After reviewing Netflix's (NASDAQ:NFLX) earnings, I'm not completely convinced that the stock merits the high valuation it currently trades at. While it was nice that the earnings figures topped expectations of $0.79 EPS for the fourth quarter versus consensus at $0.64 EPS, the revenue grew by 24.5% which only beat sales growth estimates by around 3 to 4 percent. The current market cap isn't sustainable unless revenue growth trends substantially higher and competitive threats are substantially mitigated.
The company reported 2.33 million net additions, which was only a 14% improvement in additions year-over-year. This implies that domestic growth is likely to slow as competition is expected to increase from the likes of Verizon (NYSE:VZ), Amazon (NASDAQ:AMZN), Hulu, Sony (NYSE:SNE), YouTube, and Apple (NASDAQ:AAPL). International markets should do a little better in terms of revenue growth, which will offset Netflix's weakening domestic business.
I expect Netflix's international business to eventually contribute to profit as indicated by the rapidly improving contribution margin from -40.6% to -25.9%. The improvement in contribution margin should result in net earnings from international subscribers at some point.
International reported a 78% year-over-year improvement in total members. However, international net additions slowed year-over-year. The number of international subscribers has increased by 1.74 million versus the 1.81 million in additions in the year ago period. The company's reductions on advertising spend and other related costs internationally indicate that while international subscriber growth in total should increase, the rate of increase may eventually slow. I wouldn't be surprised to see the contribution margin from this division stay in the negative for the remainder of the year.
Next quarter forecast
Netflix expects subscription additions and contribution margin to improve. How this is possible is beyond me as the company reported net addition declines for the current quarter as contribution margin improved. If the company is able to pull off better cost control and sales momentum at the same time that would be the very definition of success, but based on personal experience I have seen very few companies' lower costs and accelerate sales in the same quarter.
The company expects 2.25 million net additions domestically, and 1.6 million net additions internationally in the first quarter of 2014. This totals to 48.2 million members. The company forecasts that sales will grow to $796 million domestically in Q1 2014, which means that sales are expected to increase by 7.4% quarter-over-quarter and 24.5% year-over-year. This marginally beats analyst expectation on top line for the next quarter, and it is what has contributed to the massive rally in the after-hours session.
The 24.5% year-over-year sales growth doesn't come from net subscriber ad, but from an increase in the number of paid members. The company gives free trials, for its movie streaming service, before converting them into long-term subscribers. Netflix expects that the vast majority of non-paying subscribers will be converted into paying subscribers.
The company is experimenting with pricing, and it's not expected to have an immediate impact on revenues or earnings as pre-existing members are expected to be "grand fathered." This means that pre-existing subscribers will pay the same rate, whereas new subscribers may have to pay a more expensive price for Netflix streaming. This should have a negative impact on member additions in future quarters as higher pricing will reduce demand for Netflix's services.
Netflix is currently experiencing industry headwinds with "net neutrality." Internet service providers can now impede on video streams. In the worst case scenario, Netflix may end up having to pay fees to enable Netflix streaming at higher speeds.
According to the Verge:
The DC circuit court has ruled on Verizon v. FCC, a challenge to the net neutrality rules put in place in 2010, vacating the FCC's anti-discrimination and anti-blocking policies, though it preserved disclosure requirements that Verizon opposed - in other words, carriers can make some traffic run faster or block other services, but they have to tell subscribers.
My personal take on earnings
The company expects to release more original content in the current quarter. The impact from these releases is perhaps a better retention rate, as Netflix's original series by themselves do not generate membership growth. However, as membership figures trend higher, the company will be able to increase its production budget. The company doesn't need to spend too much money on marketing the in-house series as it has a pre-established market for its in-house productions.
I'm starting to believe that much of the future growth has been adequately priced in, and that the risk-to-reward is extremely bad for investors who want to initiate a long-term position currently. The company should be able to get a boost in earnings and revenues from higher pricing, but it's not like Netflix can consistently increase the pricing of its subscription every-year, which implies that Netflix's durable advantage is limited.
Currently, Amazon Prime, while a loss-leader tends to offer a bit more utility than Netflix. This is because Amazon Prime members are able to get both 2-day shipping, video services, and other benefits. Amazon has more financial resources than Netflix. Verizon is experimenting with its own web streaming service, and there are even rumors of Apple entering into the web streaming market. Personally, I can shrug off Jeff Bezos, as Amazon's primary focus has been international sales and the Cloud. But, Apple is a whole different story as it has enough assets to easily buyout Netflix 5x over, and a pre-established user base and marketing ecosystem that could catch up to Netflix's leadership position in a very short matter of time.
Currently, what's keeping Apple out of streaming has been the cost of content. But when considering Apple has very limited options for growing earnings, and a lot of cash sitting around doing nothing, perhaps Apple's entry into the space could make it extremely difficult for Netflix to secure content deals in future years. Without content, Netflix knows that it's going to be in a lot of trouble, which is exactly why Netflix has been turning to in-house productions. In-house production can only supplement a content collection. Netflix still needs to buy content from studios and networks.
There may be a high probability of Apple releasing a movie streaming business, when considering Tim Cooks unwillingness to give up cash to shareholders. I can only name a couple investment opportunities on Apple's part that could require "unprecedented investment." TV licensing and content rights are extremely expensive, and Apple could easily use up the cash on its balance sheet in an attempt to offer a web streaming service superior to Netflix. This could cost approximately $20 billion per year, for Apple. On the bright side, Apple may be able to record content license purchases as an asset purchase, which would reduce the impact on cost of revenue (this would boost intangible assets and could generate content licensing and subscription revenues on the back-end). Since Apple is primarily engaged in consumer electronics I don't think Apple's purchase of content licenses will be factored into cost of revenue. If in the event content licensing is considered a cost of revenue, I doubt investors will bail on Apple just because it's making an entry into another product category.
I'm also fairly certain that the unprecedented investment that Apple is saving up for isn't R&D. While, it's true that Apple needs to innovate in order to create phones that are superior in quality. I think that Apple has hit a wall on the innovation side of smartphones and is instead looking for alternative business opportunities to invest into.
The competitive threat to Netflix is very real. Despite the negative headwinds, I give Netflix a very generous valuation. Currently my price target is $333 for 2014 (I arrive at my target by calculating the mid-point between the upper and lower bound of my price assumption). The stock is currently trading $55 above my price target, implying that the stock is overvalued by 16.5%.
Investors have chased the valuation substantially higher following the company's earnings announcement. I'm concerned that major investors will get a little jittery and unload massive positions like what we saw last quarter (Carl Icahn dumped half his stake). The risk to reward to owning Netflix isn't that great at the present moment. Investors could find better upside in other web properties like Facebook (NASDAQ:FB), LinkedIn (NYSE:LNKD), and Twitter (NYSE:TWTR) for the same amount of volatility.
Momentum is generally built on the assumption of better outcomes in future years. While Netflix should be able to generate triple digit EPS growth this year, I'd be wary of whether or not that kind of growth is sustainable when considering sales are only expected to grow by 20-25% year-over-year, for the remainder of the year.
I think investors should wait until the dust settles before initiating a long position. The stock will remain volatile after earnings and if the stock does in fact pivot and decline even further, investors may have to wait a while before the growth catches back up to the valuation.