The market was quite weak on Thursday. Things looked decent to start out the day with earnings pretty solid and data okay. It was a better morning domestic tape in pre-market, but things overseas in China were not as strong. The market is in an interesting space right now where it very much wants to correct. For a while, bulls were stubborn and the volume selling was not there. The volume buying was not either, and we were in a consolidation pattern. Earnings and data is really crucial right now without the Fed, and that lack of support creates a scenario where we can be volatile.
Things started out pretty solid after we got decent earnings in after hours Wednesday combined with decent earnings Thursday AM. F5 Networks (FFIV), eBay (EBAY), and Netflix (NFLX) all had very good earnings. FFIV beat expectations and guided well for the rest of the year. The rest of the year looks much rosier. EBAY had decent earnings, but the company looked stronger after some speculation about a PayPal spinoff broke wind. Finally, Netflix added a whopping 2.2M new subscribers, crushed earnings, and also suggested new payment plans that were taken well by the market. Overall, earnings were pretty solid. On the data side, jobless claims came in better than expectations and flat week/week while existing home sales hit a 7-year high.
So, what happened? The weakness came from China missing on their flash HSBC PMI report that showed weakness in manufacturing for January. The same flash report for the USA also showed weakness. Earnings from McDonald's (MCD) were bland, and the market took some early selling and ran with it. Overall, confidence is weak in the near-term, and a lack of buyers committing at these levels seems to be catching up with the market.
On the company news side, we will be focusing on Netflix today. The latest round of earnings showed some definite strength in the name that cannot be ignored along with some future pricing plan prospects that are appealing. We want to dive into the name a bit more, breakdown the earnings, and price the company for 2014 given these recent developments.
First, let's breakdown what was reported. The company reported $1.2B in revenue along with an EPS at 0.79 and subscriber add at a click of 2.3M users. Revenue came in about at expectations, but the company surprised on earnings as well as subscribers. The company's continued addition of subscribers is one f the most exciting parts of the company's prospects. Some critics had suggested that NFLX could not keep up their additions and may end up seeing some nets more flat due to losing clients. It has not happened. The two main parts of the company that we see as the most interesting are their international potential and original programming.
For the latter, the company will release their original shows House of Cards and Orange is the New Black in 2014. HoC comes out in mid-February with OISTNB releasing in the summer. Original programming remains one of the most intriguing parts of the Netflix opportunity. As for overseas, international is developing nicely, and the company notes that their top priority is this along with mobile. Yet, the company was able to bring in $221M in revenue in overseas markets in the latest quarter and had their highest total members at just under 11M (1/3 of their domestic members). They added their largest net since Q4 2012 as well. Here were the company comments on international:
We haven't been specific about what country or countries we are going to expand to. So there is a number of players in all the major markets and then the smaller markets. They are all doing good work. I think what we have seen with our success in the UK is that there can be very strong players like the BBC iPlayer, (indiscernible) and Sky. And we can still build a very successful business. And so I think the key is having unique content, a great reputation, a good value proposition and we can succeed and in many cases, that competitors can also. So we mostly focus on finding good markets that love content and that will steadily expand in Europe.
The stock rose 16% on the news, and it now sits with a 208(ish) P/E ratio. Future P/E still sits at a bit over 80. The stock is quite expensive, but it is still growing significantly. The question for investors is whether or not it is a good deal at this point or is something they can pass on. A popular article today commented that Netflix was in sky-high valuation territory, and therefore, a sell:
I firmly stand by my assertion that Netflix is in sky-high bubble territory. For now, the bubble keeps inflating as witnessed by Netflix's strong after-hours surge. However, share price growth is driven by speculators not investors. Such speculators concentrate on subscriber metrics way too much and neglect basic valuation metrics such as earnings or free cash flow. Booking $1.2 billion in revenues this quarter and achieving a free cash flow of $5 million is a really dismal performance. Add to that two sequential declines of low-level free cash flow and nose-bleed free cash flow- and earnings multiples. Netflix's current profitability and historical cash flows do not justify the outlandish multiples in the market. Investors should also realize that the valuation multiples from above are based on yesterday's closing price of $333.73 and today's surge in pre-market quotes will only add to the massive overvaluation we already see. Short Netflix on overhyped subscriber figures and unsustainable valuation.
The writer here misses a couple things. First off, a high-growth company acquiring and spending lots of money will not create a lot of FCF, so while its not great performance…it should be expected. Further, while speculation is obviously a major part of this, the writer should understand that shorting is not a good prospect. While it may be overvalued, growth stocks will remain quite strong until they are seeing some type of slowdown. Netflix is not, and it will retain high valuations until those growth rates slow. When will that happen? Further, are these valuations outlandish like they are suggested? Applying NFLX on a simple cash flow model misses the most important part of the argument…growth. We can apply it to the Oxen Group's proprietary DCF model that includes a coefficient factor for growth to get a more reasonable number.
Revenue: Currently, projections are for NFLX to see 19% and 17% growth in 2014 and 2015. From there, we can expect a 10-12% rise in 2016 to 2017 in a conservative model. And let's assume they come back to Earth and see 6-8% in 2018. What this assumes is they continue to see modest growth domestically with strong growth overseas. Price increases and new plans are also on the way as is more original programming that the company can potentially mine out as well.
Margins: For our model, we care about operating margins. The company saw these dip with high SG&A over the past couple years, but they were at 7% in the latest quarter. We believe a 7-8% rate in 2014 and 2015 is capable with movement into the 10-12% range by 2018.
Taxes: We assume a 36% tax rate.
Capital Expenditures: This is probably the most crucial aspect of the model as the company's biggest concern is their continually growing cost of licensing new material. At the same time, NFLX is doing well with original content and should continue to produce their own content. Yet, that cost is still high right now as well. Interestingly, CapEx dropped in 2013 from 2011 and is not significantly higher than 2012. Yet, we expect this number to continue to grow as content prices and contract renewals start to pop up. We can anticipate this growing to $180-$200M by 2018.
Debt: We will use $900M in our model given the announcement of $400M added in Q1 2014.
When we use this model, we use a factor that discounts at a much lower rate to account for NFLX's high growth model. Yet, we also have to look at depreciation and amortization. The company is amortizing their streaming library right now, and that is key to cash flow. If we include that amortization, we get a $490 price target for 2014. Without, we get a $90 price tag. So, the question is whether or not it should be include.
What is amortization of streaming content?
Amortization is what NFLX does to account for content costs in their cash flow model. Amortization is what happens with intangible assets (licenses for content). Yet, in our opinion, this is a must to include. NFLX is a content library, and their assets are their right to stream content - its their business. Therefore, we believe it is justified for Netflix to include this into their cash flow, and that they are not hiding profitability like others have suggested.
Overall, what we see with Netflix is a company that has a great deal of potential. They have revolutionized the way people watch TV, continue to grow, and are just starting to move into the international scene. The company's success in 2014 will be defined by their ability to keep margins at the levels we saw in the latest quarter, grow subscribers overseas, and see solid follow through on original programming. We will stop in throughout the year to review these factors.
For now, to put things in perspective. In 2018, with a revenue around $8.2B and a net margin at just 6%, the company would have an EPS at 8.30, putting P/E at around 45, meaning that this stock is still expensive. Therefore, it is imperative that this company continue to grow consistently and not see any snags. If they do, the stock will definitely see some correcting of significance. At the same time, if it does not, this stock has a lot of potential still this year. Best case we see this stock reaching around $490 this year. The worst-case is a bit harder to determine because in the case that they do have a slip up, they will definitely see some significant correcting. For long-term investors, understand that there is a good deal of speculation that is still occurring here, but the prospects are bright still.
The market looks like it has found some potential support right now at the 1820 line on the S&P (SPY) and the 50-day MA for the Dow Jones (DIA). Tech (QQQ) has been the only strong part of market. That support could lead to a temporary hiatus from the downside, but if those lines fail, downside could push even further. So, it will be interesting to see how the market fairs from here. The keys for tomorrow will continue to be earnings as well as any further overseas developments. China was a major impediment today and might remain that way with weakness there, but Europe is a bright spot. For earnings, the most important report for the week is Microsoft (MSFT) as we discussed here. Additionally, we will get key reports from Starbucks (SBUX), Discover (DFS), Bristol Myers (BMY), and GE (GE) between tonight and tomorrow's open. Those reports should set the stage for tomorrow. Overseas, we have no planned economic data, which may be a relief after recent weakness in China.