Netflix: My Missed Opportunity

Feb. 7.12 | About: Netflix, Inc. (NFLX)

I confess. I missed my opportunity to participate in the big run-up in Netflix (NFLX). My methodology and analysis said that Netflix was a good, undervalued, company with a beaten down market price. I began to doubt my own analysis after reading the opinions of others. I am a Netflix subscriber and was hit with the subscription price increase. I was unhappy with the increase and eventually switched to the streaming subscription. I am still not especially happy with Netflix's service. The streaming product selection is unsatisfactory.

In spite of the marketing gaffe, the share price of Netflix has doubled from its 52 week low of $62.37 to a recent $126.43. To be sure, Netflix is trading far below its 52 week high of $304.79. Is the run-up justified? Analysts were encouraged by Netflix's surprising growth in its subscriber base. The company reported adding 610,000 new subscribers in the U.S. The run-up may not be justified if analyst consensus earnings estimates for FY12 of -$0.23 are realized. However, estimates for future years are expected to return to levels seen in the past.

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Netflix offers a subscription service to consumers who are interested in renting movies and television shows. The service started off by offering DVD rentals by mail. The company offered several different subscription plans that allowed consumers to rent multiple DVDs simultaneously. The company subsequently moved to offering its service as a streaming format available over the internet. With this service, consumers could watch movies on-demand on their computer or tablet. With the newest generations of internet enabled televisions, movies can be streamed wirelessly directly to a consumer's television. Streaming video is now available on most internet capable devises.

For all the doom and gloom, Netflix is showing remarkable top line growth. Sales grew in FY11 by 48.2%, well above its five year average growth rate. Growth rates for other metrics (shown above) are also strong and above respective five year averages. The company has had operating profits in each of the past seven years, including the 2008-09 period. FY 2011 operating profit, at 12.0% is down from FY10's margin of 13.1% but is higher than any prior year. Profitability, as measured by return on assets, return of equity and return on invested capital are all good. ROA is down from the five year average but ROIC has remained steady.

The company has added long term debt which is driving the higher ROE. In FY11, long term debt doubled to $400 million from $200 million in FY10. With a long term debt to capital ratio of 38.2%, debt may not be excessive. We are also satisfied with debt as a percentage of working capital. We are concerned with debt as a percentage of free cash flow. Generally, we look for companies that can pay off their long term debt with three years of free cash flow.

EPS diluted was up about 44.3% over FY10 and has been up every year. Analyst projections for a $0.23 loss in FY12 may be an overreaction. We note that the 30 analysts providing estimates, the range is rather broad:-$1.05 to $0.95. Nine analysts have revised their estimates upward while there have been 24 downward revisions. The divergent opinion may indicate an opportunity.

Valuations are always difficult. Shown above are several enterprise value multiples for Netflix along with industry medians. Based on these metrics, Netflix would seem to be overvalued. Target prices from analysts also cover a broad range: $45 to $135 with a median value of $99. Analysts now consider Netflix a hold. On a near term basis, we see Netflix trading up to $141. Looking out a bit further, our model provides a target value of $166. I missed my opportunity when Netflix was trading in the $60s. At the time, my model provided a target of about $77.

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