I don’t really have a problem with the fact that Netflix, Inc. (NASDAQ:NFLX) is valued at about 150x earnings. After all, Netflix stock is a growth stock, and the opportunity is huge. Net margins are small (under 5%), and 20%+ annual increases and associated margin expansion mean that NFLX stock can grow its valuation very quickly.
Simply dismissing NFLX stock because it looks expensive right now and blaming a supposedly “shortsighted” market isn’t good investing. In fact, it’s the definition of being shortsighted. It’s akin to the similar knee-jerk arguments against Amazon.com, Inc. (NASDAQ:AMZN), and it shows a lack of understanding of the companies themselves and the stock market in general.
All that said, NFLX stock’s current valuation is starting to look more than a little high. Netflix stock obviously must grow into its valuation, and that process might be tougher than some NFLX bulls think. With competition rising and content owners increasingly looking toward their own path, Netflix may not be as dominant as many are predicting. If that’s the case, NFLX stock likely has some downside from here.
Is the Netflix Model Breaking?
One of the key reasons NFLX stock has doubled over the past 13 months is that the company clearly is establishing its dominance. Amazon Prime Video hasn’t made the inroads some expected. Hulu’s complicated ownership structure — 30% Walt Disney Co (NYSE:DIS) through ABC, 30% Twenty-First Century Fox Inc (NASDAQ:FOX, FOXA), 30% Comcast Corporation (NASDAQ:CMCSA) through its NBCUniversal arm, and 10% AT&T Inc. (NYSE:T) via soon-to-be-acquired Time Warner Inc (NYSE:TWX) — likely is holding it back.
Netflix has the most and best content across movies and television. To be sure, as NFLX bears point out, it’s spending heavily for that content, including original series like Narcos and House of Cards. Negative cash flow aside, though, Netflix clearly is the #1 destination for “cord-cutters.”
The current concern is that those content owners are starting to push back. Disney is pulling its movies from Netflix, looking to create its own service. CBS Corporation (NYSE:CBS) is going its own way with CBS All Access. Fox unit FX has rolled out its FX+ streaming service as well.
The bullish case for Netflix is that it is a gateway to content. Its original series aside, Netflix’s role is to aggregate content owned and developed elsewhere. But those owners increasingly are looking to open their own digital storefronts.
And so it’s not hard to imagine a very different future for content. Rather than NFLX aggregating content, a software/device maker like recent IPO Roku Inc (NASDAQ:ROKU) could aggregate services from CBS, FX, AMC Networks Inc (NASDAQ:AMCX), and other providers. That would in turn significantly limit Netflix’s role in the content ecosystem. It might not limit subscriber growth, at least in the near term, but it could limit some of the pricing power Netflix needs to justify the billions it is presently investing in original and licensed content.
But Netflix Stock Is OK, Right?
Admittedly, it’s a bit too early to see Netflix being squeezed out of the digital content space any time soon. But the risks suggested by recent maneuvers from content owners are real. And with NFLX trading at a sky-high valuation, it’s not difficult to imagine the narrative surrounding NFLX stock changing, particularly if another major content owner goes in a different direction.
Netflix does have an international business that is growing well. The overseas subscriber count passed the domestic total in Q2, which was one key reason I was so impressed by the Q2 report. Revenue per subscriber is much lower, though the weaker dollar and, eventually, price increases should help narrow that gap.
But international licensing and wholly owned content aren’t enough here. Bear in mind that NFLX now has about the same valuation as the price AT&T paid for Time Warner, when accounting for Netflix’s debt. Time Warner is a massive international conglomerate. Its assets range from HBO to CNN to Warner Brothers. Without success in being a content gateway, NFLX simply can’t match that strength, not now and possibly not ever.
That’s the risk to NFLX stock, and that’s one of the reasons the stock has pulled back of late. NFLX stock is priced as if the company will be the dominant player in content going forward. If it’s just another player, however, Netflix stock is going to decline.
As of this writing, Vince Martin has no positions in any securities mentioned.