I've been having a great conversation with Komodo about the current valuation and future prospects of Netflix (NASDAQ:NFLX). He* has been bringing some great arguments about why it just doesn't make sense to pay what the market is currently asserting Netflix is worth.
He asserted that Netflix doesn't have sufficient pricing power to justify current valuation and can't get it given that it doesn't have the following:
1. exclusive licenses for content,
2. a regulated monopoly for delivering internet services (like cable systems have, for example), or
3. a competitively earned monopoly on delivering bits better than anyone else (especially since Netflix is outsourcing that heavy lifting to AWS and CDNs).
The threats arising from this could be that:
1. the studios cut Netflix out of the middle by offering their own service,
2. the studios cut Netflix out of the middle by licensing to whoever wants the content, or
3. Netflix gets squeezed on the delivery side by ISPs/telcos/etc.
He couldn't come up with a fourth option for obtaining pricing power that would preserve margins and make the current valuation more reasonable. I think the missing piece is that the options he explored are all coercive routes to pricing power. I think that there's room to gain pricing power in the future in a more cooperative fashion by earning an effective monopoly on the consumer experience (think Ebay (NASDAQ:EBAY) and their network effect -- all the sellers go there because that's where all the buyers are). This could be accomplished through a consumer experience that is significantly better such that all the buyers default to Netflix for movie finding. Then, providing a significantly easier method for producers to monetize content drives that content to Netflix because that's where the people are.
I suggest that Netflix could gain significant pricing power in the future if it can continue to offer a service that movie watchers love and evangelize at 100 or 200 million members as much as the current 20 million love and evangelize it today.
Then I got to thinking about another company I've worked for in the past. Another middleman that didn't do anything all that complex when you look at an individual transaction, but executed massive volumes of those transactions so much more efficiently than anyone else that they became the defacto standard. The thing is, they didn't even need pricing power to be massively profitable. Eleven cents per transaction when I was there back in the late1990s, and not a whole lot more today.
The more I thought about it, the more similarities there were between the models I saw. Both this company and Netflix are in the business of connecting a producer and a consumer with an electronic message as quickly, reliably and efficiently as possible for as low of a cost as possible that is still profitable.
Company X sits on top of a multi-trillion dollar flow of cash and is able to skim out billions per year by the simple act of connecting producers to consumers. Granted that Company X is only passing hundreds of bytes per transaction, and Netflix is passing hundreds of megabytes, but Moore's Law has taken care of most of the difficulties of that scaling feat. Also, Company X doesn't have to add any value by guiding the right consumer to the right producer's product (since the consumer knows exactly who they have to talk to, and it's more like connecting a phone call than recommending a place to eat dinner). Netflix is a past master at that recommendation task and should only get better over time.
Who is Company X? Visa International (NYSE:V). Originally an association of banks to allow for the shared creation of standards for transaction interchange and shared costs of implementing a network for doing so. Now they're a public company with 6 billion in annual revenue, handling over 4 trillion dollars in transactions per year. They weren't always that big, and they weren't always that good at doing the job, but there was a similar drive in the early days to scale massively through effective use of technology, just as there is at Netflix today.
I've included a comparison of the numbers below. The biggest difference is that Visa enjoys much better margins at all points than Netflix does today, but Netflix is still in the early growth days (see PEG ratio), and I expect that margins will get better if that cooperative monopoly actually emerges. Actually, Netflix appears to be much more efficient with its capital than Visa (return on assets and return on equity), which may have something to do with the aggressive use of AWS and CDNs shifting capex to opex.
In any case, I think that looking at Visa is looking at the future of Netflix. It's a big pair of middleman boots to fill, but I think Netflix is walking a path that follows in those boots' footsteps.
Data courtesy of Capital IQ via Yahoo!
|Market Cap (intraday)5:||52.24B||11.62B|
|Enterprise Value (Feb 5, 2011)3:||47.36B||11.04B|
|Trailing P/E (ttm, intraday):||17.57||74.35|
|Forward P/E (fye Sep 30, 2012)1:||13.02||35.9|
|PEG Ratio (5 yr expected)1:||0.78||1.52|
|Enterprise Value/Revenue (ttm)3:||5.87||5.1|
|Enterprise Value/EBITDA (ttm)3:||9.85||34.3|
|Fiscal Year Ends:||30-Sep||31-Dec|
|Most Recent Quarter (mrq):||30-Sep-10||31-Dec-10|
|Profit Margin (ttm):||36.78%||7.44%|
|Operating Margin (ttm):||56.34%||13.12%|
|Return on Assets (ttm):||8.65%||21.34%|
|Return on Equity (ttm):||12.31%||65.75%|
|Revenue Per Share (ttm):||11.28||41.17|
|Qtrly Revenue Growth (yoy):||12.70%||34.10%|
|Gross Profit (ttm):||5.45B||591.00M|
|Net Income Avl to Common (ttm):||2.97B||160.85M|
|Diluted EPS (ttm):||4.15||2.96|
|Qtrly Earnings Growth (yoy):||50.60%||52.30%|
|Total Cash (mrq):||4.05B||350.39M|
|Total Cash Per Share (mrq):||5.65||6.64|
|Total Debt (mrq):||83.00M||236.21M|
|Total Debt/Equity (mrq):||0.33||81.4|
|Current Ratio (mrq):||2.5||1.65|
|Book Value Per Share (mrq):||34.98||5.5|
|Cash Flow Statement|
|Operating Cash Flow (ttm):||2.69B||276.40M|
|Levered Free Cash Flow (ttm):||1.62B||320.62M|
*As far as he or she, I'm just guessing, since Komodo is an anonymous contributor -- no offense meant [and that would be really cool] if you're really a 'she'.
Disclosure: I am long NFLX. I have written some covered calls against my Netflix holdings and I have recently divested about 10% of my former-employee options. I hold no positions in Visa.