by Dan Burrows | September 11, 2013 1:28 pm
Will it be deja vu all over again for Netflix (NFLX) stock?
Shares in the streaming video and rental company are flying high once again and appear to have rocket-propelled momentum. Too bad the last time Netflix stock went on this kind of tear, it crashed and burned in an epic meltdown.
NFLX continued to set new all-time highs Wednesday, topping $314 a pop at one point early in the session. The proximate cause was an announcement that Netflix struck a deal with Virgin Media (VMED) to embed a Netflix app in the U.K. broadband company’s set-top cable boxes.
But that was just the latest reason to be bullish on shares. Robust subscriber growth, international expansion and success in producing its own content are making good on Netflix’s promise to totally upend the TV industry.
The problem is that we’ve seen this kind of crazy exuberance before. A couple of years ago, Netflix was trading just shy of $300 — and then the roof caved in.
Among other issues, new subscriber figures kept falling short of Wall Street estimates, and Netflix had to backtrack on its stupid idea to split the company into two separate services.
Shares went from about $300 to near $50 from mid-2011 to mid-2012 — a drop of 80%.
So, should you buy Netflix stock even after the huge rally, expecting momentum to keep it charging ahead? Or has the easy money more than been made? To help decide, let’s take a look at some of the pros and cons:
Momentum: Shares have more than tripled for the year-to-date and show no signs of slowing down. Netflix stock is well above both its 50- and 200-day moving averages, which suggests plenty of technical strength and upside in the short- to medium-term. Additionally, heavy short interest in the stock lends upside support because short sellers keep finding themselves on the wrong side of this trade. The shorts are getting squeezed, stuck in a buy-to-cover corner that serves as another source of demand.
Market Dominance: The pioneer of video streaming is conquering not just the U.S., but the world. True, growth in the U.S. has slowed, but it’s still growth. Netflix added 633,000 streaming subscribers in the most recent quarter, bringing its U.S. total up to nearly 30 million. More importantly, Netflix is expanding rapidly overseas. It gained 605,000 international streaming subscribers in the latest quarter to bring that total up to 7.8 million. And with Wednesday’s announcement that Netflix is coming to the Netherlands, the company now has operations in 41 countries.
Robust Growth: Wall Street analysts forecast earning per share to quintuple this year — to $1.49 from 29 cents a year ago. And EPS is projected to more than double in 2014. Increased profitability will deliver more cash to the bottom line, as revenue is forecast to rise 20% this year and 17% next year. Furthermore, Netflix’s long-term growth rate is forecast to average 23% a year for the next five years. By way of comparison, the S&P 500 has a compound annual growth forecast of less than 10% for the next half-decade.
Valuation: Netflix’s stock hasn’t been reasonably valued since it fell to $50 a share, but lately it’s gone bonkers. This is an incredibly overpriced stock by relative valuation measures. Sure, profits are expected to grow at a 23% clip over the next few years, but that hardly justifies investors paying a whopping 93 times future earnings. Furthermore, that forward price-to-earnings multiple represents a huge premium to the stock’s own five-year average of 56, according to data from Thomson Reuters Stock Reports. Trailing P/E, price-earnings-to-growth and price-to-sale ratios are also orders of magnitude above historical averages.
Thin Margins, Low Quality: Netflix’s operating margin stands at just 3% and the net profit margin comes to 1.2%. Even famously low-margin Walmart (WMT) has a net profit margin of 3.6%. With margins that thin, the company has little room for errors that would push it into a net loss. Just take a look at Amazon (AMZN) for an example of that. Moreover, Netflix is what you’d call a low-quality stock based on its return on equity, which is a paltry 5.3%.
Vulnerable Balance Sheet: Netflix’s balance sheet has improved over the last decade and it carries relatively little long-term debt — but it’s still not all that strong. It costs a lot of money to grow this business aggressively and internationally, especially amid strong competition from the likes of Amazon, Hulu, Comcast (CMCSA) and Dish Network (DISH). The company carried total assets of $4.5 billion at the end of the last quarter — but it also had total liabilities of $3.4 billion. Meanwhile, the company’s capital base is highly leveraged, with a debt-to-equity ratio of 45.
You certainly could play Netflix as a short-term trade — if you watch it vigilantly, maintain a stop-loss order and remember to raise your stop-loss proportionately as the stock continues to rise. Momentum certainly augurs well for some more upside in the near future.
But as for making Netflix part of your long-term portfolio? No way. It’s obscenely expensive by its own averages, and if there’s one thing we know about valuation, it’s that it reverts to the mean. Buying and holding at current levels makes no sense at these multiples.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.
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