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Netflix, Inc.: Time to Make Some Real Money

By Adam Levine-Weinberg - Jul 7, 2015 at 3:15PM

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Netflix has been on a growth tear, but soon it will have to start making some real money to keep the stock moving higher.

Netflix (NFLX -1.85%) stock has given investors plenty of scares in the past few years. But those brave enough to hold on through all the chaos have earned huge profits. Last month, Netflix stock touched $700 for the first time and it is up more than tenfold since late 2012.

Netflix's share appreciation has been driven by steady subscriber growth and margin expansion in the U.S. along with growing signs that Netflix is catching on in international markets.

Netflix stock has soared in 2015. Photo: The Motley Fool

However, Netflix is reaching the point where it will soon have to start making some real money to keep the stock moving higher. Slender accounting profits and negative free cash flow -- which have been the norm for the company in recent years -- won't cut it as Netflix transitions to being a relatively mature company over the next five years or so.

Still in investment mode
One thing that should be clear to investors is that Netflix stock trades purely based on projections of what it may achieve many years down the road. Netflix's adjusted EPS reached $3.96 last year, but analysts expect that to dip to $1.31 this year before rebounding to $3.16 in 2016. Based on those estimates, Netflix stock trades for more than 200 times forward earnings.

In fact, Netflix's 2016 EPS will still be well below the amount it earned all the way back in 2011, when diluted EPS peaked at $4.26. This just goes to show that Netflix is deep in investment mode. It is developing lots of new original content while launching its service in new foreign markets at a torrid pace.

Netflix's cash flow statistics highlight its aggressive investment posture even more clearly. After running at around breakeven in terms of free cash flow for much of 2013 and 2014, Netflix's free cash flow has turned sharply negative, reaching -$163 million in Q1. Netflix CFO David Wells has warned investors to expect this negative free cash flow to continue.

International expansion isn't the only drag on profit
This isn't to say that Netflix investors should be worried about the company's big investments. Netflix's investments in new markets and developing of compelling original content seem like smart moves that have a very good chance of paying off in the long run.

Netflix is investing heavily in content, especially originals. Photo: The Motley Fool

Many Netflix bulls take comfort from the strong growth of Netflix's domestic contribution profit. In Q1, the domestic streaming contribution margin hit a record 31.7%, while domestic streaming contribution profit rose 55% year over year to $312 million.

However, the reality is a little more complicated. Netflix's "contribution profit" metric excludes technology costs and other corporate overhead. These costs totaled $235 million in Q1, thus absorbing about three-quarters of Netflix's domestic contribution profit. Netflix also incurred interest expense of $27 million in the quarter.

Thus, after deducting all of these other expenses, only $50 million of Netflix's $312 million domestic streaming contribution profit made it to the (pre-tax) bottom line. In other words, Netflix's low profitability can't just be blamed on international expansion costs. (That said, if Netflix's international operations were profitable, they could offset some of the overhead costs.)

How high can domestic profit grow?
As Netflix continues to penetrate the U.S. and starts to mature in its international markets, its profitability will undoubtedly shoot higher -- especially if it starts getting material contribution profits from its international operations. But just how much profit should investors expect?

In the past few quarters, Netflix's management has repeatedly laid out a goal of earning a 40% contribution margin in the domestic streaming business by 2020. CFO David Wells clarified on the company's Q4 earnings call that this target assumes steady growth between now and then.

So let's assume that Netflix adds 5 million subscribers annually between now and 2020. That would represent a very solid performance. It would be a little less than the 5.73 million domestic subscribers Netflix added in the past year, but that in turn was down from the 6.5 million domestic subscribers added in the previous year.

This would bring Netflix's domestic subscriber base to about 66 million. Assuming annual revenue of $115 per subscriber -- which incorporates the likelihood of another price increase within the next five years -- Netflix's domestic streaming revenue would reach roughly $7.5 billion. At a 40% contribution margin, the contribution profit would be $3 billion.

However, Netflix's other operating expenses could easily reach $2 billion by then. (That would assume a compound annual increase of only 15%; last quarter, other operating expenses jumped 41% year over year.) Meanwhile, DVD segment profit will be negligible by then -- perhaps enough to cover Netflix's interest payments, but not much more.

The Netflix DVD business will be more or less gone by 2020. Photo: The Motley Fool

The net result is that Netflix might earn $1 billion in pre-tax profit, excluding the international business. Considering that the domestic business will be more or less mature by then, that's not nearly enough by itself to justify Netflix's current $40 billion valuation.

Netflix needs to make a lot of money abroad
To drive strong share price appreciation for investors, Netflix eventually will need to earn at least as much money outside the U.S. as from its domestic operations. Continuing with the scenario described above, even with a $3 billion international contribution profit, Netflix's after-tax profit would be around $2.5 billion (assuming a normal tax rate).

Netflix already trades for 16 times its hypothetical earnings in this favorable 2020 scenario. For the stock to keep rising rapidly, investors need to see the potential for significant upside beyond that.

Is it possible that Netflix will be able to capture this upside? Absolutely. But it won't be simple. Before betting any of my own hard-earned cash on Netflix successfully dominating the world, I'd like to see it make some real money for a start.

Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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