With Netflix (NASDAQ:NFLX) up 80.2% for the year to date, after a dramatic decline from its early-July 2011 peak, investors have started to give the media company the benefit of the doubt. However, with ever-increasing content costs and competitive risks, Netflix is in a precarious position. Having spurned much of its DVD business, the company has more uncertainty than ever surrounding costs. Time Warner (NYSE:TWX), unlike Netflix, offers attractive sustainable sources of free cash flow and has strong upside.
From a multiples perspective, Netflix appears drastically overvalued. It trades at a respective 29.2x and 48.2x past and forward earnings, with no dividend yield. Time Warner and Viacom (NASDAQ:VIAB) trade at a respective 14.3x and 9.8x past and forward earnings and offer dividend yields of 2% or more. Netflix's free cash flow yield is also the lowest at 2.6%.
At the fourth-quarter earnings call, Netflix's CEO, Reed Hastings, emphasized a positive feedback loop for content acquisition:
"We're rapidly increasing the amount of money that we spend on content domestically and internationally. The only thing that's slightly different is this quarter, we're increasing our spend over a year ago over 100%. So it's more than double one year ago. And that year-over-year increase is declining. But it's still a substantial increase on a year-over-year basis all through this year. And the question is are we comfortable with the content? We always want to get more content. That's the virtuous cycle, which is as we get more subscribers; we're able to get more content, which then helps us get more subscribers. So we'll continue to invest in improving the service by adding more content for a very long time".
Much of the momentum from the appreciation was driven by better-than-expected fourth quarter results. Revenues of $876M were 47% up from the same quarter of last year. However, despite the notorious price hike, operating margins were actually down 510 basis points from 4Q10 to 13.2%. And the much publicized 600K domestic subscriber additions becomes less attractive upon digging beneath the surface. Paid domestic subscribers only rose by 15K.
Furthermore, Netflix's global expansion has yielded slower-than-expected growth rates. Estimates for profitability in Latin America have now been pushed back. But the greatest issue facing Netflix is competitive pressure. Amazon (NASDAQ:AMZN) is releasing a platform that will undercut Netflix. Consensus estimates for Netflix's EPS forecast that it will decline to -$0.23 in 2012 and then rise to $2.59 in 2013.
In light of the high multiples that Netflix is trading at, media investors should consider shifting to firms like Time Warner that will be able to showcase long-term strength in fundamentals. During the fourth quarter, Time Warner's revenues were strong at $8.19B, with Turner's licensing fees rising a significant 16% y-o-y. Networks gained by 4.5%, while filmed entertainment gained by 6.9%. EPS of $0.94 was 8% ahead of consensus. The firm has strong control over its cost base, and is well positioned to limit SG&A growth as demand picks up.
Consensus estimates for Time Warner's EPS forecast that it will grow by 9.3% to $3.16 in 2012, and then by 14.6% and 16.9% in the following two years. Modeling a CAGR of 13.5% for EPS over the next three years, and then discounting backwards by a WACC of 9%, yields a fair value figure of $53.62, implying 41.4% upside.