The last several weeks have been nothing short of fantastic for shares of Netflix (NFLX). From a low of $54 on October 1, 2012 to a high of $188 this past week, the stock has gained 248%. This huge run was driven by news of Carl Icahn taking a 10% investment in November, an exclusive deal with Disney (DIS), and of course their earnings report two weeks ago. It has been quite a ride higher for Netflix investors and very damaging to the 10 million short shares in the stock. Everyone is now asking if this incredible move in Netflix is over or if this is just the beginning. We will try to answer that below.
Netflix last traded at $300 in the summer of 2011, right before the company announced its 60% price increase and business split up. This plan was quickly abandoned, but it did not stop the exodus from Netflix. This large mistake by the company was a major reason for the 75% drop in the stock price and the move from its position as Wall Street darling to Wall Street pariah. At $300 a share Netflix would enjoy a market cap of approximately $16 billion, very lofty for a company that made only $8m in net income in the most recent quarter. How do we justify this valuation? We simply say Amazon (AMZN). Amazon is a stock that has, for essentially all of its existence, had a high market cap, high PE and diminished earnings. Amazon has and continues to get a "free pass" from the market when it comes to profits. They spend to grow down the road and Wall Street accepts this. Netflix used to enjoy this advantage as well, before the Quikster debacle. The recent 80% move in shares of Netflix has brought that "free pass" back to shares of Netflix. Investors and analysts are again focused back on down-the-road and growth. As long as the company can continue to show growth the market will be forgiving when it comes to the bottom line. Correct or not this is how the market acts. Driving expenses for Netflix going forward will be:
- Investing in international markets
- Investing in original content
- Content deals with studios
If these moves and expenditures can continue to grow subscribers, the stock price will increase.
Much has been written in other articles regarding the recent earnings report, so we will just go over the key points:
- $8m in net income caused a $4 billion market cap increase
- Cash flow was negative
- 13c EPS versus consensus estimate of -12c
- $105m loss on international streaming
- 2.1 million new U.S. subscribers
- 1.8 million new international subscribers
The DVD business, which Netflix is trying to exit, continues to be their major profit center. "Netflix had a 50 percent profit margin in its movie-by-mail segment in the fourth quarter -- $128 million profit on $254 million of sales. Compare that with a profit margin of 18.5 percent in domestic video streaming -- $109 million profit out of $589 million sales." What is likely to help earnings in the coming quarter is news that the US Postal Service is canceling Saturday service. This will actually help the company save on shipping costs and cash flow and add to the bottom line in the upcoming quarters. Netflix has also raised $500m through an oversubscribed debt offering, a smart move for the company that reduced interest expense and again helps with their cash flow.
Netflix has a lot riding on its original programming. This past week saw the company premiere "House of Cards," a $100m investment in its in-house content creation strategy. Initial reports say the show caused no increased spike in viewing. Critics are hailing the show as a hit so it may take a few weeks for the hype to build. It is still very early to judge the success of this strategy. To keep current subscribers happy and attract new subscribers, an expanding content base is required and it may be cheaper to make than buy. Time will tell if the "HBO Model" will work. A big hit can quickly drive those on the sidelines into trying the service and aiding in growth.
Probably the biggest reason to believe Netflix will see $300 again is the exclusive content deal signed with Disney in December. According to the terms, starting 2016, Netflix would be able to stream movies from the Disney Studio and its associated studios instantly after release. Moreover, Netflix would gain access to Disney's direct-to-video releases starting 2013. While the main part of the deal does not kick in until 2016, this appears to have been a major coup for Netflix. The recent acquisition of Lucasfilms by Disney adds greatly to the appeal of this deal. Disney is planning multiple spinoffs of the hugely popular Star Wars franchise, along the lines Marvel has taken with its comic books. Given the development cycle of films, new releases are unlikely to hit the market until 2015 when Star Wars 7 is set to hit the screen. Subscribers will go to the content and this deal, especially in future years, should be a big benefit to the company.
Amazon remains the main competitor to Netflix and they have deep pockets. Still, as Amazon has been growing over the last year so too has Netflix. The recent launch of RedBox Instant looks as though it will barely impact Netflix, good news for investors here.
Over the last several weeks, the darling of Wall Street, Apple (AAPL) has seen its luster diminish and with that other stocks have moved to the top of investor focus lists, chief among them Netflix. The overpriced argument we hear about Netflix is the same we have heard regarding Amazon over the last decade during its continued rise. The pendulum appears to have swung from extreme optimism in Netflix to extreme pessimism back to extreme optimism. While the stock is extremely overbought in the near term, the medium and longer-term outlooks look attractive from a momentum trader's outlook. Strictly fundamental and value investors will not be able to justify an investment here based off the numbers. No matter what Wall Street earnings wizardry you use, this stock will remain a momentum, hot money stock. 18% of the Netflix float is still short the stock and this, in itself, is justification enough for a large continued move higher. The large move over the last two weeks on the surprise earnings was only part of the reason for the price explosion. This high short interest was, and is also a major reason. Amazon shorts over the last decade know that pain. Netflix has traded at $300 previously and it will trade at $300 again.
Disclosure: I am long DIS.