Shares of Netflix (NASDAQ:NFLX) have soared nearly 50% in the last 12 months. Following the company's expansion into six new markets in Europe last month, Netflix stock has been hovering around $460, just short of its all-time high.
While Netflix has a lot of momentum, it also has a sky-high valuation. This might be justified by its considerable growth opportunities. However, even a small misstep could lead to a big fall in the stock price. Investors may want to wait until after Netflix reports Q3 earnings next week in order to get more information about the European rollout before buying Netflix stock.
Taking the world by storm
Just three years ago, Netflix was in the doghouse with investors and customers after an ill-advised attempt to spin off its DVD business as a separate company called "Qwikster."
Those woes have long since been forgotten. Between the end of 2011 and the middle of 2014, Netflix grew its domestic streaming subscriber base by 67%: from 21.67 million users to 36.24 million users. Meanwhile, the international subscriber base has exploded from less than 2 million subscribers to nearly 14 million.
Netflix's rapid growth in the U.S. has allowed it to spread its content costs over more users, thus boosting its domestic profit margin. Furthermore, while Netflix is still losing money on its international operations, these losses have narrowed considerably in the last 2 years.
Netflix's rapid growth in the U.S. and its international markets has demonstrated that Netflix is still running circles around its would-be competitors. Amazon.com's Prime Instant Video is Netflix's most serious competition in the U.S., and also competes with Netflix in the U.K. and Germany.
Amazon doesn't release any statistics about user numbers -- let alone active user numbers (many people subscribe to Prime solely for its free shipping benefits). However, it appears to be way behind Netflix in terms of usage.
Netflix accounts for more than 34% of downstream Internet traffic in North America, according to Sandvine. By contrast, Amazon represents less than 2% of downstream Internet traffic. (Hulu, the other major subscription video-on-demand service, is also at less than 2%.)
Sandvine has also found that Netflix is the dominant subscription video service by traffic in most of the international markets where it is available. For example, during peak evening hours, Netflix already accounts for 17.8% of downstream traffic in the U.K. and Ireland -- markets opened in early 2012. Other competitors are in the 1%-3% range.
A valuation to match
All of these data points on Netflix's popularity are positive for investors. However, Netflix stock has an extremely high valuation. It currently trades for nearly 120 times expected 2014 earnings and nearly 70 times expected 2015 earnings.
Netflix also has a sky-high valuation when looking at revenue rather than earnings. Netflix stock trades for about five times sales. (By contrast, Amazon.com has also maintained astronomical earnings multiples in recent years, but it is valued at less than 2 times sales.) These high multiples indicate that investors expect Netflix's earnings to grow astronomically in the coming years.
However, the exact pace and extent of Netflix's future earnings growth is hard to judge. For example, Netflix CEO Reed Hastings recently stated that he expects Netflix to be profitable in Europe within five to 10 years, following its recent expansion into France, Belgium, Germany, Austria, Switzerland, and Luxembourg.
That would be much slower than the two- or three-year time frame to break even that Netflix executives have previously cited when entering new markets. It's possible that Hastings was being ultraconservative in making this projection. If not, then Netflix investors need to prepare for a much longer period of international losses, which would crimp its overall earnings growth.
Wait and see
Netflix stock has been very risky for investors for quite some time. However, it looks especially risky now, as the management team has not yet clarified the likely impact over the next few years of its recent expansion in Europe.
Netflix's upcoming Q3 earnings report will give investors a peek at how many "early adopters" signed up for Netflix in its new markets. Its Q4 guidance will also provide estimates on the immediate impact of international expansion on Netflix's profitability. Depending on what the company discloses, Netflix stock could make a big move up or down.
Warren Buffett has famously stated that there are no "called strikes" in investing. You don't lose any money by not buying a stock that subsequently rises. With that in mind, investors may want to adopt a "wait-and-see" attitude until after Netflix's earnings report. Right now, Netflix stock is too pricey to buy without more information about how it's doing so far in Europe.