Let's face it, Netflix (NFLX) has been one of the best positive surprises in 2013. The company, which many were leaving for dead, has skyrocketed from roughly $50 to $350 over the last year plus. I'll admit that I was one of those who used to be bearish on Netflix, although not to the extent of some, but I started changing my tone a few quarters ago. Since we are past the halfway point of Q4, it is time to start looking forward. Today, I'll analyze some of the key questions facing Netflix in 2014, and detail why the bull case may keep going.
How big is the international plunge?
Netflix stated in the Q3 investor letter that it plans to enter new markets next year. The question is when and where. Does Netflix go into a bigger market, like it did with the UK, or a smaller type market like the Netherlands? One thing is sure. Unless something dramatic happens, Netflix's international streaming segment will pass the DVD segment in terms of revenues by Q1 of 2014. It's possible that international revenues will pass DVD revenues in Q4 of this year, depending on how things play out. If the growth trajectory continues, Netflix's international segment will produce more than one billion dollars in revenues during 2014. Depending on when and what markets those are, it is even possible for Netflix to hit $1.25 billion in 2014 international revenues and inch towards $1.50 billion.
The expansion into new international markets will again spark a critical debate in regards to Netflix, and that is profitability. At least three times a week, I read some sort of Netflix article saying you must sell or short Netflix because the P/E is whatever high number it is. I'm specifically not giving a number to make a point, which I'll expand on later in this article. When Netflix expands into a new international market, the added expenses will lower profitability for a quarter or two at least. That will impact the P/E. But if Netflix doesn't expand into a new market, the bears will criticize the company for slowing subscriber and revenue growth. As I continue to say, you can't have it both ways, but the bears just don't get it.
Does management blame the Olympics again?
I almost am joking about this one, but you really have to think about this one after what happened in 2012. Netflix said that its Q3 2012 results were going to be slightly impacted by the Summer Olympics. Well, for a few weeks in February, the Winter Olympics will be here. Netflix may need to address this issue on the Q4 call, and it might have a slight impact on guidance for Q1. Netflix opened up this can of worms in 2012, so it is something to think about again in 2014.
What happens with the DVD segment?
This is one of the more interesting decisions that Netflix will have to make over the next couple of years. Back in May, I asked whether Netflix should dump the DVD segment. In May, it seemed like a better deal, as revenues/profits from the segment were higher, and Netflix had a much smaller market cap. Now that Netflix stock has continued to rise, it might just be worth holding on to the DVD business for a little while longer. It is still fairly profitable, as contribution profits have not declined as much as expected. The following table shows some key DVD segment numbers over the past year.
Netflix did a good job in Q3 this year of holding up contribution profits despite the drop in revenues. The DVD segment is holding up a bit better than I thought. By now, I would have expected contribution profits to be under $100 million per quarter. They will most likely drop below that $100 million level in 2014, and maybe even in Q4 this year. The USPS postage rate hike will hurt Netflix by 3 cents each way, which Netflix says will translate into $3 million to $4 million in additional expenses each quarter.
From the few DVD subscribers I've talked to, they are very content with the service. Blockbuster is stopping its DVD mail service, so Netflix is helped out in that respect. Netflix DVD subscribers don't want their service to go away, so while Netflix can still generate decent contribution profits, it makes sense to hold on to this segment. But if enough DVD members flee and the postage rate rise really hurts, Netflix may need to make a key decision on this segment late in 2014 or early 2015. The DVD segment used to be Netflix's bread and butter. As we look at 2014, it will become the third leg of the company.
Do we get more clarity on a price raise?
One of the items that hurt Netflix in 2011 was the price raise. By raising prices, Netflix has almost cut the DVD segment in half. Eventually, Netflix will need to raise prices again, and most Netflix subscribers I've talked to would be fine with another dollar or two raise for the service. For this argument, I'm only talking about a raise on a domestic streaming prices, not DVD prices. An extra $2 a month for Netflix is only $24 a year, literally just a few cups of premium coffee. But a price raise for Netflix could have a huge impact on the company's bottom line. I'll show you how much better Q3 numbers could have looked, using the following assumptions:
- 25% increase in revenues, then subtract out 5% for subscriber defections/losses.
- Cost of revenues stays the same.
- Marketing expenses increased by 10% to prevent further subscriber losses.
The results of my calculations are found below, with dollar values in thousands for this segment.
By raising domestic streaming prices, this segment produces an extra $130 million plus in revenues, or 18.75%. However, the more stark number is that segment contribution profits are up by 75%, or $125 million. The only extra "cost" Netflix has here is the increase in marketing expenses. Almost all of this price raise goes to the bottom line of the segment. Streaming contribution margins in this example go from 23.75% to 35.02%. Sure, you can adjust the assumptions a little here and there if you wish, but the general result is basically the same. A price raise of two dollars, which most Netflix subscribers would be willing to bear, would dramatically improve profitability. This is another reason why I argue against P/E for Netflix, as it could lower the P/E substantially overnight with a price raise. Don't forget, the numbers above are just for one quarter. Project out a whole year and you are talking about half a billion in extra segment profits.
Does the balance sheet improve or get worse?
One of the biggest concerns for Netflix investors is that the company's balance sheet is not in great shape. As the company signs more content deals, liabilities pile up, and the bears have been quick to point this out. Some key balance sheet metrics are found below for the end of the respective quarter, with dollar values in thousands. The debt ratio below is also known as the liabilities to assets ratio.
Certain balance sheet metrics have improved over time. Thanks to some debt and equity raises over the past two years, working capital is up, but shareholders have been diluted. Now, those streaming content obligations are very controversial, so I wanted to take another look at them. The following table shows two key breakdowns of these liabilities, which I can then explain it more detail. For the years, these are the "payments due in" values, so the "less than one year" number represents obligations due in the next year.
The big headline is that total streaming obligations have risen by $1.5 billion over the past year. They now total $6.5 billion, and that is a key number. Sometimes, the bears say that the $6.5 billion, or $5.0 billion number from a year ago, are not liabilities on the balance sheet yet (off-balance sheet), and thus Netflix is in big financial trouble. Well, as the second half of the table shows, this is not the case. Some of those streaming liabilities are included in current liabilities, other are in non-current or long-term liabilities, and the remainder is off-balance sheet. Interestingly enough, the off-balance sheet number came down in Q3, mostly due to an increase in current liabilities (rounding above makes things a little off). It will be interesting to see how these numbers change at the Q4 report. Netflix has a fair amount of working capital right now, so I don't think the balance sheet is a big problem just yet. It will be interesting to see how many content deals Netflix signs over the next year, and how this will change the liability picture. You can see all of Netflix's latest financials in the most recent 10-Q filing.
Does another large investor make a long/short play?
We all know the history of Carl Icahn and Netflix, so I don't want to focus on that here. The key question for 2014 is whether or not another large investor or hedge fund makes a play for Netflix, in either the long or short direction. One thing is certain, and that is that short sellers have run away from Netflix. The chart below shows short interest in Netflix going back to early 2012.
It was the end of October 2012 update where short interest peaked at 17.2 million shares. A year later, that number was under 5.9 million. At this point, less than 10% of Netflix's outstanding share count is short. That number was above 30% at points last year. Part of the reason for the slow climb in Netflix shares has been short covering. Short interest could change greatly (in either direction) if another large high profile investor were to make a Netflix investment.
Why the bull case might still exist:
As I mentioned above, the price-to-earnings ratio is useless in my opinion as Netflix is intentionally hurting earnings to boost revenues. The company could easily change that if it wanted to. Lately, I've been looking at Netflix on a price-to-sales basis. In the following chart, I've compared Netflix against other names such as Apple (AAPL), Google (GOOG), Priceline (PCLN), Microsoft (MSFT), Amazon (AMZN), and Facebook (FB). These are all for 2014 revenues. For those that don't use a calendar fiscal year, I've estimated 2014 full year revenues.
Netflix trades for 4 times expected 2014 revenues. The average of the six names I've collected above (ex-Netflix) is 5.27. If I exclude Facebook, which trades at a double digit P/S value, the five other name average is exactly 4 as well. On a price-to-sales basis, Netflix is fairly valued with the group. Don't forget that Netflix's core business (excluding DVDs) is growing faster than all of the names on this list except for Facebook. Additionally, if you were to subtract out Google's traffic acquisition costs, Google's revenues would be a bit lower, meaning Google's P/S value would be a bit higher and so would the averages.
So how can you translate these numbers into the bull case? Well, let's use that average of 5.27 for a P/S value, and let's assume Netflix has 2014 revenues of $5.25 billion (slightly above current estimates). Give Netflix 61 million shares outstanding, and you get a value of $453.57 for Netflix shares. The flip side is that you use the 4 value for P/S and a revenue number of $6 billion, assuming a domestic streaming price raise. Using the same share count, you get Netflix shares at $393.44. The bull case can definitely be made.
What could derail Netflix?
Netflix is the clear leader in the streaming space, but there are several challengers out there. Obviously, Amazon's Prime unit is a large competitor, and Hulu Plus competes as well. There is the potential that a bigger name like Microsoft, Apple, or Google could make a serious play into this space, but don't expect a Netflix buyout anymore. A year ago, with Netflix at a much lower valuation, that was possible. The key question is will one of these larger names decide to sacrifice margins to grow revenues? As Netflix has shown, it does take time for a streaming service to become somewhat profitable. Apple bears are criticizing Apple for its margins, so the thought of Apple entering such a low margin business would give the bears much joy. It does take a fair amount of resources to enter this space, so only someone with really deep pockets could attempt it. For now, Netflix is the clear leader.
Additionally, Netflix could take down Netflix. What do I mean by that? Well, management has made some questionable decisions in the past, and there is always the possibility that management does it again. Should Netflix get too stretched financially with its content purchases, or have some original programming disaster, the company could be hit. The cable companies could also make some sort of play to bring down Netflix, but I don't want to get too far into that right now. Right now, Netflix as a business model is working, so there would have to be some catalyst that takes the company off that track.
Netflix has some key questions to answer in 2014. Decisions over the international and DVD businesses are very important to Netflix's story going forward. The company will also have to decide on a potential price raise to offset the large costs of content it is acquiring. In the end, using the price-to-sales ratio shows how Netflix stock still has the potential for upside from here. I'd probably wait for the next pullback before entering this name, and investors probably shouldn't be expecting a repeat of 2013 in 2014. But it wouldn't surprise me to see Netflix continue higher if it continues to add a large number of subscribers and grow the revenue base past $5 billion. Just a year or so ago, $400 for Netflix shares seemed impossible. Now, that level is definitely within reach.
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.