Netflix: Lack of Legal Competition Creates Huge Upside

Includes: AAPL, AMZN, NFLX
by: Kurtis Hemmerling

It is not every day that you get offered an opportunity to sit, watch movies, and simultaneously build your stock portfolio. With Netflix (NASDAQ:NFLX), you might be able to do just that.

What does Netflix have going for it? You get an eclectic selection of movies and diverse TV series offered at low monthly flat fees. Add to that, you can watch an unlimited amount of online movies legally. In non-US countries such as Canada, there are few alternatives that can offer comparable services. As Netflix aggressively works toward expanding globally, there is big potential.

Another forward-thinking feature is the iPad application that allows tablet computer users access to Netflix. This is particularly welcome since iPads do not currently have native Flash support, which is the video format many streaming sites carry.

But what about the other Netflix rivals such as Facebook and iTunes?

Facebook and Other Rivals?

True, there are other boys walking the streets looking to establish their turf. Apple iTunes (NASDAQ:AAPL) has been offering digital content for some time and now Facebook appears to have a partnership with Warner Bros. for renting movies through their social network.

But is this true competition? Not really. Although iTunes and Facebook offer digital online content, only Netflix currently offers a flat fee for unlimited viewing of titles at budget prices. Until these other companies start to offer a corresponding service at a comparable price internationally, Netflix still has this niche market cornered. Other digital providers, such as Amazon (NASDAQ:AMZN) have limited streaming offerings in other countries. That being said, Netflix had better enter new markets fast. Remember Betamax?

Then again, there is rumor that Facebook may team up with Netflix. If Facebook can offer the Netflix model in addition to the pay-per-movie service, there could be multiple winners.

The Two Driving Forces of Growth
Netflix Price Chart

Price and earnings growth should come from an increase of subscribers and an improvement in net margins.

Starting up international operations, however, takes time to turn profitable. Netflix’s Canadian service began in September 2010 with negative margins, but they hope to be positive in 2011. Until they have a firm hold in the global market, they will need to protect the bread and butter from US subscribers to fund such expansion, at least at first.

Net margins will initially experience some downward pressure from international growth. This should have a turnaround with the increase of online-only subscribers globally. Say goodbye to the purchase of physical DVDs and postage being paid to mail movies to customers. As the DVD model phases out, net margins should continue to grow.

What about sales growth? Subscribers have increased by a net 1.9 million in 2008, 2.9 million in 2009, and 7.7 million in 2010. They have a total of 20 million subscribers and growing daily.

What can we expect from share price over the next 36 months?

Forecasting Sales and Earnings in 3 Years

Quarterly revenue has been increasing at an average pace of 6.11% (between serial quarters) over the past 2 years, and this has jumped to 7.63% sales growth between serial quarters over the last year. Overall, revenue growth is on the rise and this trend should continue as global markets open. Due to anticipated expansion, we will use 8.5% sales growth per quarter when forecasting the next 3 years. This gives us estimated sales of 5.6 billion of FY 2013. Assuming no share dilution we can forecast $107 of revenue per share. If net margins continue to increase up to 9.2% by the end of 2013, the EPS should be around $9.80.

Next, we need to convert sales and earnings into a share price. The price-to-earnings and price-to-sales ratios have been volatile. To provide a margin of safety, we will use multiples 26-44% less than current. The P/S will be estimated at 4 and the P/E at 40 in contrast with the current multiples of 5.3 and 72.

What could be the share price by the end of 2013? A forecast on sales puts the price at $428 and based on earnings it is $392. This is a 75% upside to today’s current price. This is in-line with other analyst forecasts. Current analyst earnings estimates have a range of $6.36 - $14.06 per share with the average of the 10 forecasts being $9.088 for 2013.

Downside Risk?

However, there are also a myriad of risks to consider such as the potential of dilution to pay for expansion, problems arising from dealing with diverse countries, an increase in competition, market saturation, acquiring new distribution rights, risk of changes to copyright laws, ISPs putting bandwidth caps on Netflix subscribers, and the list goes on. Netflix is aggressively meeting those challenges, such as finding ways to lower bandwidth by up to 2/3rds with little quality reduction.

This is by no means a slam-dunk – not by a long-shot. Still, based on the lack of legal competition in many countries, Netflix has a huge upside potential if they can quickly enter the global market.

Bottom Line: Netflix is on the verge of entering exciting new markets with a decent online service. If Netflix can quickly establish themselves internationally, they could see share prices more than double by 2013.

Make no mistake, the price of Netflix is trading at high price multiples and it would be great to see a pull-back for a better entry. But will that opportunity come? Is it worth waiting and potentially missing out on a double-bagger? That reward-to-risk decision is up to you.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.