By now, everyone knows that Netflix (NFLX) reported a great quarter. The company had one of the greatest short-term rallies in stock history. Shares opened higher on Monday before falling back quite a bit, but shares are still up more than 60% in the last couple of days. However, for part of the day on Monday, Netflix shares were trading at over 600 times trailing twelve month, or 2012, earnings. That's right, for every penny of Netflix earnings, investors were paying six bucks. Today, I'll break down why this stock has soared so much and what it needs to do going forward.
Part 1 - What happened?
I won't go into many of the headline numbers again because I covered them in depth in the article above. Rather, this part is about why the quarter was so good, and why the stock soared more than 70% in a couple of days.
Reason 1 - free trials / seasonality / international expansion:
Netflix added more than 2 million total domestic streaming subscribers in the fourth quarter, higher than they guided to. There seems to be a couple of explanations as to why they were so successful. First, this winter has been a bit colder than last, so it wouldn't be surprising if people decided to stay home and watch a movie or TV rather than go out. Second, Netflix seemed to target former customers in an effort to get them back, offering a free month trial (Netflix offers a free trial to customers, but you have to be a new customer). With the whole price hike and Qwikster debacle being roughly 18 months behind us, Netflix has worked to repair its reputation, and the company is hoping it can get some of these former subscribers back. The third reason is just that the fourth quarter usually sees a high number of subs added, according to Netflix's "seasonality".
On the international side, Netflix entered the Nordic region. They built up a large content library for this launch, their largest build for any international expansion. The company added about 1.8 million international subs in the quarter, but they won't be expanding internationally in every quarter. I'll explain more about this in detail later on.
In both domestic and international numbers, there were a large amount of "non-paying" subscribers at the end of the fourth quarter. This is the difference between Netflix's total subscriber and paid subscriber figures. The table below shows, in millions, that difference over the last couple of quarters.
Based on Netflix's guidance in their investor letter, they expect to get the non-paying numbers down in both the domestic and international streaming segments during Q1. That's good, because the goal is obviously to get your free trials to paying subscribers. They guided to about the same non-paying number for domestic DVD, as they continue to bleed DVD subs.
Reason 2 - Redbox Instant:
In terms of DVDs, Netflix competes with Coinstar's (CSTR) Redbox, which allows you to rent DVDs at a kiosk, like at your local supermarket or convenience store. Coinstar is partnering with Verizon (VZ) on a new service, called Redbox Instant. This is a combo service, which will allow you to stream content online, as well as pick up 4 movie credits at the kiosk if you so choose.
When the initial news came out about the partnership, there were rumors that Redbox Instant would launch in the third quarter of 2012. However, there have been several delays to that timeline, which I've covered every step of the way. Recently, Redbox Instant has launched in beta to many problems, so it's now the end of January 2013 and the service isn't fully up and running quite yet.
I think the failure of Redbox Instant to launch already has helped Netflix, even if ever so slightly. Given that Redbox's content rollout isn't as large as Netflix, the streaming side won't kill Netflix. But I think the DVD portion of Redbox could have sped up Netflix's DVD subscriber losses. Had Redbox Instant actually launched back in Q3, I think Netflix's domestic streaming subs probably wouldn't have been impacted by that much, maybe a quarter of a million less than they ended up. The real impact in my opinion is in the DVD segment. I think Netflix would have lost another quarter of a million or so DVD subs. Given that DVD is the more profitable segment, the DVD loss of a quarter million would have been a lot more important than the streaming losses.
However, once (really if) Redbox Instant launches and can be moderately successful, we should see a bit more of an impact on Netflix. A quarter of a million subs here or there doesn't seem like much, but it probably would be a few million and revenues and potentially a couple of cents a share in earnings. Imagine if Netflix had reported $940 million in revenues and a profit of $0.10 instead of $945 million and $0.13. I don't think the reaction would have been as great, and the guidance for Q1 would not have been as strong either.
Reason 3 - The fall of Apple (AAPL) and the core four:
I think that a large part of the Netflix rise has been due to the fall of Apple after its latest earnings report. Apple started dropping, and quickly, in the after hours session. With all of those people selling, they were flush with cash. As Apple went from $500 to $480 to $460, Netflix went from $120 to $130 to $140. That trend continued on Friday, with Netflix surging even more, and Apple still falling. Between Apple's close Wednesday and its close on Friday, about $70 billion of market cap was lost. With all of the people selling, that money had to go somewhere. Netflix seemed like a great place to put it with shares continually rising.
But it wasn't just Netflix that benefited from Netflix's rise. Other momentum names did very well also, and their performances over the past few days were similar, albeit on a smaller scale. If you don't know which names I'm talking about, it's the core four that includes Netflix, Green Mountain Coffee Roasters (GMCR), SodaStream (SODA), and Deckers Outdoor (DECK). All of these names tend to rise and fall together at times, and there may have been some "short squeeze" potential in this rise. More on that later. But look at the chart below, showing the performance of these five names over the past three trading days. There is a bit of a pattern.
Reason 4 - Short squeeze:
Netflix has about 55 million shares outstanding at this point. At the end of March in 2012, about 9.2 million shares were short, less than 17% of the outstanding share count. By the end of October, more than 17.2 million shares were short, or more than 31%. When you get good news on a heavily shorted stock, a short squeeze can push up shares very quickly. Now, by the middle of January, roughly 10.1 million shares were short. That probably had a lot to do with the rally going into this report. But you can expect that a number of shares short were covered after this quarterly report. We'll get the official numbers in about a week or so, but the shorts must have been really scared watching shares rally so much. A few of them might be back now, with the shares declining from their highs on Monday, but I'm expecting the overall short count to drop when we get the numbers.
Now that I've covered a few reasons why shares have rocketed higher, investors want to know where Netflix may go from here. That's the focus of part two.
Part Two - Looking Forward:
There are a few things I'd like to discuss in this section. First, I want to show that even though the subscriber count soared in 2012, it wasn't exactly a great year in terms of financial performance. Second, I will show how Netflix can get back to those 2011 levels, and why there is a tough choice to be made. Third, I will examine how analyst expectations have soared in the past few days, and why there may be a disconnect between Netflix and the street.
Part 1 - financial history:
Netflix reported revenues of more than $3.6 billion in 2012, which is a new yearly record for the firm. That's more than double what revenues were in 2009, and well above the $500 million the company did in 2004. But as you can see from the chart below, net income was at its lowest point since 2003. So despite revenues rising from half a billion to more than $3.6 billion, net income, earnings per share, and the net profit margin have plunged. In the table below, revenue, income, and share numbers are in thousands. Earnings per share and the net margin are actual.
The other interesting item to look at is the share count. Netflix had been buying back shares for a few years, which took the share count down quite a bit. But with net income and cash flow levels being poor, the company hasn't bought back shares for over a year now. The share count is rising from executive options, and don't forget the equity deal they did in November 2011 to raise money. As long as net income and cash flow levels remain poor or stagnant, the share count will go up. What are the implications? Well, that's covered in my next section.
Given that Netflix has decided to focus on streaming going forward, margins are going to shrink over time. Most of that has already occurred, but we could see them dip a bit more as DVD margins contract on the postage rate increase. But with domestic streaming contribution margins under 19% and DVD contribution margins at 50%, the killing off of the DVD segment will keep profitability low for a while.
That brings up a crucial question for Netflix. If Netflix decides not to do any further international expansion, international losses will subside and margins will rise. However, subscriber growth will level off, so revenues won't rise as fast. On the other hand, Netflix could decide to expand further internationally. That will help revenues to rise at a good pace, but increased costs will drag down profits.
Part 2 - How do we get back to 2011 levels?
In 2011, Netflix recorded revenues of $3.2 billion, with net income of more than $226 million. That produced a profit of $4.16 per share, with a share count of under 54.4 million. The net profit margin was 7.06%. Other than revenues and the share count, everything came down in 2012.
So the question becomes, how does Netflix get back to those 2011 levels? Well, it's going to take a bit of an effort. Let's first think about them getting back to that roughly $226 million in profit. The first table I will show gives Netflix a 15% revenue growth rate going forward. I gradually increase the margin, and that gets them to hit the $226 million profit again in 2016. For this to happen, Netflix would need a net profit margin of 3.58%, roughly half of the 2011 levels. For this argument, the earnings per share number column uses the 2012 share count. More on this in a bit.
But what happens if revenues don't rise at 15% per year? What if they only rise at 10% a year? Well, as the following table shows, they would need to get that net margin back up to about 4.28% to hit that net income number.
Now you may ask why there are two lines for 2016. Well, the two tables above, up to the first 2016 line in the second table, assume the 2012 share count. That share count (for EPS purposes) was about 4.6 million more than the 2011 count. So the second 2016 line shows what Netflix would need to do to get back to the $4.16 profit. They would need about 4.64% on the net margin, or about 2/3 of what the 2011 levels would be.
So that brings up an important issue. Everyone wants to focus on earnings per share, but they don't always realize the importance of the share count. Think about it this way. If Netflix's 2012 share count was applied to 2011 net income, earnings per share would have been $3.84 instead of $4.16. That's quite a difference.
At this point, I don't expect the share count to decline anytime soon. Executive options will dilute shareholders further, and there is always the possibility of a further equity offering. Netflix has stated that they intend to raise more money, which they expect through debt, but an equity offering is always possible. It doesn't seem like the company will be buying back shares any time soon. So I put together a table showing the impact on net income. In the table below, the top row shows net income numbers, in thousands, so the first one would be a net income figure of $30 million. The left column shows the share count, in thousands, so the first one would be 56 million shares. Netflix's share count for EPS purposes in 2012 was 58.9 million. The highlighted area shows where earnings per share are higher than 2011 levels.
As you can see, Netflix is going to need a huge rise in net income going forward to get back to 2011 levels. Can they do it eventually? Sure, it is possible, but if they expand internationally, profits will be depressed for some time, and don't forget the importance of the share count!
Part 3 - Analyst expectations and the disconnect:
Thanks to a better than expected Q4, Netflix's Q1 guidance was well above expectations. Netflix guided to revenues of $1.004 billion to $1.031 billion, well above the roughly $970 million analysts were looking for. On an earnings per share front, Netflix guided from breakeven to a $0.23 profit. Analysts were looking for a $0.07 loss.
Not surprisingly, analysts have jacked up their estimates. As of Monday, analysts were looking for $1.01 billion and $0.17, respectively. I think those numbers could further edge up in the next few weeks.
I'm more concerned with the full year numbers at this point. Analysts have taken up their full year revenue number from $4.07 billion to $4.22 billion. The new figure represents growth of about 17%. That's decent growth, and the number could continue higher.
But the real place where I feel there is a disconnect with analysts is in the earnings per share number. Going into the Q4 report, analysts were looking for a profit of $0.41 this year. They now expect a profit of $1.15 this year, and $2.74 in 2014. I think in both cases, analysts are assuming that Netflix does not expand internationally, and I think Netflix will. Internationally expansions are costly, and they will not hit these earnings forecasts if they do expand, which Netflix said they might in the second half of 2013. To me, there is a disconnect here, and if estimates continue higher, I think there will be some disappointment going forward.
Final Thoughts / Valuation?
When it comes to Netflix and rival Amazon (AMZN), valuation doesn't seem to matter. Netflix did actually report a 93% plunge in 2012 earnings per share, but nobody seems to have cared. Shares are up roughly 60% since the report. Netflix reported a 77.5% drop in net income for the fourth quarter, and shares are up 60%. Apple on the other hand reported one of the best quarters in corporate history, and is down 12.5%. While it doesn't make sense, that is just how the stock market is some times. It can be very frustrating.
So when I say that Netflix is trading at 141 times this year's expected earnings, 59 times next year's earnings, or 559 times trailing twelve month earnings, does it really matter? So far, the answer seems to be no. As long as Netflix grows subscribers and revenues, along with maintaining marginal profits, shares seem like they will go higher. It doesn't hurt to have someone like Carl Icahn on your side as well.
At Monday morning's high, which was actually a new 52-week high by the way, Netflix shares traded for 611 times trailing twelve month earnings. Yes, you were paying six bucks for a penny of earnings. That valuation has proved to be unreasonable, as shares have declined from more than $177 to Monday's close around $162. I wouldn't be surprised if shares traded back down a bit from here. Netflix will always remain a short candidate on valuation, but does that valuation matter? Over the past few days, it hasn't. Remember, being a short candidate doesn't mean I am recommending you short Netflix today. I've just detailed a number of items over time that might make you want to short it. An important part of the "valuation" question could be answered this week, when Amazon reports its earnings. For now, it just seems unreasonable to pay six bucks for a penny.
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.