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Introduction

There has been a raging debate over the future of Netflix (NASDAQ:NFLX). I am highly convinced that the stock will do an outstanding job of returning money to investors hand over fist. Outlook remains bright because of the successful completion of its Warner Brothers (NYSE:TWX) and Walt Disney (NYSE:DIS) deal. Investors should anticipate long-term appreciation in the value of the stock, and position themselves accordingly.

Qualitative Analysis

Source: Information pertaining to Netflix came from the shareholder annual report, with additional information from the Netflix quarterly report, Caterpillar Year in Review, International Telecommunication Union, and the Walt Disney Annual Report.

In a previous article I had stated that Netflix would trade at approximately $107.46 - $181.30. The current market valuation of the stock is $162. It is trading within the range of my price target which was made on December 7th 2012. My assumption on valuation was more accurate than the consensus price target of $67.48.

I am reiterating my buy recommendation due to Netflix's unique value proposition in both foreign and domestic markets.


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The numbers presented seem fairly meaningless, but it is extremely important to recognize the profound growth Netflix has been able to accomplish in net subscribers. In Quarter 4 2011 the company had 1.86 million total subscribers in its international streaming. In Quarter 4 2012 the company had 6.12 million total subscribers in its international streaming division. The growth in terms of subscribers has been exponential (229% year over year growth in subscribers). The domestic streaming growth has also been exponential which grew subscribers by 25% year over year. This is the primary reason for why investors are willing to pay a high-premium on earnings.

The debate over whether Netflix can or cannot remain competitive has been a moot point, also whether or not Netflix can or cannot secure top-tier content is a non-issue. Netflix was able to sign two high-profile content licensing deals with Warner Brothers and Disney. Because of these deals Netflix is able to secure animated live action programming from Cartoon Network, Warner Bros. Animation and Adult Swim, as well as TNT. The Disney deal will include Pixar, Lucas films, Marvel, and Disney content. Netflix will become the exclusive distributor of Disney content in 2016. By becoming the exclusive distributor of Disney content, Netflix is able to turn the traditional cable networks into a legacy business model (imagine the transition from cassette tapes to CDs). I will further elaborate on this.


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The above diagram is trying to explain the number of popular content Netflix has in comparison to its competitors. Of them, Amazon.com prime has 73 of the top 200 movies and shows that Netflix has content rights over. However, Amazon.com prime cannot be seen as a serious competitor because Amazon is heavily diversified and presents a confusing brand identity making it less attractive to potential consumers. Redbox when compared to Netflix operates a legacy business model of offering DVDs at a vending machine and is not a significant competitive threat. HuluPlus has an inconsequential amount of market share relative to Netflix. So in summary I believe that based on the quality of content and Netflix's unique market position, it is extremely safe to assume that Netflix has an overwhelming competitive advantage.

Morgan Stanley reiterates this point by stating:

We believe that price elasticity is not as high as investors believe. Redbox increased its cost to rent DVDs from $1.00 per day to $1.20, which is effectively a 20% price increase. A 20% price increase for Netflix would bring the company's Domestic Streaming average revenue price per unit to $9.59. A $9.99 price point would be a 25% price increase. As long as Netflix continues to develop a differentiated content portfolio, we believe the company has the ability to exercise modest pricing power down the road.

Netflix has been successful at creating a differentiated product portfolio (Disney and Warner Brothers), but there's even more to be cheerful about. Netflix itself is producing content, and anticipates that its platform of in-house produced content will be disruptive in nature. The advantages of in-house production of content:

  • Traditional television media channels require that programming be shown at certain times of day when a large percentage of people are in front of their television (the 7-9PM slot). Netflix on the other hand does not have to worry about this constraint in programming because it operates a separate revenue model, and is not driven by advertising. The content can be viewed whenever, and by a large global audience instantaneously at any time. The advantage is that the audience gets to determine the best content through viewer ship over time.
  • Traditional television media needs the shows to be hits, otherwise the media content fizzles out and the producers lose money. With Netflix's guaranteed revenue model, the subscribers can support new content on a consistent basis, allowing for long-term in-house content generation.
  • Because Netflix does not design episodes around advertising content, the show length may vary. In other words, the show producers can design episodes that are not exactly 22 or 44 minutes in length. This competitive advantage allows for producers of content added creativity. This also includes the reduction of stress when it comes to including both product-placement and show timing based on ad-slots. Producers will be delighted when they find that the platform is extremely flexible and easy to work with.

Re-examining the deal between Netflix and Disney, I believe that Disney needed the deal more than Netflix. Walt Disney's business model needs a lot of eyeballs. It opens its entertainment and television network (Disney channel) in emerging markets, this acquaints the audience with the Walt Disney brand, then up-sells the audience to a Walt Disney theme park (this is what happened in South America and China). This synergy is what makes Walt Disney a powerhouse in the entertainment industry. Netflix is a growing force in content distribution internationally. Walt Disney needs to acquaint the audience with the Disney brand in some shape or form, and by distributing content on the Netflix subscriber network; Disney is better able to create brand awareness in foreign markets. This means that Disney up to a certain extent is relying on Netflix's content distribution in order to up-sell foreign consumers into its Disney theme parks. In fact a large share of Disney's revenues depends heavily on its theme park business, and less on its studio entertainment (based on the table below).


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The content deal between Walt Disney and Netflix was valued at approximately $300 million per year. I believe this deal was made under good conscious. What I mean by good conscious is that the mutual benefit to both Walt Disney and Netflix is going to be huge. Walt Disney is investing capital expenditure on theme parks, and is off loading some of the marketing of its content to Netflix. In the process Walt Disney is going to earn an additional $300 million in revenue which Netflix is able to afford.

For this deal to be lucrative, Netflix will have to expand the international presence of Walt Disney by doing a phenomenal job of marketing the Disney brand. Disney gains added marketing and on-going fee income ($300 million per year from Netflix). Disney derives a vast majority of its income from movies at the box-office (movie theatre), then allows Netflix the right to distribute the content 6-months after the content is aired in theaters. This means that Walt Disney is fully taking advantage of consumer surplus, than bypasses the legacy cable-television model in favor of Netflix's global Internet television concept.

Netflix's business model is likely to succeed in foreign markets because of its low-entry price. The movie-streaming service from Netflix only costs $7.99 per month. This is important because it's less expensive than traditional cable television. This becomes extremely important for developing and emerging economies where the middle class is constrained by the scarcity of economic resources. The income elastic demand of movies is 3.41. This means that for each percentage increase in income, consumption of movies will increase by 3.41 times. In 2010 income GDP per capita worldwide was at $7,329, by 2020 this is forecasted to be at $9,388. Income on a world-wide basis is likely to grow by at least 28% over the decade; this means that global aggregate demand for movies is likely to increase by more than 95% over a 10-year period.

Since Netflix is in the beginning stages of its global roll out of Netflix subscription services, it has an extremely small percentage of households with Internet. World-wide use of Internet is likely to trend higher; implying that the overall trend supports Netflix (based on the chart below).


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Approximately, 32.5% of inhabitants in the world currently have access to Internet. The world population is 6.7 billion. This means that Netflix's target market is approximately 2.17 billion people. Of that amount of people Netflix only has 33 million of them as members of its content platform. This means that Netflix has a whopping 1.5% of potential market share. Now let's not forget, this global market is going to increase consumption on movie based entertainment by 95% over the next 10-years on an aggregate basis. Netflix prices its streaming product competitively. Netflix charges a rate of $7.99 a month, which is an affordable price for the emerging middle class to pay and is much cheaper than the legacy cable networks who charge anywhere from $30-$50 a month. The infrastructure for the Internet is being built throughout the globe and Netflix is going to ride the benefits derived from it.

Based on the underlying economic factors that are driving the growth of the stock, along with recovering profits, and sales growth I disagree with some of the negative commentary in the investment community. On January 27th 2013, Valuentum states that, "normally, we'd be ecstatic about a sticky business adding lots of subscribers and generating tons of highly-profitable marginal revenue. Unfortunately, the cost side of the equation is becoming more challenging for the company, so we're not jumping headfirst into the name." The analyst community is anticipating higher net-income in the following years, implying that profits are likely to improve. However the improving profits will not mean that Netflix will have net-profit margins remotely similar to other Internet service based companies like eBay (NASDAQ:EBAY) (18.55% net profit-margin). Rather, I anticipate that Netflix's improvement in profits will be compromised in order to improve cash-flows and maintain a reasonable amount of capital expenditure relative to cash in-flows.

I also believe that the business itself is not trading on profit margins; rather the business is trading on future revenue growth. For example, Amazon (NASDAQ:AMZN) is currently trading at a 3,689.4 trailing P/E multiple. While earnings multiples are important, they become inconsequential when a company is trying to spend every bit of retained and non-retained earnings back into the business. The reason for this behavior is the limited window of opportunity Netflix has to secure a meaningful amount of market share globally. Reed Hastings (CEO of Netflix) is acting upon the best interest of the shareholders despite the unpopularity of having revenue rather than a net-income based business strategy.

Netflix perceives that it can become a global content network with hundreds of millions of subscribers watching streaming content. The global-market penetration is why major hedge fund managers like Carl Icahn are investing heavily into the future potential of Netflix. In fact, I believe that Carl Icahn's bet is likely to succeed going forward, and the investment is being done based on good faith and not on the intent to manipulate the price of the stock.

In fact, I have to sharply disagree with Alejandro Guillú Mendoza from Seekng Alpha. Alejandro Guillú Mendoza states:

Sell short Netflix. Carl Icahn is smart and one of the richest men in the world, but he is going to lose on this one. Unless of course, he is only pretending to be long on Netflix and actually selling short the entire company. Billionaires should not talk to the press about their current holdings. You can invest in a company or you can talk about a company. You cannot do the two things at the same time. This article may or may not be read by just a few hundreds of thousands of readers. I cannot influence the price of Netflix one way or the other. Billionaires can.

I disagree with Alejandro's statement for three reasons:

  • Netflix has a lot of potential in terms of both profits and revenues. The company has a strong moat through a strong collection of content. The business is growing internationally at triple digit rates. The company is starting to return profits to shareholders, based on its recent string of earnings beats which is forcing analysts to raise price targets.
  • Assuming Carl Icahn is making an investment based on the counsel of financial analysts. It is likely that the analysts who are briefing Carl on the merits of the investment came up with the same conclusions that I have, meaning that Carl is knowingly making an investment based on the merits of the investment.
  • I am fully aware of the debacle that had occurred between Carl Icahn and Bill Ackman. It is easy to come to the conclusion that hedge fund managers would be willing to manipulate the price of a stock based on financial incentive. But contrary to that popular belief, I also have to recognize that there are very stiff and expensive penalties for manipulating stock prices, meaning that there is economic incentive for Carl Icahn to act in accordance within ethical, moral, and regulatory standards. Therefore the stock is not likely to be a pump and dump by a group of hedge funds because they wanted to lift a penny of the ground and float it in the air before dropping it. Hedge fund managers are generally: intelligent, well-disciplined, emotionally intelligent people who are capable of making investment decisions based on the merit of the investment, rather than basing it on flawed judgment.

I have to remain optimistic on the forward outlook on the stock because of improving profits, rapidly growing sales, untapped market potential, improving global economic outlook, along with implied optimism from institutional investors.

Technical Analysis

Netflix has been on a continuous up-trend since October of 2012. Some of this has to do with changes in institutional ownership along with a sudden short-cover squeeze (short interest as a percentage of float is approximately 18.64%, based on Jan 15, 2013 statistics).


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Source: Chart from freestockcharts.com

The stock is trading above the 20-, 50-, and 200- Day Moving Average. The stock is in a confirmed up-trend (higher highs and higher lows), the up-trend further supports my buy-thesis, and the confirmed break above the symmetrical triangle formation will further support the positive momentum behind the stock.

Notable support is $90.00, $140.00, and $145.00 per share. Notable resistance is $172.00, $209.25, and $225.00 per share.

Street Assessment

Analysts on a consensus basis have high expectations for the company going forward.

Growth Est

NFLX

Industry

Sector

S&P 500

Current Qtr.

312.50%

224.10%

8.90%

7.50%

Next Qtr.

163.60%

N/A

28.50%

17.20%

This Year

296.60%

58.40%

31.80%

6.60%

Next Year

138.30%

22.90%

-15.00%

13.00%

Past 5 Years (per annum)

10.61%

N/A

N/A

N/A

Next 5 Years (per annum)

18.75%

15.23%

13.77%

8.52%

Price/Earnings (avg. for comparison categories)

147.44

21.72

0.89

15.15

PEG Ratio (avg. for comparison categories)

7.86

1.4

0.78

4.2

Source: Table and data from Yahoo Finance

Analysts on a consensus basis have a 5-year average growth rate forecast of 18.75% (based on the above table).

Earnings History

12-Mar

12-Jun

12-Sep

12-Dec

EPS Est

-0.27

0.05

0.04

-0.13

EPS Actual

-0.08

0.11

0.13

0.13

Difference

0.19

0.06

0.09

0.26

Surprise %

70.40%

120.00%

225.00%

200.00%

Source: Table and data from Yahoo Finance

The average surprise percentage is 153% above analyst forecasted earnings over the past four quarters (based on the above table).

Forecast and History

Year

Basic EPS

P/E Multiple

2003

$ 0.14

195.29

2004

$ 0.42

29.36

2005

$ 0.79

34.25

2006

$ 0.78

33.15

2007

$ 0.99

26.89

2008

$ 1.36

21.98

2009

$ 2.05

26.87

2010

$ 3.06

57.42

2011

$ 4.28

26.19

2012

$ 0.31

298.68

Source: Table created by Alex Cho, data from shareholder annual report, and price history is from Yahoo Finance.

The EPS figure shows that throughout the 2003- 2011 period, the company was able to grow earnings. Between 2011 and 2012 earnings contracted as the executive team decided to heavily invest pre-tax cash flow back into the business in order to maintain growth in overseas markets.


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Source: Table created by Alex Cho, data from shareholder annual report

By observing the chart we can conclude that the business has a unique business model, and is able to grow earnings during both recessions and expansionary growth phases (ignoring investment years). Assuming the world economy continues to grow, the company will generate reasonable returns over a 5-year time span based on the forecast below.


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Source: Forecast and table by Alex Cho

By 2018 I anticipate the company to generate $13.00 in earnings per share. This is because of cost management, growth in foreign markets, improving economic outlook, and its unique product offering.

The forecast is proprietary, and below is a non-linear chart indicating the price of the stock over the next 5-years.


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Source: Forecast and chart by Alex Cho

Below is a price chart incorporating the past 10 years and the next 6 years. Detailing 16 years in pricing based on my forecast and price history on December 31st of each year.


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Source: Forecast and chart created by Alex Cho, data from shareholder annual report, and price history is from Yahoo Finance.

Investment Strategy

NFLX currently trades at $162.11. I have a price forecast of $125.10 for December 31st 2013. I believe that the stock is slightly over-valued over the short-term. Therefore investors should anticipate volatility in the price of the stock and should buy the stock based on a longer-term investment horizon.

Short Term

Over the next twenty-four months, the stock is likely to appreciate from $162.11 to $202.76 per share. This implies 25% upside from current levels. The stock is in an up-trend, which further supports my investment thesis.

Investors should buy Netflix at $162.11 and sell at $202.76 in order to pocket short-term gains of 25% between 2013 and 2014.

Long Term

The company is a decent investment for the long-term. I anticipate NFLX to deliver upon the price and earnings forecast despite the risk factors (competition, economic environment, balance sheet). NFLX's primary upside catalyst is improving economics, international growth, and managing costs. I anticipate the company to deliver upon my forecasted price target of $962.34 by 2018. This implies a return of 494% by 2018. This is an exceptional return on investment.

Netflix has a market capitalization of $9.0 billion; the lack of liquidity makes this an investment opportunity appropriate for smaller growth oriented investors who have a high tolerance for risk.

Conclusion

I believe in the long-term potential of the company. The business model continues to work. Netflix continues to expand its competitive advantage through its own programming. Netflix is aggressively growing its business in foreign markets, and is likely to capture a larger percentage of the total Internet populace. Netflix will accomplish an exceptional rate of growth for many years to come.

The conclusion remains simple: buy Netflix.

Source: Buy Netflix On Global Movie Demand