This year has brought a rude awakening for Netflix Inc. (NASDAQ:NFLX) investors.
The stock that led the S&P 500 last year with a 134% gain is already down 17% this year despite beating estimates in its recent fourth-quarter earnings report. Since reaching an all-time high in December, the stock has lost 29%.
Not surprisingly, the bear calls have picked up. Deutsche Bank's Stuart Kirk claimed the growth implied in Netflix's current valuation is "titanic" and implies signing up 40% of the world's homes. Meanwhile, The Street's Doug Kass says he sees no ability to improve cash flow or improve margins. The bear arguments seem to rest on the belief that Netflix's future profits won't be enough to justify its current valuation, but the naysayers overlook several major factors.
1. Results are being dragged down by its international expansion
Looking at any of Netflix's recent letters to shareholders, you'll notice a stark contrast between its domestic and international segments. Domestically, the company is amply profitable, but it continues to lose money abroad as it spends on expansion and marketing.
In 2015, Netflix's domestic streaming segment delivered $1.4 billion in contribution profit, but it lost $333 million from abroad. Backing out the loss-making international segment would give the company 2015 operating income of about $1 billion. That would leave the company with net income of more than $500 million for the year, or more than $1 per share, making the company's valuation seem much more reasonable.
Netflix's mature international markets like Canada and the U.K. are already profitable so we should assume that the international segment will eventually get out of the red now that Netflix has completed its expansion. Once it does, earnings should begin building quickly.
2. Domestic profit will more than double by 2020
Management has set a goal of a 40% domestic contribution margin by 2020. Looking at the company's progress toward that target, it seems as if it could easiy pass it. Domestic contribution margin reached 32.9% in 2015, topping out at 34.3% in the fourth quarter. For the first three months of 2016, management has forecasted a rate of 35.9%. As Netflix raises prices for grandfathered customers later this year, contribution margin should continue to expand.
Based on a conservative estimate for 2020, Netflix would have 65 million paying domestic subscribers at an average rate of $10 per month. That would make domestic streaming revenue for the year $7.8 billion, good for a contribution of $3.12 billion. Imagining an improved scenario with 75 million members paying $12/month and a 45% contribution margin would yield a contribution profit of $4.86 billion. Using those numbers as a range, Netflix's domestic contribution profit is set to triple over the next five years. Growth like that deserves a high multiple, and that's without the potential of the international segment.
3. Competition is rising but it remains a distant second
Netflix bears like to make a big deal out of the intensifying competition in video streaming, citing threats from Amazon.com (NASDAQ:AMZN), Hulu, HBO Now, and others, but the fact remains that Netflix is the clear leader in video streaming.
Despite launching almost nine years ago, Hulu has only 9 million paying subscribers as of last year, and the TV companies that own it seem more interested in using it as a vehicle for increasing viewership for their shows rather than as a stand-alone streaming service. According to surveys, Amazon Prime has more domestic members than Netflix, but many of them don't even taken advantage of the video content, signing on instead for Amazon's primary business, online retail. Time Warner (NYSE:TWX.DL)-owned HBO and CBS (NYSE:CBS)-owned Showtime both launched their own streaming services last year, at higher price points than Netflix. Netflix long ago passed both networks in domestic subscribers so it seems unlikely that their streaming services would present a significant challenge.
The competition is already here, and Netflix keeps growing.
Netflix CEO Reed Hastings has said many times that he sees rival services as complementary rather than competitive as viewers will likely subscribe to multiple streaming services.
4. The international opportunity remains huge
Netflix's international subscriber base could surpass its domestic base as soon as the end of this year. Marketing expenses in 2015 were more than 50% higher abroad, at over $500 million, than they were domestically. Clearly, management sees a long growth path here, and is investing for the long term.
Building out local content and adding new languages will take time, but that investment will grow its subscriber base and eventually deliver profits. For a comparison, three quarters of HBO's subscriber base hails from outside the United States. Applying the same math, Netflix could one day have 200 million international subscribers, if not more.
Some bears have pointed out that broadband connectivity is much lower in developing countries than in the U.S. For instance, only 42% of people in Asia/Pacific region have mobile Internet, but 10 years ago before the iPhone existed, that percentage was zero. Technology is fast improving, and in 5-10 years connectivity may be much better than we imagined. Further broadband expansion will only support cord-cutting. That's an argument for Netflix, not against it.