As Q4 earnings reports pile up, more and more companies are posting red numbers, and the market is dropping under the weight. Even Netflix (NASDAQ:NFLX), despite better-than-expected earnings and encouraging news about international expansion, is feeling the burn -- the stock dropped last week.

On this episode of MarketFoolery, Chris Hill, David Kretzmann, and Anthony Arsta talk about what the company has to worry about in the upcoming years, why IBM (NYSE:IBM) just had its 15th consecutive down quarter, and what's going on with volatile cybersecurity stock FireEye (NASDAQ:FEYE)

A full transcript follows the video.

 

This podcast was recorded on Jan. 20, 2016.

Chris Hill: It's Wednesday, January 20th. Welcome to MarketFoolery! I'm Chris Hill. Joining me in studio today from Motley Fool Rule Breakers and Supernova is David Kretzmann, and from Motley Fool Funds, Tony Arsta. Happy Wednesday, gentlemen!

David Kretzmann: Good to be here.

Hill: Good to be here, not good to be on Wall Street, because holy cow is there a lot of red out there. We're going to get to some earnings from Netflix and IBM. We'll dip into the Fool mailbag. But it may be good just to start with a comment from a friend and Tony's colleague, Bill Mann, who wrote on Twitter this morning, and it's a nice reminder on days like today, when -- again, there's so much red out there. What Bill wrote on Twitter was: "Market volatility scares people, scared people flee, fleeing creates bargains, bargains are what investors should want." And it is what we should want. And we talk all the time about, have a little cash on the side, have a little watch list, that kind of thing. But still kind of painful.

Anthony Arsta: It can be painful to look at. But there are some bargains appearing. So that's always the nice part.

Hill: Let's start with Netflix. Fourth-quarter profits came in higher than expected. David, we'd talked recently, you were out at CES, and there was a big presentation from Netflix, a lot of talk about their international expansion, and help me understand what's going on with the stock, because they reported after the market closed yesterday. Right after they announced, the stock popped somewhere in the neighborhood of 10%. Now it's down more than 5%. That's a pretty big swing when you just factor in the after hours and just a couple hours of trading so far. First, let's just start with the quarter. Was the quarter as good as the 10% pop? Or was it as bad as the 5% drop we're seeing right now?

Kretzmann: I think it was a pretty good quarter when you take it in the long-term context, which is how management is looking at us. They're not so worried about near-term profitability, especially with that international segment. They're focused on expanding quickly, building that presence, and then scaling profits from there. So on January 1st, they crossed 75 million members globally, which is a big number for them. They have 45 million in the U.S., about 30 million internationally. This quarter, they beat their own internal forecast of 5.15 million new members.

They added 5.6 million new members. So the numbers that I think matter for Foolish investors like us, patient, long-term investors, you want to see that member count expand internationally. They have a bigger international addressable market now that they're in 130 more countries like they announced at CES. Now, their addressable market, in terms of households with broadband Internet connection, is up from 360 million homes to now 550 million homes. So with that expansion of addressable market, they're trying to scale internationally, basically, as quickly as they can.

Hill: Tony, is part of what we're seeing today with Netflix just ... in politics, you hear the phrase "a pox on both your houses." Is part of what we're seeing today just investors saying, "Yeah, I don't care about how good this quarter was, I'm just selling for the sake of selling?"

Arsta: I don't know if that's quite accurate. I think the big issue with Netflix now is that their next trick is going to be much more difficult. They've grown so successfully within the U.S. -- U.S. streaming is up to about 35% operating margin now, and their goal is to get that to 40%. And the number of subscribers in the U.S. has basically plateaued. It's still growing, but it's not growing nearly as quickly. By the end of 2016, I expect that they'll have more international subscribers than U.S. subscribers, and that's still a money-losing business. It's still an area where they're trying to grow quickly.

But the story now has switched from growing in the U.S. to growing internationally, where there's just more competition, there's more languages you need to write your programs in, there's a lot of other concerns that maybe weren't as relevant when they were only a U.S.-focused company. So I think things are just getting more difficult for them. If they continue to grow and get the same market share internationally as they have in the U.S., it'll be a great investment. But that's a much more difficult trick to pull off.

Hill: Have they given any sort of a time line, or even a time frame, for when they expect some of these bigger international markets to start turning a profit? And I don't own shares of Netflix, but Reed Hastings and his management team strike me -- just as someone who watches how companies operate, and watches how management operates -- as a pretty forthcoming bunch of people. For all the praise that's heaped upon Jeff Bezos, no one has ever accused Jeff Bezos of doing anything other than holding his cards incredibly close to the vest. Netflix executives seem like they're pretty straightforward about, "Yeah, this is how much money we're going to spend this year in content."

Arsta: They do give a lot of information, and my problem with Netflix was that they always frame it in the way that they want you [to] follow their story. For example, a few years ago, they would always give their churn numbers, so you always knew how many subscribers are being added and how many were leaving.

And then, they decided one quarter that they would no longer give that information. With international, on every call, they give a few country anecdotes of where things are going well, where they've had success, but they don't give full data where you can actually build up your own models. So they're more open than Amazon, that's fair to say. But they are selective about what they share.

Kretzmann: They have been pretty consistent since they announced that they were going to be more aggressive with international expansion. That was, I think, the middle of 2015, last year. They mentioned that they expect the international segment to become profitable by 2017. And that's stayed consistent, even through that announcement at CES where they really ramped up international expansion at, I think, a faster pace than anyone really anticipated. So they're still expecting material global profits beginning in 2017.

Whether or not they get there is the question. At this point, the company has burned almost $1 billion in cash in 2015. Their free cash flow was -$276 million in the last quarter. So really, the big question for Netflix is, can they scale quick enough to the point where they can become a cash-flow-positive business? I think that's the big question for investors looking out for the next two to three years.

Arsta: I believe, on the call, they said they'll burn about $120 million international per quarter going forward until they get to that breakeven point. They also said that, by the end of 2016, early 2017, they'll need to raise more money. It sounds like they're leaning toward debt. Honestly, at this share price, I don't know why they're not doing more equity offerings. But at any rate, they'll need more cash in the future.

Hill: This is one of those stocks that some people look at and go right to the P/E ratio, and they say, "My gosh," even on a day like today, when it's selling off a little bit, it's still got a P/E of 270. What is one metric people should use to look at the stock? Because I know neither one of you looks at this and thinks, "Well, P/E, that's how you should be measuring this stock." Tony?

Arsta: For me, it's more looking at a set of beliefs. They've said that, by 2020, they can get their U.S. business to 40% margin. If you assume they can get their international business to a similar level, you can look at what percent of international broadband households would need to have Netflix to make it a reasonable investment, and that's somewhere between 25% and 50% of the world with broadband access, who would need to be paying $10-$15 a month. Somewhere in that ballpark would make it a reasonable investment today. The P/E today is -- given their efforts not only in international expansion but new content -- the P/E today doesn't tell you one way or the other if it's a good investment.

Kretzmann: Yeah, I think you really just have to focus on their addressable market, and how successfully they can capture members around the world. Their pricing is consistent around the world. That was a question I asked some of their PR folks when we had a chance. They had a press day after that announcement at CES, and I was asking them, do they have different pricing for different countries? Because $9.99 or $7.99, in some countries, that's a hefty amount to pay each month. But the pricing, they said, it is remarkably consistent in all these countries around the world. So for Netflix to pay off for investors within five to seven years, they'll need 200 million or more members, I think. So that's really, I think, the metric investors should pay attention to.

Hill: Let's move over to Big Blue. IBM's fourth-quarter profits and revenue both came in higher than expected, but I'm assuming, Tony, that expectations are consistently lower for IBM these days, since this was the 15th quarter in a row that their revenue has fallen. That is a staggering number.

Arsta: That's a lot of quarters, yes. To be fair, though, their revenue would have only fallen 2% if it wasn't for currency, rather than the 9% it did fall. So two-thirds of their business being outside the U.S. has really been a drag on the business. What they've been doing over the last few years, though, is getting out of their traditional things like hardware, and a lot of the core businesses they'd been doing in the past, and instead focusing on growth markets like analytics, cloud security.

And those are all growing, maybe a little bit slower than people would like, and again, with currency effects, it only grew about 10% in the quarter. It would have been about 15%, I believe, without the currency headwinds. So that's growing. And the question is, can that grow and take up the slack from the legacy businesses that they're getting out of. The company is trading at about 11 times free cash flow. It bought back $4.6 billion of stock last year. Dividend yield is over 4%. So it's a reasonably priced, stable company that's trying to grow into growth markets.

The bigger issue is that those growth markets they're trying to grow into, there's a lot of competition. When you look at cloud services, they're competing directly with Amazon. You look at analytics, they're competing with Splunk, which Rule Breakers, I know, has recommended. And then, in the security business, there's companies like Palo Alto Networks, FireEye. Everywhere they're trying to grow, there's a lot of competition that's more nimble and only focused on that one thing. If you want to invest in future technology, it's maybe a more stable play than some of these more niche growth-oriented companies, but there's a lot of competition there.

Hill: We'll get to FireEye in a second. But is this a company, when you think about IBM's history and how it's gone through, at various points, decade-long stretches of outperformance for the stock, and certainly, as we've seen today, it's hitting a five-year low. Is this one of those behemoths that should consider spinning off part of their business? Should they be looking at their cloud business and saying, "You know what? This is going to do better if we spin this off."

Arsta: Well, they've already spun off everything that isn't a new technology area. They've spun off their foundries, they've spun off their server businesses...

Hill: They still have Watson, right?

Arsta: They still have Watson, yeah.

Kretzmann: (laughs) That's important.

Arsta: When they spun off the foundries, they paid a company called GlobalFoundries to take that off their hands. So they have been divesting of things that are not new growth areas. But they have things like Watson, their cloud business is growing nicely.

There's a lot of competition, though. Amazon's strategy with Amazon Web Services is basically to charge as little as possible to capture a large share of the market, and use that to provide other services. If your only business is something that another company is choosing to cut prices on, that can be a tough place to be. But IBM has reinvented itself many times in the past. They are investing in the right areas. It's just a question of if they can outpace all the small up-and-coming threats that they face.

Hill: Let me go back to one thing; I want to make sure I understood what you said correctly. Did you say that, when they were looking to sell off their foundry business, they didn't sell it so much as they paid someone to take it off their hands?

Arsta: Yeah... depending on how you read the press release and what happened, they shelled over some cash for GlobalFoundries to...

Hill: It's like when a baseball team has some high-price slugger, they're like, "Yeah, I'll tell you what, we're going to trade you, but we're going to still pay you the majority of your salary."

Arsta: I believe it raised the value of the company in the long run. But yes, they did give up a little bit to get that off their hands.

Hill: MarketFoolery@Fool.com is our email address. From Kent Turner: "I own shares of FireEye. This is a company that is declared an industry leader, but I'm beginning to have my doubts. I've held in with them thinking that things will soon reverse their decline and the stock price will improve. Are they a good company for someone to acquire? Are they headed to bankruptcy? Please help!" Two very different outcomes. FireEye, as you mentioned, Tony, cybersecurity, really more of a pure-play cybersecurity company that really has seen its stock price whacked over the last year or so. Where is this thing going, David?

Kretzmann: Well, the short answer is, no, they won't go bankrupt any time soon. This is a company, similar to Netflix, they're trying to capture a share of what's a very large and fragmented market, which is cybersecurity. Cybersecurity as a whole, globally, is anticipated to grow 10% annually to $170 billion in size by 2020.

So that's a big market. And FireEye is really just plowing money into investing and scaling their business. So far, they haven't been consistent producing positive cash flow, much less free cash flow. So they're burning a lot of cash. But they do have a net cash position of $471 million, so they won't go bankrupt any time soon. The question is, can they get to a point where they have that scale and they're able to produce positive, consistent cash flow? That's really the big question with them over the next couple years. And I think it's hard to call them a leader. Like I said, this is a very fragmented space.

They're a $2.5 billion company. So they're sort of in the middle tier, I'd say, when it comes to the size of companies in this space. But they do have some product partnerships with larger players like Checkpoint, they have some product partnerships with smaller companies like CyberArk. So I don't know. It is a challenging space to be in right now. It's very fragmented. There's a lot of competition. So we probably will see some consolidation. At a $2.5 billion market cap, they could be an acquisition target. As an example, Checkpoint Security, which is, like I said, a much larger company in this space, they have $1.3 billion in cash and no debt. So they could, conceivably, acquire someone like FireEye or Checkpoint, which there are actually already rumors about.

Arsta: Yeah, it would make sense for some consolidation to take place in the industry, because there are so many competitors out there, between them and Palo Alto Networks, there's a few competitors that are, from what I can tell, trying to do the exact same thing. Basically, this is a stock that was trading at a tremendous premium six to 12 months ago, and is now trading at a tremendous discount to its peers. The story hasn't changed much. They said last summer that their goal was to be cash-flow-positive by 2019. So you're looking at a company that is still a few years and a lot of revenue short of where they need to be to become a viable business.

If you bought the company at any point since its IPO, you trusted that long-term vision that it would take them, from the time of IPO, somewhere between three-to-six years to become a profitable company, and that they'd grow along the way as the industry grows along with it. And that story really hasn't changed. It is a difficult industry to be in. Maybe you want to invest in a few companies there instead of just choosing one you think will be the winner. But it's the same investment you made six or 12 months ago, just at a bargain price right now.

Kretzmann: Yeah. I mean, it's important to remember that, even though their growth has been decelerating, they still grew sales 45% in the most-recent quarter. So this is still a very quickly growing company. They are capturing market share, but like Tony said, it's really a matter of scaling over the next few years. So that'll be a key thing to watch.

Hill: I don't know what number I was expecting to come out of your mouth, but when you said 2019, the first thing I thought was, "Gosh, I don't know if FireEye is a stand-alone company in 2019." I mean, if 2016 is anything like 2015 for this company, I could see someone going in... and I don't know if it's IBM, but I could see a tech behemoth saying, "We like you and we're making a godfather offer."

Arsta: That is possible. The other possibility, since this is such a service-driven business, is that with the decline in share price, and employees being paid so much in stock options, is that they just lose all their talent. So one of those outcomes would be good, one would not be, and I don't know which will happen.

Kretzmann: Yeah. And we can also take a step back here and recognize that, on days like this especially, companies that aren't making money and don't have consistent cash flow, their stocks will often be much-more volatile. So in the case of Netflix, they reported, by all measures, a pretty good quarter, but the stock is still down. FireEye, I think, is down 10% today. These are companies that aren't making money, and the money they do make isn't consistently positive. So in the context of portfolio allocation, you probably don't want a huge chunk of your portfolio in these kinds of companies, especially if these volatile share prices get to you.

So a company like FireEye, you might not want more than, say, 2% or 3% of your portfolio in that company. Or like Tony mentioned, you might want a basket of the cybersecurity companies, because there's not one clear winner at this point. So I think that's something to keep in mind with these smaller companies that are investing a lot of money. They're not profitable today; you have to recognize that their share prices will be volatile. The stories are exciting. They're often developing new technologies or platforms. But you have to recognize, yeah, those share prices will be volatile.

Chris Hill owns shares of Amazon.com. David Kretzmann owns shares of Amazon.com, CyberArk Software, FireEye, Netflix, and Twitter. Anthony Arsta owns shares of Amazon.  The Motley Fool owns shares of and recommends Amazon.com, FireEye, Netflix, Splunk, and Twitter. The Motley Fool recommends CyberArk Software and Palo Alto Networks. 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.