The rise of Netflix (NFLX), or other companies offering video streaming services such as Amazon (AMZN), is the biggest threat to the status quo of American cable. In its last quarter, Netflix was able to add 630,000 domestic streaming subscribers, which was in line with its guidance of 230,000 to 835,000 additions and an improvement from 530,000 additions reported in the same quarter last year. The company's total domestic streaming base has now reached 29.8 million. Netflix is eyeing 700,000 to 1.2 million net additions in the current quarter. Therefore, we can safely assume that Netflix's domestic subscriber base will easily cross the 30 million mark when it reports its next quarterly results.
Traditional Cable Television On The Back Foot
Essentially, every additional streaming subscriber of Netflix, Hulu or Amazon is a loss to traditional cable television companies such as Cablevision Systems (CVC). I have been a believer in the idea that the future of television lies on the broadband, but to my surprise, the head of Cablevision has also said something to this effect. In a recent interview to Wall Street Journal, James Dolan, the CEO of Cablevision said that "there could come a day" when broadband would dominate the industry. While analysts have been pointing out the changing landscape for a long time, but a head of a cable company has never made such comments. I believe this implies that Cablevision's current business model is approaching obsolescence.
Dolan has also said that his company is investing in networking and is doing a revamp of its business to cope with the changing environment. However, I think that Cablevision will have to, eventually, make some significant changes to its business model. This would make Cablevision somewhat riskier investment as a big revamp of operations can go either way.
Contrasting Subscriber Base Growth
While Netflix is adding hundreds of thousands of subscribers each month, Cablevision keeps losing customers. In its previous quarter, Cablevision lost far more video customers as compared to the growth of high-speed-data and voice customers. Cablevision added nearly 4,000 new broadband and voice customers sequentially, but it also reported a massive decline of 20,000 video customers.
Cablevision's customer base has been shrinking, and with fierce competition in broadband, this trend will likely continue in the future. This is particularly disappointing since the company still earns 56.6% of its revenues from video customers, despite diversification of the revenue base to high-speed-data, voice and advertising.
Cablevision's stock has risen by 25.12% this year, but this has more to do with the takeover rumors than anything else. Therefore, I would not recommend investing in a company with shrinking customer base and an extremely challenging future.
Netflix is expensive by traditional metrics. It is trading 218 times its current year's profit estimates and looks even more expensive in terms of trailing estimates. However, Amazon's comparable P/E is 332, but then again, this is essentially a comparison of two firms with entirely different core offerings (although Amazon itself is a disruptive business. For instance, through Kindle, it has thoroughly shaken the publishing industry and brick-and-mortar book stores).
Amazon's P/E is also unusually large. Its total sales rose by 149.27% in just three years to $61 billion by the end of 2012, but its operating income has fallen by 40% in the same period. Add the company's disruptive nature, its willingness to sacrifice current profits for long-term growth and the anticipated future income, and we have a company that doesn't trade on its P/E ratio.
Amazon's margins are razor sharp (trailing operating margin of 0.95%), but it is working on this by building its own warehouses that are closer to market. The company is also delivering products using its own trucks, instead of using UPS or FedEx vehicles. Such measures usually require a high upfront cost - which creates additional pressure on margin - but will generate long-term value for shareholders through millions of cost savings.
Similarly, a fair evaluation of Netflix requires us to move beyond the P/E numbers. Its business model is essentially disruptive in nature. The company is out to change the dynamics of American cable industry. Therefore, it has an unusually large P/E ratio.
Netflix's EV-to-EBITDA ratio of 85.37 is above Amazon's EV-to-EBITDA ratio of 42.99. The lower ratio of Amazon shows that it is relatively more valuable as compared to Netflix.
Beyond P/E: The Only Pure Play
What makes Netflix particularly attractive is that while it has many direct and indirect competitors in this emerging Internet-based industry, such as Google, Apple and Amazon, but Netflix is the only pure play. Google's bread-and-butter is primarily advertising revenues, Apple is essentially a hardware manufacturer and Amazon is mainly an online retailer. So if an investor is willing to bet on the future of Internet-based cable television then there is no other firm out there besides Netflix.
Beyond P/E: Bright Prospects
Netflix has been able to expand its domestic and international subscriber base at an impressive pace. The second quarter is usually a difficult one in terms of new customers, but Netflix was still able to add more than 600,000 customers. Moreover, the surge in the sale of smartphone and tablets has caused an increase in the demand for Netflix's streaming content. In the current year, according to Gartner, the sale of these gadgets would increase by around 50% to 1.2 billion which would translate into more opportunities for Netflix.
Netflix has also shown a lot of promise in the international markets with +7.75 million subscribers in just two-and-a-half years of operation. Although there is little value here right now due to the high content costs, but once the number of subscriber doubles or triples, (the Europe + Canadian market alone represents 38 million potential customers considering just 30% market share) then through economies of scale, Netflix will start getting a significant portion of its earnings from outside of the U.S.
Conclusion: So Should You Buy?
So at these price levels, Netflix's outlook is still extremely bright but it is overvalued. The company's shares have gone up by 190.8% this year. If its EV-EBITDA ratio falls significantly to 40-45 range then Netflix will be an attractive buy. This can happen if its stock somehow plummets (such as the 74% drop in H2-2011 which would be a relatively small decline now since the stock is up nearly 200%) or it manages to double its already impressive earnings growth (up 378% in the previous quarter). So in essence, Netflix is a hold and a buy on a dip.