In the wake of the incredible run Netflix (NFLX) has experienced during the past fourteen months, I think the time has come to address the stock's ability to sustain such a high valuation. I recently wrote an article about how the cold weather has (and will continue to) helped NFLX drive user adoption during the current and previous quarters. In doing so, I noted that I'm a big fan of the NFLX product offering and actually anticipate better-than-expected growth in Q1 and Q2 of 2014. But as strong as user growth and the product offering might be, the stock price has gotten too high. Let's take a look at the why:
- Divergence between core business performance and stock price
- Revenue Analysis: What's the best case?
- Marketing Spend Vs. User Acquisition: Determining efficiencies of marketing dollars
- Cost of Revenues Analysis & Contribution Margin: Getting to the bottom line
Divergence between core business performance and stock price
The most recent quarterly report (Q4 2013) for NFLX was a strong beat. The stock rose 16.5% ($333 to $388) after results showed that new domestic subscribers rose 2.33 million instead of the estimated 2 million (a 16.5% surprise upside) during the quarter. The numbers might seem to work, but they don't.
In a frictionless world, a stock should remain unchanged if it reports exactly in line with the street's expectations and guides exactly to the street's future expectations, the reasonable thesis being that the share price accurately reflects those expectations. So there's no surprise that an upside beat warrants growth in share price because of a better-than-expected performance. But how much is too much? The relationship between upside surprise in user adoption and share price for NFLX is not a linear one, but the rise was linear after the beat.
The incremental, unexpected .33 million new users that NFLX acquired during Q4 will generate incremental annual revenues of $31.6 million, but the surprise beat lead to an increase of $3.3 billion in the company's market cap. Not to mention, since the 16.5% day after earnings, the stock has risen another 11.3% to its current trading price of $431.88, an addition of another $2.63 billion in market cap.
Revenue Analysis: What's the best case?
I argued in my previous NFLX article that the company will surprise to the upside again in Q1 2014, citing one of the harshest winters on record as one of the leading drivers of growth. But how much will the company grow? What's the best case?
Source: NFLX Q4 2013 Letter to Shareholders
In the chart above, NFLX forecasts domestic net additions of 2.25 million in Q1 along with 1.6 million foreign net additions. Due to the weather (domestically), the company can expect to outperform by 15%. School & work closings will contribute to new demand generation. Users have consistently spent upwards of 20% more time in the home this winter because of conditions; NFLX is a leading source of in-home activity.
An 18% outperformance in domestic growth will yield 2.66 million new users. If the 1.6 million foreign users are in line, the company will have generated $408 million in annual revenue going forward. I based the 18% outperformance prediction on past outperformances and currently favorable conditions for outperformance given the weather. During the previous four quarters, the stock has outperformed consistently with regard to domestic net additions. Q1 19.4%, Q2 12.7%, Q3 18.3%, Q4 16.5%.
In 2013, NFLX grew revenues 21% y/y. If over the next four quarters the company can consistently accelerate its growth rate by 18%, we'll see FY 2014 revenues 25% higher than the previous year, or $5.46 billion.
Marketing Spend Vs. User Acquisition: Determining efficiencies of marketing dollars
What's driving the growth at NFLX? The incredible content library (its product offering) far exceeds that of any competitor, so it's got a competitive advantage. But new user adoption is tied pretty closely to the marketing spend, and in FY 2013, the company spent just over $500 million and acquired 11.09 million new users domestically and internationally. In 2014, those new users will account for $1.06 billion in revenues, and at an average quarterly contribution rate of 25% for the coming year, that translates to $266 million in contribution profit, so users must continue paying for the service for 2 years to reach breakeven on the marketing spend. In a constantly changing, innovative industry, time will tell if ROI on the marketing spend is too low/risky.
Cost of Revenues Analysis & Contribution Margin: Getting to the bottom line
A major cause for concern with regard to the profitability of NFLX is the cost of revenues. Take a quick look at the two charts below. The first chart is sourced from the company's 2013 10-K. The second is a personal analysis. The cost of revenues as a percentage of revenues has increased over the past five years, primarily due to the move toward original content.
The bad news is that this story isn't going to get much better any time soon. From the company's most recent 10-K:
We amortize the content library in "Cost of revenues" on a straight line or on an accelerated basis, as appropriate:
• For content that does not premiere on the Netflix service (representing the vast majority of content), we amortize on a straight-line basis over the shorter of each title's contractual window of availability or estimated period of use, beginning with the month of first availability. The amortization period typically ranges from six months to five years.
• For content that premieres on the Netflix service, we expect more upfront viewing due to the additional merchandising and marketing efforts for this original content available only on Netflix. Hence, we amortize on an accelerated basis over the amortization period, which is the shorter of four years or the license period, beginning with the month of first availability. If a subsequent season is added, the amortization period is extended by a year.
• If the cost per title cannot be reasonably estimated, the license fee is not capitalized and costs are expensed on a straight line basis over the license period. This typically occurs when the license agreement does not specify the number of titles, the license fee per title or the windows of availability per title.
Essentially, it goes to show that most of the content that NFLX is licensing is being amortized in a consistent straight line, so take any notions of significantly reduced cost of revenue numbers going forward and toss those away. High content fees are here to stay - they're the most important part of NFLX's offering and the most costly.
FY 2014 Estimates
If the company generates $5.46 billion of revenue in FY 2014 and the cost of revenue remains consistent at 70%, where does that leave the shareholders? Marketing dollars have risen over the past three years, but actually decreased as a % of overall revenues, from 15% in 2011 to 11.5% in 2013. Technology and development and general and admin costs have also risen, both in line with revenue growth. They're 8.5% and 4% of revenues, respectively.
Assuming a similar cost structure in FY 2014, NFLX stands to generate operating income of $320 million. After interest expense (primarily attributed to the interest paid on the 5.75% long-term notes), the company stands to see income before taxes of $255 million or after-tax net income of $165.7 million, and EPS of $2.85. The stock currently trades at $431.88, or a forward P/E of 152x.
NFLX is a growth company. Valuation is based on potential for growth rather than current fundamental performance. That's well and good, but it's imperative to beg the question whether or not even the high growth of NFLX can justify such a staggering valuation. By the end of FY 2014, NFLX anticipates reaching its target contribution rate of 30%. Additionally, it foresees user adoption growth beginning to taper in early 2015. I'm a huge fan of the company, the management, and the product offering. I think it's one of the most innovative companies in the marketplace. But I'm not willing to pay for the stock at the current price. You shouldn't either.