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Netflix (NASDAQ: NFLX) continues to show very strong stock performance much to the delight of its shareholders and the dismay of its short sellers. The stock has climbed ever higher since this Fall despite a short interest over 30%. Netflix valuation is higher than that of Google (NASDAQ: GOOG).

The stock closed at $211.26 on February 2, 2011, posting an over 200% return in the past 52 weeks and hovering near its all time high. Jim Cramer has suggested that NFLX could achieve a price of $400 with the anticipated IPOs of various social media stocks. Its most recent quarterly results again showed impressive revenue growth as well as a huge reduction in subscriber acquisition costs.

Netflix currently commands high valuations by most metrics:

Table 1: Valuation Metrics
Ticker P/E (ttm) Enterprise Value/EBITDA (ttm) Price/Book (mrq)
NFLX 71.4 34.6 38.7
GOOG 23.3 13.9 4.2
AMZN 68.6 34.9 11.3
GE 19.6 21.4 1.9

Data was pulled from Yahoo!Finance on February 2, 2011

A high valuation can be justified through significant growth, widening margins, and low discount rates. NFLX has shown significant growth over the past several quarters with consistent improvements in year on year revenue growth. This revenue growth has resulted in even more robust free cash flow growth - a key driver of valuation models.

Table 2: NFLX Revenue Growth
Quarter Revenue ($ millions) Growth from year prior
3/31/2008 $ 326.2 6.8%
6/30/2008 $ 337.6 11.2%
9/30/2008 $ 341.3 16.1%
12/31/2008 $ 359.6 18.9%
3/31/2009 $ 394.1 20.8%
6/30/2009 $ 408.5 21.0%
9/30/2009 $ 423.1 24.0%
12/31/2009 $ 444.5 23.6%
3/31/2010 $ 493.7 25.3%
6/30/2010 $ 519.8 27.2%
9/30/2010 $ 553.2 30.7%
12/31/2010 $ 595.9 34.1%

Revenue figures pulled from 10-Qs at sec.gov and from data at netflix.com

Clearly, part of the valuation is driven by a very consistent track record of increasing growth - not just high growth - but accelerating growth. The key question is when will this growth stop increasing. The growth is fueled by NFLX's ability to continue to add subscribers at lower costs despite a declining average revenue per subscriber. However, at some point the growth will have to slow as larger percentages of the population either have NFLX accounts or have had NFLX accounts and decided that they no longer want those accounts.

Each quarter, NFLX adds more customers, but it also loses a fair number of customers. The table below shows the recent history of customer acquisitions. New subscribers are calculated by taking the marketing expenses and dividing by acquisition cost. The lost subscribers are calculated by taking new subscribers and removing the net increase in subscribers.

Table 3: Changes in NFLX Subscribers
Date Period End Total Subscribers (Millions) Net increase in Subscribers (Millions) New Subscribers (Millions) Lost Subscribers (Millions) Lost / New (%)
9/30/2007 7.0 1.3
12/31/2007 7.5 0.5 1.5 1.0 69.8%
3/31/2008 8.2 0.8 1.9 1.1 59.0%
6/30/2008 8.4 0.2 2.2 2.0 92.2%
9/30/2008 8.7 0.3 1.5 1.3 82.9%
12/31/2008 9.4 0.7 1.2 0.5 41.3%
3/31/2009 10.3 0.9 2.4 1.5 61.9%
6/30/2009 10.6 0.3 1.9 1.6 85.1%
9/30/2009 11.1 0.5 2.3 1.8 77.7%
12/31/2009 12.3 1.2 2.8 1.6 58.6%
3/31/2010 14.0 1.7 3.5 1.8 51.3%
6/30/2010 15.0 1.0 3.1 2.0 66.2%
9/30/2010 16.9 1.9 4.1 2.2 52.9%

Data is from calculated NFLX 10-Q filings which provide acquisition cost, marketing expense, subscribers and subscribers at period end.

You can see that NFLX is at times struggling to replace defecting subscribers. Some quarters they add as many as 6 subscribers for each net increase. Other quarters are more successful when NFLX only needs 2 new subscribers to have a net gain of 1 subscriber. While other trends are more positive, the ratio between lost subscribers and new subscribers shows significant variation over the past quarters despite what appears to be a steady improvement. Ideally, NFLX would have a 0% ratio.

The next table shows a projection forward, assuming a $10 acquisition price, a 50% ratio between lost subscribers and new subscribers, and assumes that marketing expense increases at a rate of 2% quarter on quarter. Marketing expense increases have historically been highly variable.

Table 4: Projected NFLX Subscribers
Date Period End Total Subscribers (Millions) Net New Subscribers (Millions) New Subscribers (Millions) Lost Subscribers (Millions) Lost / New (%)
12/31/2010 20.0 3.1 5.6 2.6 45.5%
3/31/2011 23.2 3.2 6.4 3.2 50.0%
6/30/2011 26.5 3.3 6.5 3.3 50.0%
9/30/2011 29.8 3.3 6.7 3.3 50.0%
12/31/2011 33.2 3.4 6.8 3.4 50.0%
3/31/2012 36.7 3.5 6.9 3.5 50.0%
6/30/2012 40.2 3.5 7.1 3.5 50.0%
9/30/2012 43.8 3.6 7.2 3.6 50.0%
12/31/2012 47.5 3.7 7.4 3.7 50.0%
3/31/2013 51.3 3.8 7.5 3.8 50.0%
6/30/2013 55.1 3.8 7.7 3.8 50.0%
9/30/2013 59.0 3.9 7.8 3.9 50.0%
12/31/2013 63.0 4.0 8.0 4.0 50.0%

Data is based on my own analysis and assumptions. One key challenge is that NFLX has been pretty consistently able to reduce acquisition costs over time and this projection assumes that acquisition costs stay flat at $10 per subscriber.

At first glance, this looks pretty good - 60+ million subscribers by the end of 2013 or approximately 3x what NFLX has today. Perhaps this even defies reasonable expectations since there could only be around 120 million U.S. households at that time. However, the next wrinkle to maintaining revenue growth is that NFLX has to keep earning the same revenue from each customer. Historically, this has not been the case as Table 5 shows:

Table 5: Average Revenue per Subscriber
Date Average Subscribers Revenue Monthly Revenue/ Subscriber % Change from previous Quarter
12/31/2007 7.3 $ 302.4 $ 13.89
3/31/2008 7.9 $ 326.2 $ 13.83 -0.5%
6/30/2008 8.3 $ 337.6 $ 13.51 -2.3%
9/30/2008 8.5 $ 341.3 $ 13.32 -1.5%
12/31/2008 9.0 $ 359.6 $ 13.27 -0.3%
3/31/2009 9.9 $ 394.1 $ 13.34 0.5%
6/30/2009 10.5 $ 408.5 $ 13.02 -2.3%
9/30/2009 10.9 $ 423.1 $ 12.99 -0.2%
12/31/2009 11.7 $ 444.5 $ 12.68 -2.4%
3/31/2010 13.1 $ 493.7 $ 12.55 -1.0%
6/30/2010 14.5 $ 519.8 $ 11.96 -4.6%
9/30/2010 16.0 $ 553.2 $ 11.55 -3.5%
12/31/2010 18.5 $ 595.9 $ 10.75 -6.9%

Data is calculated from NFLX 10-Q filings. Average subscribers is a straight average of the period end subscribers.

So there is a clear downward trend in average monthly revenue. Should this trend continue, despite strong subscriber growth, NFLX will eventually experience a slow down in its overall revenue growth. While it will still have very high revenue growth, that growth will be at a declining rate. Table 6 shows some projected revenue growth. This has not been checked against any professional analyst figures. I assumed that average monthly revenue would decline 2% from the previous quarter's figure.

Table 6: Projected Revenue Growth
Date Average Subscribers (millions) Revenue ($ Millions) Monthly Revenue/ Subscriber ($) % Change from previous Quarter Year on Year revenue growth (%)
12/31/2010 18.5 $ 595.9 $ 10.75 -6.9% 34.0%
3/31/2011 21.6 $ 690.3 $ 10.65 -2.0% 39.8%
6/30/2011 24.9 $ 785.7 $ 10.54 -2.0% 51.2%
9/30/2011 28.2 $ 881.2 $ 10.43 -2.0% 59.3%
12/31/2011 31.5 $ 976.8 $ 10.33 -2.0% 63.9%
3/31/2012 35.0 $ 1,072.4 $ 10.23 -2.0% 55.4%
6/30/2012 38.5 $ 1,168.1 $ 10.12 -2.0% 48.7%
9/30/2012 42.0 $ 1,263.9 $ 10.02 -2.0% 43.4%
12/31/2012 45.7 $ 1,359.8 $ 9.92 -2.0% 39.2%
3/31/2013 49.4 $ 1,455.8 $ 9.82 -2.0% 35.7%
6/30/2013 53.2 $ 1,551.9 $ 9.73 -2.0% 32.9%
9/30/2013 57.1 $ 1,648.1 $ 9.63 -2.0% 30.4%
12/31/2013 61.0 $ 1,744.5 $ 9.53 -2.0% 28.3%

NFLX's continued strong revenue growth will eventually slow down. This analysis suggests that it could happen within 2 years. Larger declines in average monthly revenue could bring that point forward in time, especially given the significant recent declines. Furthermore, this could happen even sooner if subscriber growth is not as robust as I've projected.

Some interesting areas for potential follow up to refine subscriber growth assumptions would be whether there are many customers who are subscribers for a while, drop out, return later, drop out and continue in some variation of that pattern. The projection of 60 million subscribers seems quite high. Another key question alluded to earlier is, how low could their acquisition costs go that could enable NFLX to attract more subscribers?

The final key fundamental issue is that NFLX may continue to show very strong cash flow growth despite slowing revenue growth due to inherent efficiencies gained. This article was not written to directly address NFLX valuation, only to look at revenue growth. What do you think?

Source: When Will Netflix Growth Slow Down?