by Clement Thibault
Netflix (NASDAQ:NFLX), the internet television network and global streaming video service, reports Q2 2017 earnings on Monday, July 17 after US markets close. Consensus expectations are that Netflix will report $0.16 EPS on Revenue of $2.76B.
Currently trading at $161.12 as of Friday's close, is this a stock that's still worth having in one's portfolio and is the share price justified?
After missing the mark on expected subscriptions last quarter, Netflix, whose subscriber total then came in at 98.75 (versus 98.93 expected) has, in all likelihood, crossed the hundred million mark.
But is focusing on subscriber growth still a relevant metric for Netflix? For years, when markets still considered Netflix to be a streaming content company, that's what moved the needle after earnings reports, rather than the actual earnings in many instances. If Netflix surpassed expectations for subscriber growth – there's an extra 10% automatically added to the share price.
Not surprising, at this point, the number of new subscribers has slowed, and the trend is heading down. In Q1 2016, Netflix reported US subscriber growth of 13% and international subscriber growth of 65%. Last quarter, these numbers were down to 8% and 38% respectively. Combined, that's a 50% slowdown in total growth, from 30% in Q1 2016 to 20% in Q1 2017.
Slowing subscriber growth would be a concern for any business dependent on adding paid users, but glass-half-full investors might say deceleration signals the service has fulfilled its goal of household penetration, at least in the US, and now it's time to make some real money. For the purposes of this post we'll work with that premise.
Certainly, realists will point to the fact that no matter the product or service, there are only a finite number of people who will sign on, thus circumscribed potential growth in any arena will eventually be the norm. If that's the case, and subscriber growth is truly becoming less significant, investors will probably shift their focus to the business itself. So, is Netflix making money, or is it spending faster than it can pull in revenue?
Because revenue and spending—especially in the content industry—can vary widely from quarter to quarter, we'll look at Netflix's performance on an annualized basis. From a revenue perspective, Netflix is indeed growing nicely. Over the past four years, the company has seen growth of over 20% per year. That pace has allowed Netflix to double its revenue in just three years—from $4.4 billion in 2013 to $8.8 billion in 2016.
However, the robust pace of growth has come at a price (literally)...accelerated spending.
At the end of 2013, a year when Netflix made $4.4 billion in revenue, the company had $3.8 billion worth of content in its archives, along with $500 million of long-term debt. Since then, though revenue has doubled, Netflix had to create $7.2 billion worth of additional content assets and its long-term debt has grown significantly, now at $3.3 billion dollars.
In order to reach 110% growth in subscribers and 100% revenue growth, Netflix had to almost triple its content bank which increased the company's long-term debt six-fold. This wouldn't necessarily be a problem if at some point Netflix could recoup the expenses of its already existing content by having customers watch the same material repeatedly, giving Netflix time to slowly add new material.
However, with Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOGL) and others already in the streaming business, and with yet more competitors planning to get on board the streaming content train, customers have come to expect infusions of fresh, high-quality, new content at an unprecedented rate.
And if Netflix won't provide it, of course one of its competitors surely will. As such, the massive spending necessary for customer acquisition and retention, as well as household penetration isn't a one-time expense for evergreen content that will be re-run ad-nauseum. Rather, spending will have to continue if Netflix is to compete effectively. The company seems to be aware of this; it has $14.5 billion in content obligations over the next few years.
Still, Netflix isn't helping its own case. Its users are known for binge-watching, which means playing episode after episode of a series in one sitting. In fact, Netflix encourages and endorses this behavior by releasing full series on a specific date, rather than one episode each week for the run of a series.
As a business model, this isn't optimal for two reasons. First, Netflix is charging users a monthly subscription. By releasing its episodes weekly (as HBO (NYSE:TWX) does), it could lock in customers for months while airing a series, instead of letting them see the entire thing in just a few days. A 20 episode season, for example, can be stretched out to approximately 5-months of new content on a weekly release schedule.
Second, all the effort and funding Netflix puts into a new series provides users with only a few days of enjoyment. Once the binge is finished, they immediately crave yet more new content. Releasing a series over time would prolong the enjoyment and possibly allow Netflix to chill on its rate of expenditure.
We are fans of the service Netflix provides, but not so much of its valuation. Assuming an overvalued, expensive stock market, we see Netflix's stable P/E ratio at around 35-40. Based on 2016 annual figures, Netflix's P/E ratio was 346.
We created a model reflecting both Netflix's guidance (7% operating margin in 2017) and best case growth and margins (30% growth in the next few years with a 3% operating margin bump each year). This model shows that a price of $150 for Netflix would be justified in two to three years, at best.
A more likely scenario would have growth slow a bit more rapidly and margins grow just 2% per year. This isn't a very bearish scenario, as Netflix still manages to grow both revenue and margins rather quickly. However, even with this second senario, we're still 3 to 4 years away from a reasonable valuation.
That's the problem with companies that are highly valued – everything needs to go very right, and the margin for error is very small. Any deviation from the best case scenario will see the stock price punished.
Note also that our model reflects the current business model and pricing for Netflix's services. Because of the immense spending and heavy debt obligation discussed above, we believe Netflix will have to raise the price of its services going forward.
Netflix has been on admirable growth trajectory, and has without doubt changed the way we consume content. We believe its growth trend will continue over the next two years. However, the best case scenario is already priced in and unless growth suddenly picks up, we could see the stock trending sideways or even downward in the next few years.
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