Netflix (NASDAQ:NFLX) operates in three segments: Domestic streaming, International streaming and Domestic DVD. The company obtains content from various studios and other content providers through fixed-fee licenses, revenue sharing agreements and direct purchases. The company markets its service through various channels, including online advertising, broad-based media, such as television and radio, as well as various partnerships. In October 2012, the company launched its streaming service in Finland, Denmark, Sweden and Norway. (Source: Google Finance)
There is no doubt that recently Netflix has been the flavor of the month for investors. Since July 1st, the company's share price has gained more than $40. On top of this, they have had more than a $100 increase since their last earnings report in April. The question now is whether or not these recent gains are justified and more importantly are they sustainable? As we head into 2nd quarter's results, I would like to point out several significant factors which should not be overlooked.
An investor should always try to determine the fair value of any investment before diving into it. It is hard to define the fair value for an equity like Netflix because there are a lot of determining factors which need to be closely examined. On a fundamental level of comparison, we can take a more tangible approach and compare the EBIDTA, P/E ratio, and Price-to-Book ratio to that of its competition. On the other hand, one must also allow a concession for its other intangible assets including the value of its market share, brand, original content, license agreements, and plans for further global expansion. After all, it is these factors which make it so attractive to investors.
Let's first start with the basics. Last quarter, Netflix beat analyst earnings estimates with a revenue report of $1.023B. At the same time, however, their cost of revenue was $726M or roughly 70% of their total revenue. If you remove the R&D and selling/administrative expenses from this, you end up with only $31.8 million in profit. That equates to a 3% profit margin or roughly the value of 120,000 shares at its current stock price. Currently, this leaves Netflix with a P/E ratio of 650. For comparison, its competitors Redbox (NASDAQ:OUTR), HBO (NYSE:TWC), Dish Network (NASDAQ:DISH) and Amazon (NASDAQ:AMZN) all maintain P/E levels below 50. This industry comparison does not hold up well for Netflix.
Secondly one must examine the company's true price-to-book value. Netflix's market cap today is roughly $15B while at the same time, its shareholder equity is only $812M as of last quarter's earnings report. If you include their intangible assets, this gives you a price-to-book ratio of slightly over 18 and a tangible share value of $14.42. If you go even further to remove the intangible assets, you end up with negative $763M in shareholder equity and shares that are essentially worthless. So why are investors so eager to buy a stock with no actual tangible value? Let's take a closer look at the other determining factors.
Netflix without a doubt has several key intangible features going for them. The first and most noteworthy is the size of their market share. Since they hold the largest position in this market segment, we must assign a significant value to their brand recognition and consequently their potential for global expansion. While plans to expand are already underway in Finland, Denmark, Sweden and Norway, this factor is proving to be quite costly in the short-term and this could have a significant impact for investors.
Secondly, one must examine the value of their in-house content. Programs like Arrested Development and House of Cards have not only attracted Emmy nominations but have similarly increased their user base as well as generated a significant increase in their internal revenue. Content development like this will only help Netflix be more and more profitable in the future and they have no plans on stopping anytime soon.
Lastly, one must assign a value to their license agreements and exclusive contracts with programs like Disney. It is obvious that the more content they own, the more value a consumer will place on their services. In this respect, they continue to outperform their competitors.
Analysts' forecasts are usually a good indicator of the markets option on a stock. Recently, Netflix has been upgraded by several analysts at Citigroup, National Alliance, and BTIG Research and has been given an average target forecast of $211.53 a share. At this point, Netflix has far surpassed these estimates.
This recent increase in share price can be attributed to the recent growth in their user base results from the first quarter. Given the fundamentals we just discussed as well as the analysts' expectations however; I do not believe these values alone are enough to justify a share price of $270. For these reasons, I believe anything less than a stellar performance in the 2nd quarter will allow for a significant correction here. The key factors to look for here will be a substantial drop in revenue expenses or a striking increase in their subscriber user base. If there is no significant improvement in these fields, I believe the current share price will be far from sustainable. As a result, we may end up with a repeat of what happened exactly 2 years ago when earnings disappointed and the share price dropped over $180 in less than 6 months.
Disclosure: I am short NFLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.