 55 million, either Netflix's growth will need to tumble below 10% within the next few quarters, or subscriber growth would have to grind to a halt a few years from now.
It's certainly possible that this will happen. For instance, Amazon.com could finally make a big push to gain streaming video market share with its HBO content. Alternatively, Netflix might be on the brink of saturating the domestic market already. In either scenario, it's hard to imagine Netflix stock going to $500 -- or if it did, it would not stay there very long.
The only way to be bullish about Netflix stock while expecting a 2020 subscriber total as low as 108.6 million is to have unreasonably low expectations about content cost growth. Yet Netflix's streaming content costs have been rising about 25% annually recently, and this rate will probably go higher due to Netflix launching in six European markets this fall.
Even at a 25% CAGR, content costs would double every three years. Meanwhile, Morgan Stanley's analysts expect the subscriber base six years from now to be just a little more than double its current size. That's a recipe for low profit margins and poor stock performance.
I have been arguing for some time that many Netflix stock analysts are underestimating content cost growth. There are at least four drivers of content cost increases at Netflix that will continue for the foreseeable future:
- General inflation in streaming content costs
- The incremental cost of more exclusive rights
- The cost of adding content
- The cost of getting rights for new markets
To offset these content cost increases, Netflix needs to maintain at least a 15%-20% subscriber growth rate through the end of the decade. If (as Morgan Stanley predicts) Netflix's global streaming subscriber base will only reach 108.6 million by 2020, Netflix stock isn't worth $500 -- and it might not even be worth half that much.