Why Netflix's Reed Hastings Has Candor

Jun. 7.14 | About: Netflix, Inc. (NFLX)

Summary

Netflix's shareholders have been on a roller-coaster ride.

We think Reed Hastings' warning is still valid.

The company has significant "beta" to the downside should the broader market face declines.

Let's examine Netflix's (NASDAQ:NFLX) investment prospects and run shares through the Valuentum process. Regardless of one's opinion on the company's valuation, shares will continue to be incredibly volatile.

For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas - as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF - that's why we focus on relative value - and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Netflix posts a Valuentum Buying Index score of 3, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. Needless to say, we're not huge fans of the company's equity on the basis of this score.

Netflix's Investment Considerations

Investment Highlights

• Netflix's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle.

• Netflix is a leading Internet subscription service where subscribers can instantly watch unlimited TV shows and movies streamed over the Internet to their TVs, computers and mobile devices. In the US, the firm's subscribers can receive DVDs delivered quickly to their homes.

• Netflix's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 1.1% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. However, the firm's cash flow should be sufficient to handle its low financial leverage.

• Netflix has a unique long-term view: Over the coming decades and across the world, Internet TV will replace linear TV. Apps will replace channels, remote controls will disappear, and screens will proliferate. As Internet TV grows from millions to billions, Netflix will be a leader. Competition, however, will be ever-changing and fierce (source: company website).

• Not everything is perfect at Netflix. Rising content costs, as well as expenses associated with the firm developing its own content, will likely apply new pressures to future free cash flow.

• We think Netflix has significant "beta" to the downside. We wouldn't want to be holding shares when we approach bear market conditions (note: when not if). The market inevitably moves in cycles.

We Like Management

One of the qualities we hold in high regard with management teams is candor, and we give Netflix CEO Reed Hastings a lot of credit. Not too many CEOs will go on record saying that its firm's share price is being supported by "momentum-investor-fueled euphoria," but he did. If you understand anything about Netflix's stock, it should be this from Mr. Hastings: "In calendar year 2003 we were the highest performing stock on Nasdaq. We had solid results compounded by momentum-investor-fueled euphoria. Some of the euphoria today feels like 2003." Shares were trading under $400 per share when he said these words just a few months ago. They are now north of $430 and steadily moving higher. At the very least, investors should expect continued volatility.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Netflix's free cash flow margin has averaged about 1.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Netflix, cash flow from operations decreased about 69% from levels registered two years ago, while capital expenditures fell about 11% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Netflix's shares are worth between $167-$347 each. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $257 per share represents a price-to-earnings (P/E) ratio of about 138.9 times last year's earnings and an implied EV/EBITDA multiple of about 6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 18.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 26.5%. Our model reflects a 5-year projected average operating margin of 12.2%, which is above Netflix's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 9.3% for the next 15 years and 3% in perpetuity. For Netflix, we use a 10.6% weighted average cost of capital to discount future free cash flows.

We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers - those that drive stock prices - pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Netflix to peers Best Buy (NYSE:BBY) and Home Depot (NYSE:HD), among others. We showcase the comparisons more for perspective than we do to make any real claim that the group represents pure peers.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $257 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Netflix. We think the firm is attractive below $167 per share (the green line), but quite expensive above $347 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Netflix's fair value at this point in time to be about $257 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Netflix's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $350 per share in Year 3 represents our existing fair value per share of $257 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.