The run in Netflix, Inc. (NASDAQ:NFLX) has been absolutely breathtaking. Netflix stock now has more than doubled in 2018 alone. It’s quadrupled in less than two years. It’s risen 42x in the last six.
And at least one analyst thinks the run isn’t over. Goldman Sachs Group Inc (NYSE:GS) raised its target on Netflix stock to a Wall Street-high $490 on Wednesday. Netflix greeted the news with more gains, capping off a 20% rise just in the past month.
From here, the gains look like too much. Of course, I advised caution on Netflix stock back in January, a call that looks worse and worse with each passing session. And I do understand where Goldman analyst Heath Terry is going with his buy call.
Netflix is spending now for future profits, and the nature of its model suggests huge incremental margins for additional subscribers down the line.
The problem is this: I’m still not sure the math quite works long-term. But quite obviously, with Netflix nearing $400, many investors and analysts disagree.
The Goldman Sachs Upgrade
What’s interesting about the Goldman Sachs upgrade is that the logic behind it seems rather weak at first glance. Terry believes Netflix won’t generate positive free cash flow until 2022, with his estimate of just $500 million in FCF that year.
In turn, that means the Goldman target of $490 values Netflix stock at roughly 430 times 2022 free cash flow. Terry’s annual estimates also suggest that Netflix will have to raise more debt to cover its cash burn over the next three and a half years.
To some investors, Terry’s model might seem to support the bear case, rather than the bull case. But the underlying logic here is that come 2022, Netflix is going to print money. The attractive aspect of the Netflix business model is that as content spend slows, incremental margins become enormous.
The cost of adding an additional subscriber is minuscule compared to the ~$168 in annual revenue that a U.S. customer brings in. Once that “inflection point” (as Terry termed it) is reached, free cash flow growth will begin to soar.
And while it’s not clear what Terry specifically is modeling next decade, it’s obvious that the analyst sees Netflix cash flow moving into the billions of dollars annually once that point is reached.
Is Netflix Stock Really Worth Almost $500?
Of course, there is a real question as to how many billions Netflix will earn. A dollar earned in 2025 is not worth the same as a dollar earned today. In the meantime, Netflix’s valuation has soared past those of many media giants.
Using an 8% discount rate, a dollar of cash flow in 2025 is worth about 58 cents today. Assuming Netflix still generates a 30x FCF multiple that year, Netflix would need to generate $10 billion in cash just to support the current valuation. To reach Terry’s target, it would need a 35x multiple – or something closer to $12 billion in free cash flow.
Bear in mind that Netflix’s current trailing twelve-month revenue is about $13 billion. Obviously, that figure will grow sharply: Street estimates already are at $20 billion for 2019. If Netflix can grow 16%+ a year for the following six years, sales would reach $50 billion. And the $12 billion figure would require cash flow margins around 24%.
That’s not nearly as crazy as it sounds. Again, once the company gets FCF positive, incremental revenue growth will lead to huge cash flow increases. But the question is whether everything truly will go right enough for Netflix for that model to play out in reality.
What Can Go Wrong
While the model makes sense in theory, I see two big risks in practice. The first is whether Netflix’s own content really will be that good, as I wrote back in February. The Goldman Sachs model requires that Netflix will be able to pull back on spending on some point. That will only be the case if the content being developed now has a “long tail”, and still attracts subscribers next decade.
In other words, that content has to be good. But with Netflix creating 80 movies this year after the six largest studios combined made 94 this year the question is how long that will be the case.
If subscribers next decade aren’t willing to pay for this decade’s content, Netflix will either lose subscribers, or have to keep content spends at currently high levels. In that case, the expected incremental margins don’t materialize, cash flow disappoints, and Goldman’s target looks too high, if not downright foolish.
The second, broader, risk is that it still looks like everything has to go right. Netflix’s growth has to last another decade even though U.S. subscriptions may start to approach a ceiling at some point.
The company finished Q1 with 55 million paying subscribers; 100% saturation probably suggests 120 to at most 150 million subscribers, given that couples and families share plans.
Content has to go right. Netflix has to fight off competition from Disney and Hulu and Amazon.com, Inc. (NASDAQ:AMZN) and Comcast and the newly merged AT&T Inc. (NYSE:T) and Time Warner in the U.S. International rivals may start to challenge the company at some point as well.
It’s likely that most of those things will go right. It’s possible that all will go right. But it’s hard not to wonder at this point if Netflix stock isn’t pricing in worldwide domination already. And if Goldman’s outlier bull call might, at some point, look like the top.
As of this writing, Vince Martin has no positions in any securities mentioned.