It’s been a great year for Netflix, Inc. (NASDAQ:NFLX) shareholders. NFLX earnings are up, and Netflix stock is up a whopping 57.62% year-to-date.
Last year, I viewed Netflix as too expensive, trading at 340 times earnings, and recommended against buying the stock. But NFLX stock is up 54.3% since then.
I’m a bit biased against buying stocks trading at high valuations, since cheap generally beats expensive. Of course, every rule has its exceptions. Growth stocks with compelling stories such as Netflix and Tesla Inc (NASDAQ:TSLA) have continued to rise this year.
Last year, I saw Netflix as vulnerable to the threat of new entrants. It’s difficult to dethrone Facebook Inc (NASDAQ:FB) because of the size of its network. Almost everyone you know uses it, so switching to another network is difficult.
In my view, the streaming space was getting crowded, and keeping users would difficult. Switching between streaming services is not as difficult. There are Hulu, Amazon.com, Inc. (NASDAQ:AMZN) Prime Video, HBO Now and many others.
I also viewed social networks, such as Twitter Inc (NYSE:TWTR) and Facebook, as potential entrants into streaming.
But this hasn’t yet put a dent in NFLX earnings. As I note in this article, Netflix grew in terms of both pricing and volume this year.
Netflix Stock Pros
Strong Subscriber Growth: Netflix needs impressive growth to justify its eye-popping valuation. And Netflix has shown impressive growth in streaming memberships. According to Netflix’s 10-K filing from 2016, the company has nearly tripled its subscriber count since 2012.
And Netflix continues to grow subscribers at double-digit annual rates. Netflix claimed 104.03 million paid memberships worldwide in the third quarter of 2017, up from 83.28 million during that same period last year. This represents an annual growth rate of nearly 20%.
Pricing Holding Steady: Using figures from Netflix’s recent letter to shareholders, I calculated the company’s monthly average revenue per paid membership over the past 12 months.
Despite fears of competition, Netflix has held its prices steady. Monthly total revenue per paid member increased to $9.21 in the most recent quarter, up 6.61% from $8.63 in the third quarter of 2016. Domestic revenue per paid membership increased 7.38%, from $9.35 to $10.04. And monthly revenue per paid user outside the U.S. increased from $7.73 to $8.40.
Some, such as InvestorPlace contributor James Brumley, worry about Netflix losing members when it hikes prices. That may occur, but being forced to lower prices because of competition would be even worse.
International Diversification: Netflix has 51.35 million paid memberships in the United States. This might not seem like much at first, but keep in mind that some memberships can cover an entire family. To sustain its growth rate, Netflix will have to increasingly look outside the U.S.
Fortunately, this is going well, and Netflix subscribers outside the U.S. numbered 52.68 million in the most recent quarter. This means there are more subscribers outside the U.S.
Subscribers outside the U.S. accounted for nearly 80% of the increase in paid memberships over the most recent quarter.
Netflix Stock Cons
Rising Debt: Netflix is a fast-growing company ramping up its production of TV shows and movies, and it can’t fund this all on its own. NFLX needs cash, and in recent years, this has meant taking on more debt.
In the third quarter of 2016, Netflix owed $2.37 billion in debt; this doubled to $4.88 billion in the most recent quarter.
Netflix’s debt-to-equity ratio has grown as well, from 0.93 in September 2016 to 1.47 now.
This isn’t necessarily a bad thing as long as Netflix can generate a return on capital higher than its cost of debt. But this means less room for error; if Netflix gets things wrong, it could find itself in trouble repaying this debt.
Valuation: Netflix’s valuation makes fund manager Doug Kass feel “air sick.” NFLX earned $440 million in net income over the trailing 12 months, giving it a price/earnings multiple of 191. And Netflix trades at a price/book ratio of 25.3 and a price/sales ratio of 7.74.
If you’ve read my previous articles, you’ll note that I often go out of my way to emphasize enterprise value rather than market cap. However, NFLX’s $87.39 billion enterprise value isn’t much higher than its $84.25 billion market cap.
Sustaining this valuation will require a lot of growth, and if NFLX earnings disappoint, investors will punish the stock.
Disney Leaving: In my article last year, I didn’t see media companies such as Walt Disney Co (NYSE:DIS) leaving Netflix as a problem. But, as InvestorPlace contributor Vince Martin notes, this is happening. Could other media companies follow suit and dump NFLX? Time will tell.
The Verdict on Netflix Stock
I’m working on better understanding growth stocks and their fundamentals, but I still hesitate to recommend Netflix stock at these valuations. Sustaining a double-digit increase in revenue and subscribers is impressive, but does this justify a 55% increase in the stock price since January 1?
An increase in debt leaves less room for Netflix to make mistakes, and if it does, it may have trouble repaying loans.
And, as InvestorPlace contributor Lawrence Meyers noted in a recent article, Netflix remains cash flow negative, like Tesla, and unlike tech stocks such as Amazon and Facebook.
I have my doubts about whether these monstrous gains and NFLX earnings can be sustained. And if sentiment shifts and investors turn bearish, the stock will suffer. If I were going to buy a stock like Netflix, I would try to hedge with options to limit my downside.
InvestorPlace contributor Nicholas Chahine shares some of these concerns, but he thinks the stock could continue rising further. He recommends some NFLX trades in this article.
As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.