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Netflix (NASDAQ:NFLX) is growing at an incredibly fast pace. The company which started out as a DVD-rental-by-mail company is now transforming itself into a video streaming company. While this business model has several advantages including reduced postage costs and better opportunities for international growth, the changed business model also reduces Netflix’s competitive advantages. These competitive advantages over traditional brick and mortar companies, such as lower operating costs, were significant enough to force Blockbuster into bankruptcy.

The new streaming video business model changes the primary threats to Netflix’s business from DVD rental companies such as Blockbuster and Coinstar to companies in the internet delivered video market. According to Netflix’s annual report, the company expects intense competition from major companies in this segment such as YouTube, Hulu and Amazon (NASDAQ:AMZN). These competitors have deep pockets and are aggressively trying to make inroads in the online rental market, a sector which has few barriers to entry. YouTube for example, recently hired a former Netflix Vice President for content acquisition in order to use the executive’s expertise to license more digital content.

In addition to increased competition, costs associated with content acquisition have increased significantly with the move to a streaming video business model. In the last quarter, the company spent $115 million on obtaining video streaming rights compared to the $10 million it spent in Q3 2009. It signed an agreement with Epix in the region of $1 billion payable over 5 years. Its existing deal with Starz expires next year and expectations are that extending the deal would also cost Netflix about a billion dollars. These expenses make sense and are critical to the success of Netflix. Before, the Epix deal, Netflix’s DVD catalog had approximately five times as many titles as its streaming video catalog.

The company will also have to increase spending on maintaining and upgrading its infrastructure. As evidenced by the recent multi-hour outage of Netflix service, the rapidly increasing subscriber base will force Netflix to make substantial capital expenses. The company currently has approximately $257 Million in cash and short term investments which is slightly below its targeted $260 Million cash reserves. Its trailing 12 month free cash flow of $109 million should be insufficient to meet the investment needs of the company and I would be surprised if NFLX does not resort to raising capital either via an equity offering or by issuing debt. If the company comes out with a follow-on offering (which I suspect it will), it will have a major impact on existing shareholders as the current book value of equity is only $200 million compared to market value of approximately $9.2 billion. Existing and future investors should keep this in mind while evaluating the investment potential of Netflix.

Wall Street is thoroughly mixed on Netflix (NFLX). Of the 30 analysts covering the stock, 7 analysts have a Strong Buy rating and an equal number have a Strong Sell rating. Valuing a fast growing company such as Netflix is not an easy exercise. The problem is exacerbated by the constantly changing nature of the industry and the entry of new products and services. Several companies are planning a push in international markets. Most of the content deals that are in place for Netflix and other companies are restricted to a particular region. Expanding in other countries will entail acquiring new and possibly local content in order to attract subscribers from those regions. Therefore, there are several unknowns which are hard to predict. It is advisable to err on the side of caution and not be overly aggressive in projecting future growth in revenue and income.

Valuation

Valuation analysis was performed by employing two methods:

  • Based on anticipated growth in subscribers over a 5 year period
  • Based on conventional discounted cash flow analysis


Based on anticipated growth in subscribers over a 5 year period

At the end Q3 2010, Netflix had 16.9 million subscribers with 15.8 million paid subscribers. I am not too concerned about the increasing numbers of free subscribers as Netflix reports that 90% of these users continue on past the 1 month free period to become paid subscribers. The company expects to end FY 2010 with 19.7 million total subscribers. Assuming that the company reports 20 million total subscribers at year end with 94% paid subscribers, the company would have 18.8 million paid subscribers.

With the company moving towards a streaming video business model, the average monthly revenue per subscriber has reduced from $13.3 during Q3 2009 to $12.12 during Q3 2010. This trend is expected to continue as subscribers move towards a lower monthly fee plan. In fact NFLX now offers a $7.99 streaming only plan in Canada and is currently testing the same plan in the US. Analysts estimate that the average monthly revenue per subscriber will reduce to between $10 and $11 in the next few years. Further, higher content acquisition costs is expected to reduce margins (this will be partly offset by the reductions in postage costs). The company expects to maintain operating margins slightly higher than 12% for the North American business.

Coming to the growth rates, analysts expect a long term growth rate in earnings of 27%. I expect the company to increase its subscribers at a faster pace than the growth rate in net income. The valuation analysis shown below assumes that the number of subscribers will grow at an average annual rate of 35% for the first 2 years, 30% for the following 2 years, and at an average annual rate of 15.3% for years 5 through 10.

Based on the assumptions outlined above, the following results are obtained:

- Year 2020 Subscribers = 136 million
- Year 2020 Revenue = $18 billion compared to TTM Revenue of $2.01 billion
- Year 2020 Net Income = $1.38 billion
- 2020 Market Value of Equity = $20.7 billion (assuming a P/E of 15)
- Present Value of Future Value of Equity = $9.00 billion (COE of 8.68%)
- Market Value of Equity per Share = $167


Kindly note that if you apply a P/E of 20 (which would be high in my opinion), the market value increases to $222 a share. On the other end of spectrum, a P/E of 10 would result in a fair value of $111 a share.


Based on conventional discounted cash flow analysis

DCF valuation of NFLX was performed by employing a two-stage model with a high growth period of 10 years. The major inputs and the valuation results are presented below.

NFLX

Bottom-Up Beta

1.03

Equity Risk Premium

6.0%

Cost of Equity

8.68%

Average Growth Rate (Years 1-5)

30%

Average Growth Rate (Years 6-10)

14.4%

Stable Growth Rate

2.5%

Present Value of FCFE in High Growth Period (Billions)

$0.86

Present Value of Terminal Value of Firm (Billions)

$6.32

Cash and Equivalents (Billions)

$0.26

Market Value of Equity

$7.44

Market Value of Equity/Share

$142


Based on the two estimates, the fair value of Netflix is somewhere between $142 and $166 in my opinion. At mid-point, the fair value of the stock is $154. With Netflix trading upwards of $175, the stock is overvalued by 14%. Although I would not personally short this stock at the moment, I can see several reasons why the company makes a good short candidate.


Disclosure: None

Source: Is Netflix Overvalued?