If you thought things were bad for the broad market this week, you must not own a stake in streaming-video company Netflix (NFLX). NFLX stock has nearly tripled the NASDAQ Composite’s 5.0% tumble this week with a 13.4% plunge of its own.
Reports of a looming price increase in Europe — on top of the commitment of more than $150 million to create its own six-season series about the life of Queen Elizabeth II — largely spurred the latter portion of the selloff in Netflix stock this week.
Of course, the wildly bearish market tide certainly offered a helping hand, tripping up a vulnerable NFLX stock in the wake of its 115% run-up between early April and early August.
All the recent volatility and the timing of the news, however, does once again raise the question(s)… how are investors even supposed to evaluate Netflix? And based on that framework, what’s NFLX stock actually worth?
Higher Costs, Higher Prices Isn’t a Long-Term Business Model
On the off-chance you just got back from a ten-year mission to Mars and have missed all the drama surrounding Netflix, here’s the synopsis up to right now: Netflix is the undisputed king of subscription-based digital video, but has to spend heavily to get and keep a growing audience. Profits are thin.
Some fans and followers of NFLX stock believe the company will eventually reach a large enough scale to begin widening profits to acceptable levels, while others feel the company’s business model will perpetually prevent the organization from ever making any real money.
Everything else is just details.
The debate was rekindled again this week when NFLX announced it would be producing yet another of its own series, spending the most it’s ever spent on its own programs to produce a docudrama about the sitting Queen of England.
Supporters cheered the idea, pointing out that many of the other home-brewed television programs Netflix produces are well-loved and critically acclaimed. These include Orange is the New Black and House of Cards. Netflix will certainly do this one right as well, they argue.
The naysayers have a valid question, though, in wanting to know if Netflix can truly afford to spend $150 million on the regal series. For perspective, the company only generated $192.7 million worth of net income over the course of the past four quarters.
But where, pray tell, is this $150 million coming from? NFLX stock would be off far more than 13% this week if there were a secondary stock offering to raise the money, that much is certain.
The plan is to charge European customers more for their monthly service, with the monthly price slated to rise from €8.99 to €9.99. With 23.2 million international subscribers (most of whom are in Europe), Netflix is on track to pocket more than an additional $200 million per year via the prince increase, fully covering the cost of the new series and then some.
It’s not that simple, however. Consumers balk at price increases. Most may tolerate this one, but if and when the time comes for another one and the monthly cost reaches double-digit levels, sticker shock may ensue.
None of the Math Makes Sense
It’s the higher subscription price — and perhaps the reason behind the higher price — that prompted the pullback from NFLX stock this week as much as the marketwide tumble did. The market may well be wondering: where does the heavy spending end?
For that matter, Wall Street may also be tacitly wondering just how much of a price hike its European customers can tolerate before they cancel their service. It’s not an unmerited concern.
In the most recent quarterly shareholder letter from Netflix, CEO Reed Hastings wrote “We remain committed to running around a break-even globally on a net income basis through 2016, and to then deliver material global profits in 2017 and beyond.”
He may be able to squeeze out some wider margins in the foreseeable future too. But, even if he does, NFLX stock is still stunningly overvalued.
Just for the sake of argument let’s say Netflix continues to grow revenue at its recent pace, and bulks up 2014’s top line of $5.5 billion to $10.0 billion in revenue by 2017 (which is plausible).
Let’s also say by some miracle that Netflix is able to reel in its swelling costs and manages to convert a typical 15% of that $10.0 billion into net income (it’s unlikely, but stick with me here). That’s a bottom line of $1.5 billion two years from now. In comparison to the current market cap of $45.2 billion, NFLX stock is trading at a forward-looking P/E of 30 in that scenario…. and that assumes Hastings actually manages to cut spending and keep expanding at the company’s current pace.
Folks, NFLX stock is priced to future perfection as it is, and then some. There’s no room for error even under the most optimistic of scenarios. Indeed, during that three year span, new competitors are apt to pop up while existing competitors get better, keeping margins crimped.
In other words, the math just doesn’t say there’s a reason for further upside with Netflix stock at current levels.
Bottom Line for NFLX Stock
This is normally where you might expect to hear someone hash out the perils of story stocks that lack any reasonable value. You’re not going to hear that, however.
Twenty years ago, or even ten years ago, yours truly here would have made the valuation case against NFLX stock. Not now though, for one simple reason… if a valuation problem doesn’t bother anybody else then it shouldn’t bother you either. As long as the market collectively likes the story, it can sustain ridiculous valuations.
On the flipside, just be sure to embrace the fact that owning Netflix shares isn’t an investment in future earnings growth. It’s a bet on how much the market will remain enamored by the story in the future, which is a matter of (relative) perception. That’s a much trickier game to play, however, as a lot of Netflix owners learned the hard way this week.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.
