Netflix (NFLX) is a controversial investment.
One can find hundreds of articles arguing NFLX is a cheap stock and that the price could skyrocket, while roughly an equal number of articles claim it to be over-valued and even a bubble.
In my professional opinion, NFLX is over-valued. I wouldn't call it a bubble yet - but this is a question of definition.
I start with the bottom line. The stock's value is in the range of $150-$200. Let me tell you how I have reached this range.
All the growth and expense assumptions in this article are based on NFLX reports and data. Most of it can be found here and here. I will be more specific in the text. As a rule, I have tried to be on the optimistic side with my predictions. In this article I will use the outcome from a detailed DCF for the years 2014-2016 and a growth adjusted discount rate thereafter.
Let's look at the 3 reported segments:
- Domestic: the total number of households in the USA is estimated to be a bit more than 100 million. I think it is fair to assume that this is the available market for NFLX's domestic business. That means that NFLX already has a 33% market share, but also that the growth potential is limited. We shouldn't forget that the old cable and satellite TV companies are competing in the market and that there are also other IPTV competitors. So it is obvious Netflix won't reach 100 million subscriptions (100% market share). It is impossible to predict NFLX's ultimate market share so let's look at the "paid subscribers" growth in 2012 and 2013. It was 5.3 and 6.2 million, respectively. As I have mentioned, there is limited growth potential in a competitive market, therefore I'll assume that in the years 2014-2016 the "paid subscribers" number will grow by 6.0, 5.0 and 4.0 million subscribers, respectively. This gives NFLX almost 50% of the Total Available Market (and even more, if one looks at the total number of broadband subscribers in the domestic market) by the end of 2016. Taking into account the statement that contribution margin should reach 30% by the end of 2015 (up from 23.4% last quarter), I make some assumptions on cost of revenue and marketing (both constitute the difference between revenue and contribution margin). I assume the cost of revenue will be 60% in 2016, down from 67% in 2013. We should remember that NFLX has openly stated that it is going to invest much more in original content, so this reduction in "cost of revenue" seems to be quite ambitious. I also assume the marketing cost will be only 9% of revenues, down from 10% in 2013 - though the NFLX brand name is already very strong. I don't think it would be an exaggeration to say more people know what NFLX is than who is the president of the USA...
- International: NFLX has announced it will focus on overseas markets. It hasn't launched operations yet in major markets like Germany, France and Italy. That means there is very big growth potential in this segment - but also there will be local and international competitors, both OTT and more "traditional" TV companies in this market segment. In 2012, the number of international paid subscribers grew quarter over quarter by a staggering 36% each quarter (on average). In 2013, the growth rate went down to 19%. If you look at the number of "total members", the quarterly growth rate reach 16% in 2013, down from 35% in 2012. I assume quarterly growth of 14%, 13% and 12% in the years 2014-2016, respectively. This will yield, over the next 3 years, a staggering number of 32.5 million new paying subscribers joining Netflix - growth of 333%! Taking into account the diversity in this segment (different nations with different languages, cultures and most importantly - different regulation), I assume the cost of revenue will be 67% (like in the USA in 2013, with a similar number of paid subscribers, but much smaller population diversity) and marketing will be 9% of revenue, down from 2013, figures of 109% and 30%, respectively.
- DVD: This business is dying. It is a very profitable segment, but the customers are leaving this kind of subscription. I assume by 2016 it will retain a bit more than half of its current subscribers. There is no reason to assume NFLX will kill this segment as long as it is generating money. I assume that the contribution margin will stay close to 50% - similar to the margin in 2013.
I want to add a few more assumptions: R&D+G&A. R&D expense (as portion of revenue) might decrease marginally over time, but the G&A expense portion should grow due to the expansion into new and diverse regions. I assume both expenses, combined, will stay at 13% of revenue. Income tax will be 36%. There are 3 more issues on the corporate level, we shouldn't forget:
- The number of shares is constantly growing due to exercise of stock option by employees. In fact, the number of shares grew by 3.9 million in 2013, while reported insider selling was 1.1 million shares during the same period. Taking into account additional, unreported, sales of junior-level employees, it is safe to assume that a large chunk of the newly issued shares will very quickly be sold back onto the market.
- NFLX has announced its intention to raise an additional $400 million in debt. While this planned debt raise isn't material in itself, it shows that even the management thinks that the possibility exists that there is a situation whereby NFLX will not produce enough cash internally to support its expansion plans. In the scenario I have presented here, Netflix shouldn't need this extra cash. This might point to overly optimistic assumptions made by me.
- Monthly fee. While there is talk regarding price hikes, Netflix has stated that, if it happens, it will apply only to new subs, and old subs will have a long transition period. Any price hikes can't be substantial since it is a competitive market (Amazon Prime (AMZN) costs only $80 a year plus shipping benefits for other Amazon purchases).
Since the market is quite dynamic the uncertainty is quite high. Therefore I assume a discount rate of 15% and from 2017, for 25 years, I assume a growth adjusted discount rate of 5% (a very generous assumption).
When I put it all on a nice Excel sheet, the value of NFLX comes out as $12.3 Billion, which is slightly more than $200 per share. Since I think the assumptions presented here are quite generous, I think $200 is the upper valuation limit. I personally would feel better with a valuation of roughly $150 per share.
Don't get me wrong, Netflix is a tremendous company in a growing market and has excellent management. It is a classic growth company that enjoys the edge of being first in the market. The stock is the market's darling and enjoys very good momentum, but I can't find any economic justification for a price tag of $400. NFLX's CEO warned the market a couple of months ago of a share price bubble. I will just say it is grossly over-valued.