- Netflix just met estimates but the stock is likely to continue climbing.
- Drivers are international growth, decline of DVD business and cost management.
- Margin expansion has room to run but will not continue for ever.
Netflix (NASDAQ:NFLX) shares maintained their price in the postmarket after meeting estimates of $1.34 billion of revenue and $1.15 in earnings per share (estimates from briefing.com). A tie goes to the runner in baseball, not in stock market investing. When a stock that is trading at 152 times trailing 12 month earnings holds up when just meeting estimates, it is an exceptional feat. If you dive into the numbers and get behind the fundamentals, you'll see why this is the case though.
First let's cover the basics of the quarter though. Revenue of $1.3 billion was up 25% as the company rolled through its first price increase that isn't likely to be retracted. On the call, Reed Hastings, CEO, touched on the overall impact of the increase and said "we've seen the impact of the price change go through already, it's pretty nominal." This is a far cry from the last time the company raised prices and caused such a consumer backlash that it felt the need to do a debt offering to stabilize the company's finances.
Earnings per share of $1.15 was up 134% from last year's $0.49 showing fantastic growth even as the company continues to roll out its streaming services globally. The number of international streaming customers increased by 84% year over year which is almost 4 times as fast as the 23% growth in the United States. The growth rate needs to keep up to keep the momentum shareholder base on board. If that portion of the investor base leaves and the company begins to trade on a multiple of earnings or cash flow, look out below.
Declining DVD business is a positive for margins and profit growth
Perhaps the most crucial aspect of the story though is the declining DVD business which at first seems like a drawback for the company but in reality is a huge positive. Because the content acquisition and creation costs of the streaming business are capitalized, the tangible, upfront costs, of the DVD business are much greater. This has allowed the company to dramatically expand margins and it's going to continue as the company drops Saturday delivery of DVDs.
Time to start reinvesting excess profits
However in this one case, you can be too rich. Rather than passing the excess earnings along to shareholders, when the company hits a threshold of 30% margins, it intends to begin investing more in content. Building new brands like "Orange is the New Black" or "House of Cards" generate long-term shareholder value without the sugar high of a share repurchase. These brands are an asset that will define the company in the future.
Good quarter but tough to put new money to work
Overall, it was a good quarter and I would expect the shares to go higher but we are not buying them for our clients. As the price increase flows through to the financials, there could be more upside to the share price but the valuation here is too rich for our discipline and we simply missed the boat. (Hat tip to those who didn't.) There are ways to trade this with options that we will discuss on our blog (along with more detailed financial information) but we cannot justify putting new money to work in a stock whose P/E is higher than my IQ.