Someone wrote a rather long article about the topic of Netflix (NASDAQ:NFLX) and whether or not I was being pragmatic about my investment selection and whether or not the company merits the high valuation. The article is quite long, and the opposing author presents a lot of interesting points, which I will try to address in more detail.
However to summarize, here are his three main concerns with my analysis:
- Assumption on total market potential is too high, due to competition.
- Historic CAGR not consistent with projected CAGR.
- Profit margin assumptions may be too high.
So to address his assumptions I have to work backwards and summarize the premise of my two previous articles:
- Global internet users will total 4.1 billion by the end of 2020, which is significantly bigger than Netflix's current 50 million subscriber base.
- Netflix can increase pricing, as indicated by the CEO of Netflix in the previous earnings conference call. The price increases will be incremental, and will help us to understand demand elasticity. The year-over-year price increase on subscriptions assuming a $2 increase from $7.99 to $9.99 is 25%.
- Broad appeal internationally is high, and assuming content investment trend level off at $20 billion, paired with falling web hosting costs, the fixed/variable costs will stabilize, generating a massive increase in profitability further out into the future.
Let's address the first concern of market potential
Yes, you're absolutely right; I'm using the total market potential as a means of understanding the growth potential of Netflix. Realistically, Netflix is the market leader, and has developed many competitive advantages which includes having a large content collection due to powerful content partnerships with top movie production houses like Walt-Disney, Sony Pictures Animation, DreamWorks Animation, and Warner Bros. Television.
The high market share indicates two things, first Netflix nearly monopolized movie streaming, and entry into new geographic markets will most likely be followed by high saturation rates. Therefore defining the global addressable market, and concluding that a reasonable percentage of that will soon become a part of Netflix's subscriber base is reasonable.
The NPD Group states:
The number of people who watched TV online was up 34% vs the period last year. But although the research group notes that Amazon Prime and Hulu Plus are gaining market share, the folks at Netflix shouldn't be worried. The company accounted for about 89% of the TV streams, while Hulu Plus had 10% followed by Amazon Prime's 2%
Basically, Netflix has the most user share out of all the online streaming services. It's not likely that this will change in any meaningful amount, and while the statistics are a year old, it essentially confirms the assumption that Netflix has a huge percentage of the market, and is likely to sustain that lead.
Given the fact that Netflix has continued to expand into overseas markets, paired with a proven business model, that happens to have a high barrier of entry, I don't think it's unfair to compare Netflix's current customer base to the number of global internet users.
At present, Netflix has been able to saturate 30% of households within the United States, and I don't think it's impossible for Netflix to generate meaningful saturation on global aggregate. Therefore, what seems to be a working process, shouldn't be negated on the basis of criticizing my analysis by pointing out whether or not I have a head on my shoulders that's capable of coming to rational conclusions. My ideas are not symptomatic of the times, and are based purely upon the growth potential of the business, which I believe is excellent.
Recently, Goldman Sachs came out with a research report that summarized two important things:
- We estimate that Netflix's addressable audience of subscribers will more than double over the next three years to 207 million.
- We believe the mix of multi-stream plans will increase, driving ARPU expansion beyond the basic $8.99 plan.
That's pretty similar to what I said! Obviously, I don't have the credibility of a massive investment bank behind me. So I'll let Goldman Sachs take the limelight on this one.
Unlike Goldman Sachs, I expect incremental pricing increases to be higher, and for user growth to be slower. Either way, the combined impact of higher prices, plus added users will drive sales growth. The main reasoning is that companies are prone to generate organic growth through price increases, especially when customer acquisition slows. Netflix has plenty of room to price higher when compared to the pricing plans of other services like HBO or TV programming. Also, the company can continue to generate high user growth through launches in new markets.
Currently the incremental price increase only applies to new subscribers, which makes it difficult to model into a five-year forecast. Netflix communicates that it only wants to apply higher pricing to new subscribers, and grandfather older subscriptions at a lower pricing level. But my guess is that Netflix is pricing new customers higher to determine the impact on demand for its services. Assuming it can retain its pre-existing subscribers, there's no reason to believe Netflix won't increase prices on all of its subscribers, and therein lies a core pillar to a ten-year investment thesis.
In a sense, I believe that a 143.5 million subscriber figure by 2024 is attainable, given the fact that Netflix has grown its subscriber base from 10.3 million to 48.35 million between Q1 2009 and Q1 2014. That's a CAGR of 36.24%. That's a phenomenal growth rate, and it helps to explain why Goldman Sachs thinks that the user base may double over three years.
Therefore, I find that my estimates are extremely conservative, not extremely aggressive.
Over the next ten years I anticipate 9.85% CAGR for average revenue per subscriber. That's well below the anticipated 25% year-over-year price increase that Reed Hastings was talking about over at the Q1 2014 earnings conference.
Because the price increases that I expect are lower than what has been guided by management, paired with the fact that I estimate user growth at a third of historic growth, my assumptions are grounded in solid reality, and are very conservative.
My profit margin assumption is not too high
I expect a 20% net profit margin as content costs will become a smaller component of average variable costs, and back-end infrastructure costs are likely to decline.
Quoted from Variety:
Goldman Sachs analyst, Heath Terry compared Netflix's financial prospects to HBO. Based on the premium cabler's financials, if Netflix reaches a similar scale the company's 2018 revenue could hit $14 billion with 48% operating margins.
The 48% operating margin translates to $6.72 billion in operating income. Assuming a 35% tax rate and you're looking at net income of $4.368 billion, which is a 31.2% net profit margin. That's significantly higher than what I had estimated, but the reasoning, and logic behind it is reasonable. As pricing increases, paired with falling incremental costs per subscriber, the net profit margin will drastically improve.
While, I'm a little more conservative on my estimates, I believe that they're extremely reasonable when compared to the longer-term forecasts of other notable and well-respected analysts.
I don't think I have modeled too aggressive of a profit margin in other words, and I believe that investors should anticipate incremental profit expansion as user growth, paired with price increases continue.
I'm going to reiterate that the market potential is definitely there. I'm not going to offer a short-term price target, but I will mention that I think that the stock will have a market capitalization in excess of $150 billion over the next ten years, assuming a combination of expansion, plus price increases were to occur.
I think that investors will have plenty of time to ride this investment, making it an ideal candidate for dollar cost averaging. I don't think the short-term intrinsic metrics like P/E, or sales growth are fully indicative of the future. Based on key performance indicators, and management guidance on pricing, and recent history of year-over-year user growth revenue growth will accelerate.
I reiterate my buy recommendation on Netflix. Best of luck to you investors and traders.
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.