Congratulations to anyone who happened to own Netflix (NFLX) before Monday’s close. NFLX stock — already rallying — was up another 8% yesterday on the heels of new bullish coverage from Guggenheim Securities. The stock’s valuation was and is irrelevant. NFLX stock holders enjoyed another batch of bullish press, and the bulls acted accordingly, since news for story stocks is cumulative rather than cyclical.
In many ways, it’s a story in the same vein that Amazon.com (AMZN) is in. That is, AMZN stock isn’t an investment. It’s not even a trade. It’s a gamble on a premise, rooted in the notion that the stock will look and feel even more valuable in the future, forcing the stock up even higher than it already is.
Indeed, the two storied consumer-services companies are leaving many observers to wonder: Which one of these “investments” — AMZN or NFLX stock — will be the first to be exposed as the emperor with no clothes?
NFLX Stock Races Into Ludicrous Territory
As was noted, Tuesday’s round of bullishness for NFLX stock was spurred by the initiation of coverage by Guggenheim Securities that was accompanied by a healthy target price. Guggenheim has deemed NFLX a buy right out of the gate, establishing a price target of $160 on the stock.
Guggenheim’s analysts noted:
“Internet TV is also compelling outside the U.S., where the addressable market is larger. We expect significant investment through 2016 as Netflix completes its global launch. Global adoption should be supported by broadband improvements and mobile.”
They also detailed the rationale for the price target by saying:
“Our discounted-cash-flow analysis yields the $160 share value using a 8.9% weighted average cost of capital and 4.0% long-term growth. The implied market capitalization at our target is $70 billion, which we feel may ultimately prove to be modest for the Internet TV industry leader.”
Fair enough. The problem is, Guggenheim is valuing NFLX stock like a company that makes light switches and manhole covers. Netflix may have a very nominal cost of capital, but that’s the least of its concerns. Netflix’s biggest costs are its content costs, which Guggenheim inexplicably failed to address.
Even so, based on 2016’s anticipated earnings of 30 cents per share, Guggenheim has NFLX stock targeted at a near-term forward-looking P/E of 533.
Just for the sake of argument (and only for the sake of argument), let’s take Netflix CEO Reed Hastings’ comments on Q2’s results at face value and assume the company really is going to “deliver material global profits in 2017 and beyond.” Without even really knowing what that means, we do know the company would need to post profits of $8 per share at some point in the foreseeable future to justify Guggenheim’s target price of $160.
How’s that?
At a profit of $8 per share and a price of $160, NFLX stock would still be priced at a frothy-but-palatable P/E of 20. And to earn $8 per share (assuming typical net margins of about 15%), the company would probably need to generate at least $50 in revenue per share per year. That translates into company-wide revenue of about $21 billion. For perspective, Netflix generated $6.1 billion worth of revenue over the course of the past four quarters.
So, Netflix would need to multiply next year’s likely income by a factor of more than 26 for the target price to make sense. And to earn that $8 per share, it will likely need to triple its top line.
It’s admittedly just back-of-the-envelope math, but the scope is still in the right ballpark. And it’s that scope that makes the absurdity of Netflix-mania and the Guggenheim target clear.
NFLX stock is a growth story, and scale is certainly important, but that kind of growth is simply out of reach. The cost of capital is quite irrelevant.
AMZN Stock Isn’t Much Better
As ridiculous as the mania surrounding NFLX stock has been and still is, AMZN stock is valued just as ridiculously.
Even factoring in the e-tailer’s bigger-than-expected profits last quarter, Amazon is presently valued at a forward-looking P/E of 107.6 — and that assumes the company is going to earn the expected $4.94 per share of AMZN stock for 2016. That would by far be the most profitable year ever for Amazon.com, nearly quadrupling the bottom line projected for 2015.
Problem: The outlook is based on the assumption that Amazon won’t find something else it needs to spend heavily on in the meantime — as it is wont to do — in the name of growth. Never even mind the fact that Amazon’s margins are habitually paper-thin.
None of this is new to those who know Amazon.com well, of course. Its valuation has simply been one of those things people chose to ignore because they really, really liked the story.
But, as is always the case, the piper has to be paid at some point.
And the Winner Is…
So which of the two stocks will be the first to hit the wall of reality, and implode as a result?
My money’s on Netflix.
Not that expectations of Amazon still aren’t stupidly high, but after 20 years, CEO Jeff Bezos is finally starting to at least partially get the message that he needs to prove Amazon.com can get by without buying its growth. Slightly more attuned to the situation, the king of online-retailing is starting to cater to investors a little more than it has in the past.
Netflix, on the other hand, simply isn’t in a position to cater to owners of NFLX stock.
Even if (when) the company’s firing on all cylinders in the future, the best-case scenario math still simply looks out of reach. Investors are likely to come face to face with that reality sooner than later though, and unlike Amazon’s story of late, the Netflix disappointment will catch a lot of shareholders off guard.
That’s possibly the worst situation for a much-ballyhooed ticker like NFLX.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.
