Netflix - No Great Risk-Reward Opportunity After Goldman Fuels Momentum

Jul. 2.14 | About: Netflix, Inc. (NFLX)

Summary

Goldman's big upgrade adds to momentum in shares of Netflix.

Its assumptions for the medium-to-long term are optimistic but attainable.

Still, I believe analysts might be too bullish, as current levels don't offer a great risk-reward entry point, in my opinion.

Shares of Netflix (NASDAQ:NFLX) received a boost on Tuesday from a big upgrade from analysts at Goldman Sachs. Using optimistic but potentially very realistic assumptions, analyst Heath Terry derives a $590 price target for the company's shares, only adding to the stock's recent momentum.

While I see the further potential upside, as well in a favorable case, I don't like Netflix at the moment, based on the risk-reward ratio. I remain on the sidelines, thereby not jumping onto Goldman's momentum bandwagon.

The Upgrade

Analysts at Goldman Sachs upgraded Netflix from neutral to buy, rising its price target by $210 to $590 per share. Analyst Heath Terry believes the "global subscriber opportunity will drive sustained performance."

Underlying in Terry's thesis is the leveraging of growth in the connected device ecosystem and continued international expansion. Terry furthermore expects continued high subscriber growth, which will exceed expectations. Margin gains are anticipated as well through scale in areas like content, acquisition costs of new customers and technology investments.

Terry notes that the valuation is steep at an estimated 26 times 2015 EBITDA. Still, three potential catalysts have been identified which could push shares even higher.

For starters, there is the great addressable audience across the globe, which is anticipated to roughly double in the coming three years to about 207 million potential customers.

Second, there is the potential to boost ARPU even after the recently announced price increase. The mix is furthermore anticipated to shift to multi-stream plants, which will drive ARPU up even more above the $8.99 domestic basis plan.

And last, estimates are revised upwards on the back of these trends. Goldman has raised the 2014-2016 revenue estimate by some 6% on the back of these trends.

Catalyst 1: Looking Into The International Addressable Market

Netflix is a major brand within the US, but for a long time, was little known outside of the country. The company moved into Canada and Latin America back in 2010 and 2011. In 2012, it entered the UK and Ireland, as well as the Nordic countries, to launch its Dutch operations last year.

All of this has driven subscriber growth, with the company now having 12.7 million international subscribers. Goldman now sees Netflix adding another six countries this year, followed by more countries being added in 2015. At the moment, large nations like Germany and France are still not served by Netflix.

These moves could double the addressable audience to little over 200 million. Assuming a penetration rate of 30%, Goldman believes there is potential for 62 million subscribers by 2017. This compares to just 12.7 million subscribers by the end of the first quarter.

This massive anticipated growth could be accompanied by significant margins expansion, which should come in above 20% as acquisition costs come down and scale benefits are being realized.

Catalyst 2: Boost ARPU

Earlier this year, Netflix announced a $1 monthly price hike for its US subscribers, pushing the price to $9 for a monthly subscription. The first price hike in three years will ultimately affect the 35.7 million domestic users and most of the 12.7 million international users as well, which will see a similar price hike.

The price hike has been carefully communicated, after an aggressive intentioned price hike in the summer of June was a big disaster. A steep proposed price hike resulted in many subscription cancellations.

Consumers might also be more receptive for a price hike given the huge content boost, which has improved the value of the deal in recent years. Netflix furthermore excludes current users from the hike until 2016.

On top of the plain price hike, Netflix announced a multi-stream plan, which allows consumers to stream as many as four streams at the same time for $12 a month.

Valuation

Back in April, Netflix released its first-quarter results, ending the quarter with 48.3 million subscribers. In total, these subscribers generated revenues of $1.07 billion for the quarter.

Now let's assume that by 2017, Netflix can grow its domestic customer base by roughly 15 million users over the coming three and a half years to about 50 million users. At the same time, let's assume Goldman's predictions are accurate and the international subscriber base could grow to 30 million. This would result in 80 million global subscribers at the time.

Applying a generous ARPU of $10 per month, which seems fair given the positive anticipated mix effects, higher prices and fewer trial subscriptions, and revenues are seen around $2.4 billion a quarter, or close to $10 billion per annum.

Overall contribution margins came in at 15.6% in the first quarter, as international losses related to expansion weigh on strong margins of 25.2% domestically. Applying an aggressive 25-30% overall margin target by 2017 would translate into operating earnings of about $2.5 to $3.0 billion. In comparison, for 2013, Netflix posted revenues of $4.4 billion, on which it net earned $112 million.

At the moment, with shares trading at $475 per share, Netflix is valued around $28 billion. This would value the company at about 10 times operating earnings three years down the road, which makes the optimistic view and current sky-high price-earnings multiple easily justifiable. Note that such a roadmap assumes very favorable trends in subscriber growth, ARPU and overall margins.

Final Takeaway

Investors in Netflix have had a huge run. Not only have shares returned 28% already this year, they have more than doubled over the past year and nearly ten-folded from their lows in 2012.

Of course, the phenomenal growth, improved prospects and successful fencing off of the competition have all been huge drivers of this. At current levels, there might be upside as discussed above using Goldman's predictions, yet the risk-reward ratio might not be very favorable.

Besides fundamental risks like competition of Amazon.com (NASDAQ:AMZN) or other players like Hulu, Netflix also has huge and growing content obligations which exceed $7 billion by now.

The lack of serious competition so far has allowed Amazon.com to grow quick and grow into a household name, boosting its global appeal rapidly.

On the bright side, consumer still see great value in Netflix's offerings, which are much cheaper compared to the services of traditional cable companies. Yet, the controversy regarding price hikes and low switching costs might limit Amazon.com's opportunity to capture a higher portion of this perceived value by raising prices.

After the great momentum, it is time to be realistic, and I would not be a buyer on the back of Goldman's report. I remain on the sidelines.

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