Netflix, Inc. (NASDAQ:NFLX) stock soared 19% on Oct. 18 after beating earnings estimates for the third quarter. Analysts expected 6 cents a share, but Netflix stock doubled that, adding 3.2 million international subscribers ahead of the expected 2 million.
In the U.S., Netflix added 370,000 subscribers, up from estimates of 304,000. This comes after a period of lackluster growth.
NFLX even hiked monthly subscriber fees from $8 to $10 earlier this year, but still was able to beat forecasts. That said, will Netflix’s rally continue, or will Netflix stock fizzle out?
The Long-Term Goal for Netflix Stock
While NFLX may have beaten estimates for U.S. subscriber growth last quarter, this still is down from last year, when the company added 881,000 subscribers in the third quarter.
In the second and third quarters of 2016 combined, Netflix added 530,000 viewers, so at that rate it would take Netflix almost twelve years to get to 60 million viewers, and that’s the low end of its long-term forecast.
Global expansion will become more important as the U.S. market matures.
Netflix, now available in 190 countries, is the world’s first global TV network. Netflix’s rapidly growing international business currently operates at a loss, but expects this will become profitable next year.
Netflix’s global expansion could be boosted by the introduction of 4G technology. Smartphone usage is rapidly growing in the developing world, where many never will own a desktop PC. 4G technology could reduce the cost of bandwidth, allowing telecoms to remove the data caps and make NFLX subscriptions feasible for the mobile-only crowd.
But can Netflix succeed in foreign markets? The streaming company has already backed out of China, which is almost 20% of the world population. People in countries like India and Vietnam may lack the disposable incomes for a Netflix subscription. Netflix could offer them lower prices, but this would also reduce margins. HBO receives $10 per subscriber in Scandinavia, but only 10 cents in Vietnam.
Challenging Netflix’s Profitability
Netflix’s margins are low since the firm operates at a loss in foreign markets. And global expansion does not come cheap.
Netflix is investing heavily in original content, and must pay more upfront for original series than it would for content it licenses from other studios. But NFLX expects this to be cheaper in the long run, as it works directly with content creators and cuts out the middleman.
Also, producing original content helps NFLX differentiate itself from the competition and gives it greater pricing power in the long run. Series like House of Cards can only be streamed on Netflix, but can be purchased through Xfinity by Comcast Corporation (NASDAQ:CMCSA), making it harder for fans of these programs to cancel their subscriptions, even if it raises prices. In a survey of Netflix subscribers by Morgan Stanley, 45% cited NFLX’s content as a major reason for subscribing.
Netflix hopes to achieve a 40% contribution margin on domestic streaming and Morningstar projects a 10.3% contribution margin from foreign streaming by 2020.
New entrants might challenge Netflix stock for market share, however, pushing down Netflix’s already-thin margins.
Here’s Comes the Competition
With teens, Netflix comes out on top: 37% of teens surveyed by Piper Jaffray said they watched Netflix every day, while Prime Video from Amazon.com, Inc. (NASDAQ:AMZN) and Hulu each could only claim 3%. And Netflix enjoys the lowest churn rate among over-the-top providers in the United States, losing fewer of its subscribers than Amazon and Hulu.
But even if these other streaming services don’t win bids for content, they will push up prices for NFLX and reduce its profits. Barriers to entry for video streaming are relatively low, unlike social networks such as Facebook Inc (NASDAQ:FB) or search engines like Google from Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL).
And like YouTube with Youtube Red, Facebook and Twitter Inc (NYSE:TWTR) can access a ton of data about their users, which may lead them to introduce their own paid streaming services one day. YouTube, with 26% of teens watching every day, is second only to Netflix, so it has the scale with which to compete.
Bottom Line on Netflix Stock
Netflix’s sky-high valuation factors in years of rapid growth. Should NFLX fail to meet the market’s expectations, the stock will fall. Netflix trades at 340 times earnings, well above its 13-year median of 45.
NFLX may reach $13 billion in revenue by 2020, $6.2 billion from domestic streaming and $7 billion from foreign operations. With the forecasted contribution margins for 2020, this gives us $3.5 billion.
Let’s be optimistic and hold operating expenses constant (about $350 million a quarter, or $1.4 billion a year). Netflix would then earn $2.1 billion in net income in 2020.
Netflix stock currently trades at a market capitalization of $54 billion. To keep pace with the market and earn an 8% annual return from 2017 to 2020, NFLX would need to trade at $77.14 billion in 2020, at an earnings multiple of 36. Will a maturing NFLX still trade at 36 times earnings?
Netflix may have a bright future, but unfortunately for NFLX stockholders, the market has already factored this into the price.
Netflix’s business may be sound, but buying Netflix stock at 340 times earnings carries a lot of downside risk.
Wait for a better buying opportunity.
As of this writing, Lucas Hahn did not hold a position in any of the aforementioned securities.