Why I’m Not Ready to Bet on Netflix Stock Yet

There's a lot to like about the outlook of NFLX stock, but Netflix still has to overcome growing competition

NFLX stock - Why I’m Not Ready to Bet on Netflix Stock Yet

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In this market, shorting a stock like Netflix (NASDAQ:NFLX) is a fool’s errand. At least for now, investors in NFLX stock – as well as Amazon.com (NASDAQ:AMZN), Tesla (NASDAQ:TSLA), and many others – have shown that they are willing to pay for growth.

In the case of NFLX stock, the bull case makes some sense, even at a forward price-earnings ratio of 84, and even though its free cash flow is expected to be negative this year. Quite simply, Netflix has a chance to become the preeminent media distributor and creator in the world. Given the size of those markets, as long as Netflix continues to grow, its market capitalization can stay elevated and even continue to rise.

Admittedly, I’ve had my doubts. The company’s pivot toward creating content has added risk to the story and makes subscriber growth key to its long-term outlook. There’s a reason why NFLX stock plunged after its Q2 earnings, even though its bottom line beat the consensus outlook.

I still think that the company’s Q2 results raise real concerns – and I’m not convinced that Netflix can create as much quality content as it thinks it can. But margin expansion is also an important component of Netflix’s outlook. And Netflix’s recent battle with Apple (NASDAQ:AAPL) shows that NFLX has some ability to boost those margins, enabling its earnings growth to accelerate.

Netflix Tries to Bypass Apple

Netflix has initiated a test in 33 countries – including Canada, the UK, and Australia – that will force its subscribers to pay for their subscriptions via a mobile website, rather than the Apple Store, when they are using the iOS app.

The reason for this initiative is simple: Netflix doesn’t want to pay Apple 30% of its revenue from new subscriptions and 15% of its revenue from subscription renewals. As Bloomberg detailed, it’s part of a larger pushback against the “tax” charged by Apple and Alphabet (NASDAQ:GOOG,GOOGL) on sales made through their operating systems.

Will it work? It’s not necessarily clear. Netflix is the third highest-grossing app for Apple, according to Bloomberg. That gives Netflix some negotiating power. On the other hand, making the process more difficult for subscribers could impact the growth Netflix so intently desires.

And to be sure, even if Netflix is successful, it’s not as if the move necessarily is a game-changer for NFLX stock. Apple’s market share in many of those markets – notably India – is smaller than it is in the U.S.

But the move by Netflix is a reminder of a key part of the story of Netflix stock: What Netflix is right now is not the same as what Netflix will be. And the reason why NFLX stock – and so many others – have seemingly sky-high valuations is because of how much their margins can rise as they grow. What’s interesting about Netflix is that its margins can expand more quickly than its top line.

Incremental Margins

The most important reason that NFLX stock can grow into a valuation that seems close to absurd is that its incremental margins are huge. Adding a new subscriber costs it exceedingly little, meaning that its profits can grow much more quickly than its revenue. Indeed, its operating margins already are expanding quickly, rising to 11.8% in Q2 from 4.6% the year before.

But it’s worth considering that those incremental margins can come from areas other than subscriber growth. NFLX, for example, can increase its margins by cutting the fees it pays to app stores and by raising its prices. In the latter area, the company is testing a “Netflix Ultra” option. Furthermore, the company’s expenditures on marketing will probably come down over time, particularly once it has grown its overseas businesses.

It’s easy to focus on the big picture, i.e. subscriber growth and out-year earnings models. But smaller initiatives can also boost the outlook of NFLX stock.

Should You Buy NFLX Stock?

Certainly, Netflix stock has a chance to climb significantly. NFLX is clearly taking market share from other media companies. The Street expects the company’s earnings per share to surge 62% in 2019, and the most bullish analyst predicts that its EPS will more than double year-over-year. As the company’s spending on content moderates, its free cash flow should eventually catch up, although that won’t happen until years from now.

Meanwhile, Amazon and Disney (NYSE:DIS) are going to be tough competitors for Netflix. But Netflix stock can rise going forward if the company continues to remain the dominant provider of streaming content.

That remains a big ‘if’, however. Netflix’s bet on content — including its plan to release some 80 movies this year — raises both its risk and its reward. If Netflix’s content truly can compete with the best offerings of Amazon, Disney, and the world’s movie and TV studios, it will benefit from that content for years to come. Moreover, it will not have to pay more cash to use those movies over the long-term.

If, on the other hand, NFLX does not stay dominant,  its story starts to fall apart. If Netflix’s moat isn’t as strong as it seems, and competitors start to take share, its margins will not expand as rapidly as expected. As a result, its earnings growth will disappoint the Street, and NFLX stock will be range-bound, at best.

I’m still not ready to bet on NFLX stock, particularly after the recent bounce. But I do understand why other investors might make the bet. If Netflix can pick up a few small wins, its case may become even stronger.

As of this writing, Vince Martin has no positions in any securities mentioned.

Article printed from InvestorPlace Media, https://investorplace.com/2018/08/why-im-not-betting-on-nflx-stock/.

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