Netflix Might Not Be as Exciting as It Looks
- By Ishan Majumdar
Netflix Inc. (NFLX), the streaming video, on-demand entertainment giant released its results for the fourth quarter last week, and the stock has been the talk of the town ever since.
The company has been one of the most remarkable growth stories in the past decade, and analysts are expecting this growth to continue as they provided higher targets for the stock for 2019. But, with increasing competition and reduced margins from international subscriptions, it is possible that Netflix might not live up to these expectations in the coming future.
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The intrinsic value of NFLX
Netflix's result was below expectations, but analysts are bullish
For the final quarter of 2018, announced on Jan. 17, Netflix reported $4.19 billion of revenues with robust 27.9% growth compared to the corresponding quarter of the previous year. Even with a good rise in overall subscriptions, this number missed analyst estimates by about $20 million.
But, Netflix managed to surprise analysts in earnings per share, reporting 30 cents, which was about 6 cents higher than their expectations. The operating margin dropped from 12% in the third quarter to 5.2% as a result of increased marketing costs, increased costs associated with new titles and the relatively low margins coming from the company's business abroad. This caused the stock price to fall by more than 3% in the trading day following the results.
Despite the fall, analysts continue to be very bullish on Netflix. Most of the analysts covering the stock raised their price target, including RBC Capital Markets' Mark Mahaney, Raymond James' Justin Patterson, Piper Jaffray's Michael Olson, and JPMorgan's Doug Anmuth.
The general view across all analysts was that the rapid growth of on-demand entertainment across the globe coupled with Netflix's ability to produce high-quality original content create a highly favorable macro environment that is bound to support the company's future growth and profitability.
Why is the stock valued so high?
As shown in the above chart, Netflix's stock price has more than tripled in three years, and any analyst looking at the script for the first time would have his eyes popping out on seeing the valuation multiples. The company trades at an EV-revenue multiple of 9.78 and an EV-Ebitda of 89.27.
The price-earnings ratio is as high as 126.53, and one might wonder what the company has achieved over the years to deserve such a huge level of multiples expansion. The answer lies in the revenue and profitability growth numbers. Netflix's revenues have grown at a compounded annual growth rate of 27.86% over the past five years as it has spread its presence across the globe. Its net income has grown at an annualized rate of 113.48% in this five-year period, which is phenomenal. The on-demand content market has been growing across the globe, and this is the reason why the stock has practically been doubling in value every two years.
What are the negatives of Netflix that are not so visible?
There are a number of points in Netflix's recent results that need to be analyzed more critically to have a better picture regarding the future of the company. First, the subscriber growth is good, but its impact on the financials is lower than before. The reason for this is that the company has witnessed this growth in subscribers primarily in international markets, and these have a significantly lower contribution margin as compared to the U.S. subscribers. In fact, the average contribution margin of international subscribers is 10.3%, which is less than one-third of the U.S. subscribers' contribution margin of 33.7%.
It is also worth highlighting that the company faces intense competition from Amazon (AMZN)'s Prime services, Alphabet (GOOG)(GOOGL)'s Youtube, Facebook (FB) and many domestic players in foreign markets, which are adopting solid digital strategies to counter Netflix, and build good, original content. The size of the overall pie of global on-demand entertainment is growing, so there is no doubt that Netflix will continue to grow its top line despite the competition. Yet it will have to continue increasing marketing expenditure and investing more on original content creation if it is to survive in this competitive environment, which is bound to affect the margins further.
Conclusion
There is little doubt regarding Netflix's revenue growth potential. The company is certainly expected to keep growing at a healthy pace for the coming few years despite the competition, but the growth will not be backed by the kind of margins that investors have seen in the past. Whether the valuation multiples continue to support the stock or dwindle with time as the margins begin to drop, is to be seen in the future. As of today, the stock does not appear to be undervalued at all and should ideally be avoided by value investors with a low risk appetite.
Disclosure: No positions.
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This article first appeared on GuruFocus.
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The intrinsic value of NFLX
