Two weeks ago, streaming giant Netflix (NASDAQ:NFLX) reported robust double-beat-and-raise third quarter numbers which impressed Wall Street and sparked a huge rally in Netflix stock.
It seems like the market has entirely forgotten about that quarter. Since the post-earnings pop, Netflix has done nothing but grind lower. In after-hours trade following Q3 results, Netflix stock broke above $400. Today, it sits at $280, a mind-boggling 30% drop in two weeks for one of the world’s strongest, most innovative, and fastest growing companies.
Is the drop warranted?
Somewhat. At $400, NFLX was simply overvalued. Even the rosiest growth and valuation assumptions don’t support that kind of price this year.
But, at $280, the opposite seems true. Netflix simply is undervalued. Even reasonable growth and valuation assumptions support a 2018 price target for Netflix stock of of $280.
As such, while the market backdrop remains a mess, Netflix is materially undervalued as it drops below $280. If this sell-off persists to levels well below $280, then Netflix becomes a screaming buy, regardless of broader market noise.
Netflix’s Fundamentals Remain Strong
To be sure, the recent sell-off in Netflix has nothing to do with a deterioration in the fundamentals.
When you look at the fundamentals underlying Netflix stock, there are nothing but positive signs. The linear to internet TV shift has taken over the U.S. as cord cutting is only accelerating and Netflix’s domestic subscriber growth isn’t slowing despite having 50%-plus penetration among U.S. TV households.
Meanwhile, that same shift is going global with exceptional pace. Overall, net adds growth has consistently accelerated over the past five years.
Netflix is also hiking prices, and doing so without churn. That means higher average revenue per user. But, average costs per user aren’t going up by all that much. Unit revenue growth greatly outpacing unit cost growth has allowed margins to zoom higher. A few years ago, Netflix was looking at 3% and under profit margins. Now, we are talking about profit margins of 10% and up.
The growth outlook remains just as promising as the trailing growth trajectory. Netflix will end the year with about 150 million subscribers. There are 4.2 billion internet users in the world. Assuming an average household size of three people, that equates to 1.4 billion internet households. Thus, Netflix is tapping into just 10% of its addressable market.
Meanwhile, Netflix is still just $11 per month. Linear TV costs run north of $70 per month. From this perspective, Netflix still has a long ways to go before its becomes “expensive.”
In total, Netflix’s fundamentals are rock solid. This company is the leader in a secular growth market that is only accelerating in its growth trajectory, further differentiating itself from the pack, and rapidly ramping up the profit engine. Thus, so long as the valuation is reasonable, Netflix stock is a must-own for the long haul.
Reasonable Assumptions Support a $280 Price Tag
While the growth narrative supporting Netflix stock is stellar, the valuation still needs to remain within reason. At $400, the valuation on NFLX stock was not within reason. But, down at $280, Netflix actually looks like a good price considering secular growth drivers.
I’ve always looked at Netflix as a streaming platform with the potential to get 350 million households globally paying $15 per month for the Netflix service. Under those assumptions, we are talking about $63 billion in revenue at maturation.
Also at that point in time, I expect operating margins to stabilize around 30%. Putting those two together and factoring in higher debt costs, I reasonably see Netflix doing about $30 in earnings-per-share at maturation (by fiscal 2027).
Growth stocks normally trade around 20X forward earnings. That is where Netflix stock should trade at maturation. A 20 forward multiple on $30 in EPS implies a fiscal 2026 price target of $600. Discounted back by 10% per year, that equates to fiscal 2018 price target of roughly $280.
Thus, the valuation on Netflix is starting to look very reasonable, even under relatively conservative growth assumptions. Also, this stock could very easily hit 350 million subs before 2027, or very easily hike prices to $20 per month without much churn, or get a bigger multiple at maturation than 20.
In other words, this company has many levers it can pull which would warrant a fiscal 2018 price target above $280.
As such, I look at $280 as a baseline 2018 price target for Netflix. From this perspective, I think dips below $280 are compelling long-term entry points.
Bottom Line on Netflix Stock
This is a secular growth stock which has been whacked recently due to macro equity risks. But, not much has changed regarding the core fundamentals. As such, recent weakness in Netflix is a “buy the dip” opportunity when the price is right. Below $280, the price is right.
As of this writing, Luke Lango was long NFLX.
