Streaming giant Netflix (NASDAQ:NFLX) reported first-quarter numbers on Tuesday, April 21, that blew past estimates, and included a record-high 15.8 million global subscriber additions (analysts were expecting about half of that). Yet, in response to record-setting Netflix earnings, NFLX stock dropped.
Why?
Three big reasons. And those three big reasons are also why this epic 2020 rally in NFLX stock — shares are up more than 30% year-to-date — may start to cool off.
- This quarter’s robust success is not repeatable, and the back-half of 2020 will feature much more normal numbers.
- Economic normalization is coming, and that will introduce new fundamental and optical headwinds.
- Netflix’s long-term growth potential implies that shares are fairly valued right where they trade today.
All in all, while I’ve been a huge NFLX bull all year long, I think the best of this rally has already happened. Now may be a good time to do some profit-taking.
But, if shares do drop over the next few months as I expect, that will present a great opportunity to buy back into this long-term winner.
What Makes NFLX Stock Unique
Netflix added a whopping 15.8 million subscribers in the quarter, about double what was expected and far ahead of the sub-10 million net adds the company has been reporting every quarter since… well… ever.
This success, however, is not repeatable.
The novel coronavirus pandemic was a sugar rush for Netflix. Consumers across the globe, realizing they were going to be stuck at home for weeks, rushed to sign up for Netflix in March.
This sugar rush will die down going forward, on the thinking that most people who wanted to sign up for Netflix during the coronavirus pandemic, have already done so. Indeed, management’s best guess for net adds next quarter is 7.5 million — right back to the level of growth that Netflix was reporting pre-Covid-19.
There’s nothing wrong with that. 7.5 million net adds is a perfectly good number. But on the heels of a 30%-plus year-to-date rally in the stock, one could very reasonably argue that it’s not good enough to keep the rally alive.
Quicker-Than-Expected Economic Normalization
It increasingly appears that global economic normalization will happen much sooner than expected. That’s a bad thing for Netflix.
Specifically, the science surrounding the novel coronavirus pandemic is shifting.
At first, we thought this was a very deadly disease. But the most recent and most advanced research out of Stanford and USC using antibody testing refutes that.
Two separate studies show that about 3-6% of people in LA and the Bay Area have the virus, implying a true death rate for Covid-19 of somewhere around 0.12% to 0.2%, or roughly equivalent to that of the seasonal flu. There is ample research coming out of Europe which comes to similar conclusions.
As the science continues to change over the next few weeks, economic policy and consumer behavior will change, too. Federal, state, and local governments will re-open more aggressively than anticipated, while consumer behavior will normalize more quickly than anticipated.
That’s bad news for Netflix. Netflix won big in the first quarter because of stay-at-home orders and unusual consumer behavior. If those stay-at-home orders are lifted and consumer behavior normalizes in May/June, Netflix could actually report pretty weak second-quarter numbers.
After all, as management said in a letter to shareholders, if a person didn’t sign up for Netflix during confinement, they are unlikely to do so right after confinement ends.
Fully Valued
Above all else, I think it’s time to do some profit-taking on NFLX stock because shares are simply fully valued.
The company’s strong first-quarter earnings report only marginally changed my long-term model on Netflix, which assumes that Netflix leverages big data and resource advantages to sustain dominance in the secular growth global streaming TV market for the foreseeable future.
Broadly speaking, I still see Netflix as a company sprinting towards over 350 million global subscribers by 2025, with $50 billion-plus in revenues, 25%-plus operating margins, and over $25 in earnings per share.
According to those long-term estimates, Netflix stock is fully valued at $425. Based on a 25-times forward earnings multiple and a 10% annual discount rate, $25 in 2025 earnings per share implies a 2020 price target for NFLX stock of just over $425.
In other words, shares are today, where they should be by the end of the year. Sure, growth stocks can and often do trade above “fair value.” But not growth stocks with potential risks on the horizon. And that’s where Netflix finds itself today.
Bottom Line on NFLX Stock
Long-term, I love Netflix stock. This is a winning company, in a winning space, with a winning growth profile. Still, price matters. And at $425 in April 2020, Netflix stock is fully valued.
That doesn’t mean it’s time to sell everything. Never fully sell out of long-term winners like Netflix. But it does mean that it’s time to stop chasing, and start profit-taking. Sell a little bit here. Wait for the coronavirus-hype to cool down. Buy back on the dip. And ride the stock higher over the long-haul.
Luke Lango is a Markets Analyst for InvestorPlace. He has been professionally analyzing stocks for several years, previously working at various hedge funds and currently running his own investment fund in San Diego. A Caltech graduate, Luke has consistently been rated one of the world’s top stock pickers by various other analysts and platforms, and has developed a reputation for leveraging his technology background to identify growth stocks that deliver outstanding returns. Luke is also the founder of Fantastic, a social discovery company backed by an LA-based internet venture firm. As of this writing, he was long NFLX.
