When It Comes to FANG, Netflix Stock Clearly Is the Weakest Link

Advertisement

Netflix stock - When It Comes to FANG, Netflix Stock Clearly Is the Weakest Link

Source: Shutterstock

Netflix (NASDAQ:NFLX) once was the hottest in the FANG group, but now Netflix stock is down 25% off its all time highs. All of FANG has had a tough time leading the market recently, and many market observers blame Facebook (NASDAQ:FB).

The social media giant has dealt with privacy concern after privacy concern, the sum of which culminated in a disastrous earnings report that caused the company to lose $100 billion in value in a single day. Thus, it is easy and natural to blame Facebook for FANG’s recent weakness.

But, I actually think the weakest name in the FANG group isn’t Facebook, it’s Netflix.

What is going on with Netflix stock? Supercharged and unrealistic growth expectations normalized after the company’s recent quarterly subscriber miss. Hype died down. Momentum was lost. And everyone’s eyes opened up to the real risks facing Netflix stock: valuation, competition, and saturation.

Unfortunately, I think these risks will continue to weigh on Netflix for the foreseeable future. I still believe this is a company with massive earnings growth potential over the next decade, but am beginning to question the type of premium the market is willing to pay for that growth, especially considering the company’s increasingly competitive operating landscape.

All in all, of all the FANG stocks, I think Netflix is the one with the most to worry about.

Netflix’s Growth Potential Is Huge

There is no denying the fact that Netflix’s growth potential is huge.

This is a company which has pioneered the over-the-top entertainment space. This space is rapidly growing in popularity. It has already taken over the United States (where cord cutting is becoming more prevalent and more than 50% of internet households have a Netflix subscription) and is turning into a global phenomena (Netflix’s international subscriber growth has been red hot).

This takeover is inevitable. Over-the-top entertainment services are simply superior to their linear counterparts. They are cheaper and offer enhanced convenience through on-demand and multiple-screen viewing. Thus, the OTT phenomena which has swept through the U.S. will takeover globally too.

Netflix will be a big part of that takeover and most likely the biggest part of that takeover. The company not only has mastered over-the-top content delivery, but has also developed a robust original content pipeline which consumers globally seem to love.

Moreover, because Netflix is so cheap, the company has a ton of room to hike prices over the next several years without churn.

All together, this is a company that in a decade could have 350 million subscribers globally paying $15 per month. Margins will inevitably increase with scale, and that leads me to believe this is a company with $30 in earnings per share potential in a decade.

Netflix’s Risks Also Are Huge

Although Netflix has massive growth potential, the risks facing the business are big, too.

Namely, competition is ramping. Linear television operators like AT&T (NYSE:T) are getting into the OTT game with their own streaming services like DirecTV Now, and content creators like Disney (NYSE:DIS) are also getting into the OTT game with their own streaming services and exclusive content.

All together, the OTT space will be a lot more crowded in a decade than it is today.

That being said, Netflix’s original content should allow the platform to differentiate itself. But, while I believe these multiple OTT platforms can exist side-by-side, there will be some customer turnover from Netflix to Disney and other streaming platforms over the next several years.

The magnitude of such customer turnover remains a big question mark, and that adds a layer of uncertainty which clouds the long-term bull thesis.

Valuation Is Troublesome

The valuation on Netflix stock isn’t great considering that huge growth potential is met with equally huge risks.

The current 10X trailing sales multiple and 120X forward earnings multiple are indicative of the big growth part of Netflix, but don’t really have much of the big risk side baked in. Also, the company continues to spend an arm and a leg on content, so free cash flow, while improving, is still hugely negative.

Let’s take $30 earnings per share in a decade as base case. What multiple will the market be willing to pay for Netflix stock at that time? The market usually trades at 16X forward earnings. Growth stocks tend to get a 20X forward multiple. Big growth stocks can get trade in the 25-30X range.

The only way the current valuation on Netflix stock makes sense is if the company gets a big growth 25-30X multiple in 10 years. A 25X forward multiple on $30 implies a nine-year forward price target of $750. Discounted back by 10% per year, that equates to a year-end price target of $350.

Assuming a 20X multiple, that gets you to a $280 price target by the end of the year. At 16X, you are looking at a $225 stock.

I reasonably think Netflix deserves a 20X to 25X forward multiple in a decade, implying a year-end price target somewhere around $315. Thus, if Netflix stock keeps dropping towards $300, that could be the time to buy.

Bottom Line on Netflix Stock

The long-term Netflix growth narrative remains promising, but Netflix remains priced for perfection. If the stock drops towards $300, then we could see a bottom put in and a rebound ensue. Until then, I think the stock will keep dropping.

As of this writing, Luke Lango was long FB. 


Article printed from InvestorPlace Media, https://investorplace.com/2018/08/netflix-stock-weakest-link/.

©2024 InvestorPlace Media, LLC