Shares of Netflix (NASDAQ:NFLX) soared over 15% after investors digested an absolutely fantastic quarterly report (press release available here). Netflix continues to fire on all cylinders and is adding customers both at home and abroad at a blistering pace, which will give the firm the necessary scale to purchase content at an attractive price. While Netflix is a difficult company to value and is widely seen as overly expensive, it appears clear that it is a fool's strategy to bet against the company.
Netflix basically beat estimates on every single metric. The company earned $0.79 against consensus of $0.66 while revenue of $1.18 billion beat consensus by $10 million. These numbers are no doubt strong, but a 15% rally may seem excessive on a beat of this magnitude, which is why it is important to look deeper into the report. Margins remain strong and customer additions were absolutely blockbuster.
For the quarter, Netflix added another 4 million subscribers and now has 44 million members. U.S. net adds were 2.33 million, which was 13.6% better than last year's 2.05 million net adds. Netflix now has 33 million domestic subscribers and does not appear to be near saturation. Importantly, Netflix continues to perform well internationally with subscriber growth of 1.74 million members. International revenue more than doubled year over year from $101 million to $221 million. Thanks to this revenue growth, its international loss has nearly halved to $57 million. Netflix is in the process of building scale overseas and will be expanding throughout much of Europe later this year, which will help defray content costs. I would look for Netflix to hit breakeven overseas sometime in early 2015.
In the U.S., Netflix obviously has much better scale, though its position improves even more with each additional subscriber. We are seeing the firm's inherent operating leverage as profit margins improved significantly to 23.4% from last year's 19.2%. Importantly, Netflix expects to continue to grow margins next quarter to 24.9%.
In fact as impressive as this quarter was, guidance may have been even better. All things equal, the first quarter tends to be slightly weaker than the fourth quarter (which benefits from the holidays) but better than the second and third quarters. Management is looking for another 2.25 million net adds domestically. I was hoping management would guide toward 2.00-2.10 million, so this was a really solid figure. The release of House of Cards' second season on February 14 is no doubt a contributor to this strong number. International expansion should remain strong with net adds of 1.6 million, which would expand the total user base by 15%. Finally, EPS should be $0.78, which beats analysts' expectations by a penny and is up dramatically from last year's $0.05.
There are three other factors investors in Netflix should consider that were addressed in this report: net neutrality, pricing, and content costs. On net neutrality, Netflix did not seem overly concerned about the ruling of the district court that would allow internet service providers to slow down video streams. First, this case could be appealed, potentially all the way to the U.S. Supreme Court. As such, final action could be another 18 months away. Next, ISPs like Verizon (NYSE:VZ) and Comcast (NASDAQ:CMCSA) want consumers to pay more per month for a higher speed broadband plan. If they then slow down the video stream, it could lead to customers just taking a cheaper plan, negatively impacting their bottom line. While some action may happen at some point, investors should not fear a draconian expense increase or immediate action.
Next, Netflix investors remember the disaster that was the Qwikster rollout whereby Netflix planned to spin DVD out from streaming right after doubling prices by splitting the services, which annoyed many customers to begin with. This spin-off would have required customers to use two separate websites. The plan was so hated it was cancelled within a month and DVD was kept part of Netflix, though the separate pricing regimes remained. The backlash was great, and Netflix shares lost more of their value as some customers left the service. That is why it is critical for Netflix to increase prices without alienating customers.
To do this, management is talking about offering tiered plans where customers could pay less and only be able to stream one movie at a time or pay more to stream several (think of a family where no one can agree what to watch, so each watches something alone). This tiered pricing could generate incremental revenue growth while better serving customer needs. Further at some point, Netflix will likely raise prices for a subscription, but to keep existing customers happy, management has promised generous grandfathering to them. In other words if streaming prices went up to $10, existing customers would not have to pay that new rate for months or even a year, which will help minimize churn. These efforts can help to grow margins without impacting the size of the base.
Finally, content is extremely expensive, and those costs are the primary risk to Netflix. Can it generate enough revenue from its user base to pay for the content it needs to keep the base happy? In fact, the company has $7.3 billion in content liabilities (fees it will be paying Disney, AMC, Universal, etc. for the rights to their films and TV shows). This is where scale matters. As its base grows, Netflix has more leverage at the negotiating table. To lose access to 33 million Americans would be a significant revenue hit for a studio.
As content is extremely valuable, gaining scale is critical. In fact, better scale when dealing with content providers is a major reason Charter (NASDAQ:CHTR) wants to buy TimeWarner Cable (NYSE:TWC). Netflix has better scale than anyone; after all, Comcast, the nation's biggest cable company, has 21.6 million video subscribers. Netflix has 50% more subscribers than CMCSA. Netflix is in a position where content cost inflation should ease thanks to its larger base. As a consequence, the company has been free cash flow positive in each of the past three quarters. We are beginning to see the fruits of a bigger base.
Further, this scale provides Netflix with a strong barrier to entry. It would be increasingly difficult for an upstart like Hulu or Amazon (NASDAQ:AMZN) to launch a similar service without expending billions on content to entice subscribers to switch. Further, an upstart would have to pay higher content cost to convince providers to move to an unproven platform with millions fewer subscribers. Netflix has also moved into original content to differentiate its service from competitors. Some shows like House of Cards have become genuine hits while others like Lilyhammer and Orange is the New Black have been relatively successful. Original content can complement the content it buys to ensure Netflix is a unique service.
Therefore, Netflix delivered a great quarter with better subscriber figures, strong margins, and improvements overseas. These trends should continue going forward, and with better scale, Netflix should get more reasonable content deals and stronger free cash flow, which has finally turned positive. With this subscriber trend, the company should be able to earn at least $4.25 in 2014, which is up 130% from last year's $1.85 figure. Nonetheless, shares are trading 92x 2014 earnings after the press release.
Does this valuation make sense? The answer is it is really hard to say. It really depends on how long Netflix can continue this rate of growth, and I am in the camp that the potential market is significantly larger than Netflix's current size. Shares are currently trading at $535 per subscriber, but the subscriber base is growing rapidly. Within 3 years, I expect Netflix to have 45 million U.S. subscribers and 35 million international subscribers, which should drive EPS in the $18-$22 range with further growth opportunities overseas in unsaturated developed markets in Western Europe and emerging economies while the U.S. will be near saturation. As a consequence, Netflix should still be growing earnings by about 50% in 2017. Assuming a fair 25x multiple, shares should be trading at $500 in 3 years, which suggests about an 8-9% annual return from current levels.
Netflix shares are not going to repeat the run they've had over the past fifteen months when shares quadrupled. Still, I certainly would not bet against this company as it continues to deliver and has a long runway for growth as it slowly raises prices and expands internationally. At around $400, shares are at fair value and have a three year return profile in the 8% range. For investors not in the stock, I would wait for a pullback to the $375 range before initiating, but current holders can comfortably stay long. I would just not short the stock. With its current momentum and strong underlying fundamentals, the potential pain is just too great. While day traders can definitely make money going both ways; the only way to invest in Netflix is to buy. Long-term shorts in Netflix will suffer disappointment and losses.