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Summary

  • Netflix reported quarterly results that by and large met analyst expectations.
  • Subscriber growth was strong, which should help boost margins further.
  • Still, investors should wait for $400 before buying to get a better 3 year rate of return.

On Monday afternoon, Netflix (NASDAQ:NFLX) reported second quarter results, and the stakes were pretty high given the stock's recent performance. Trading near a 52-week high, shares are up 23% so far in 2014 and a fantastic 71% over the past twelve months. This rally has left the company with a pricey forward earnings multiple of about 107x. While this multiple is undoubtedly expensive, the question is whether it is excessive given the company's tremendous growth rate. In the end, I think that the stock is a bit ahead of itself with a 2017 price target of $500. This means shares have upside, but investors should wait for a pullback to earn a better 3 year rate of return.

On the whole, this quarter was relatively inline, which is why shares were barely changed in the typically volatile after-hours session. NFLX earned $1.15 on sales of $1.34 billion, which was exactly what analysts were looking for (all financial operating data available here). While headline figures met expectations, there were several other data points investors should focus on. For Netflix to prove the bulls right, it needs to continue to add scale. Content is extremely expensive, which has held back profitability. It needs to grow its user base to gain negotiating leverage and increase revenues faster than costs. This can lead to the dramatic increase in margins, which will power profits significantly higher.

We saw exactly that this quarter. Total streaming margins were at 18.5%, compared to 10.2% last year. Domestic margins were up 4.6% year over year to 27.1%. Internationally, Netflix does continue to lose money because it is still adding scale and building a brand and content library. Still, margins of -5% were far better than last year's -39.7%. In the US, NFLX has 36.24 million members compared to 13.8 million internationally. At Netflix gradually increases foreign penetration to US levels, we should see international become profitable.

Based on the pace of subscriber additions, foreign profitability could be coming in 2015. Netflix added 570k subscribers against guidance for 520k. Even with its massive size, NFLX has yet to fully saturate the US market. International net adds were 1.12 million, compared to guidance of 940k. We are beginning to see NFLX gain traction overseas, which should help improve margins over the next twelve months. Netflix also expects this momentum to continue next quarter when international net additions should total a fantastic 2.36 million subscribers while the US should add 1.33 million. These numbers portend fantastic growth into 2015 and beyond.

While content costs are high, Netflix was free cash flow positive in the quarter, generating $16 million. Streaming content obligations, which extend for several years into the future, total $7.7 billion, up from $6.4 billion a year ago. This increase is reflective of the deal with Disney (NYSE:DIS) and always rising content costs. Netflix needs to continue adding subscribers and gradually increase prices to boost margins. This quarter NFLX added more subscribers than anticipated while increasing prices in the US and some international markets. By continuing on this trajectory, Netflix can dramatically increase profitability.

Trading over 100x earnings, investors must ask: does this valuation make sense? The answer is it is really hard to say. It really depends on how long Netflix can continue this rate of growth, and I am in the camp that the potential market is significantly larger than Netflix's current size. Shares are currently trading at $532 per subscriber, but the subscriber base is growing rapidly. Within 3 years, I expect Netflix to have 45 million U.S. subscribers and 35 million international subscribers, which should drive EPS to the $18-$22 range with further growth opportunities remaining overseas in unsaturated developed markets in Western Europe and emerging economies while the U.S. will be near saturation. As a consequence, Netflix should still be growing earnings by about 50% in 2017. Assuming a 25x multiple thanks to this growth rate, shares should be trading at $500 in 3 years, which suggests about 10% upside from current levels.

10% over 3 years in an unimpressive return. While NFLX is not poised to crash, it will likely be a relative underperformer at current levels. I believe investors should wait for shares to fall back to $390-$400, which will give investors an annual return of at least 8% for the next three years. Netflix is a fantastic growth story, but the stock is simply priced for perfection. Wait for a 10% pullback and then consider adding NFLX to your portfolio.

Source: Netflix: Wait For $400