The valuation of Netflix (NFLX) is a house of cards, a small shake in expected growth could bring it down.
Will Netflix's stock tumble like a house of cards or will it win in the game of streaming? Episode 1 will demonstrate how you can justify the current stock price. However, this valuation is just as stable as a house of cards. Episode 2 will look at competitors' pricing in the game of streaming, and episode 3 will sum it all up.
Episode 1: An intent to justify valuation
Figure 1 shows a clear linear tendency in revenue as well as subscriber growth - the green and blue lines show these trends and the narrowing indicates that revenue per subscriber is falling. The following two figures kind of speak for themselves so I'll limit my commentary.
However, the basis of my later estimates is that the growth in Netflix's revenue and paid subscriptions have been incredibly steady.
Source: IR Netflix
Later, I use these trend lines to extrapolate Netflix's revenue into the future and provide an estimated net profit margin and come up with a future P/E.
Figure 2 shows that the revenue per paid membership has been steadily falling over the last four years, which isn't very positive obviously.
Source: IR Netflix
So the next table shows the extrapolated quarterly revenues into the future; the trend is still that the revenue per subscriber will fall. This extrapolation is obviously error prone, but as I will demonstrate, I believe that the current valuation is based on similar extrapolations. I do believe, however, that this extrapolation is a very optimistic scenario because I imagine growth will begin to stagnate before.
Table 1 basically shows a continuation of the quarterly linear trends that figure 1's trend lines provided.
Table 2 illustrates that with a 16% net profit margin the future five-year P/E at current market cap is around 20, and around 13-14 for the 10-year future P/E. Buying a company that at current market cap MIGHT have a P/E around 13-14 in 10 years seems quite speculative to me.
The point of this exercise was to show how I believe the market values Netflix right now. This way of looking at the company, extrapolating revenue and subscriber growth and then adding some estimated net profit margin is quite speculative and slight changes in today's growth metrics will have a compounding effect in the future.
This explains why only slightly disappointing (or encouraging) changes in growth numbers can make the stock fall (or rise) with double-digit percentages (which it has done many a times after quarterly announcements). So many unknowns are built in the share's relatively high price tag right now.
The questions we don't know the answers to are:
- What is the limit to the number of subscribers? 100 million, 200 million, 1 billion?
- What will the net profit margin be in the future?
- Will Netflix be able rise the subscription price because of unique blockbuster content?
- Can Netflix somehow price discriminate, for instance by charging more for 4K content or according to geographical location?
I do not pretend to know the answers to these questions, but I do know that wherever the limits to growth, margins and pricing will be key to providing a real value estimate for Netflix. In my earlier estimate, I arrived at over 200 million paid subscriptions in 10 years from a strictly linear approach, but who knows if it can't go to 3-400 million or higher, or maybe it will start stagnating within five years and top out around 150 million? I would love to hear from the readers any good arguments one way or the other.
That being said, I can shed some light on pricing as the monthly price tags from competitors are readily available.
Episode 2: Netflix and the other streaming services
So table 3 shows the monthly subscription cost for other video streaming services, which is between zero and $14.99. With Fox Play, you have already paid for it through your cable or satellite TV provider, and in the case of YouTube, you pay through watching ads.
The point is that pricing power seems limited even though each of these providers has unique content. It seems like $10-12 is what people are willing to pay for unique, ad-free quality content. With many providers already in the market, it seems unlikely to me that this will change in the future unless we see serious consolidation to the point where we get a mono- or duopoly in the content and streaming business. Some people argue that Netflix will be able to raise prices significantly in the future, but competitors' current prices seem to indicate otherwise.
Sources: Providers' websites.
HBO (NYSE:TWX) has great content, especially Game of Thrones which airs first episode of the new season this Sunday. Fox (NASDAQ:FOXA) has hit shows like The Walking Dead, Black Sails and Homeland. Netflix has House of Cards and Orange is the New Black. YouTube (NASDAQ:GOOG) (NASDAQ:GOOGL) has a lot of independent content creators that provide entertainment and educational content. Amazon (NASDAQ:AMZN) also is trying to create its own content, but Prime should be seen as a broader branding move to make customers stay loyal to its primary business.
You can easily imagine a situation where customers have several subscriptions (I have Netflix, HBO and Fox), so it is not necessarily the case that customers will choose one over the other. But the key is if Netflix will continue to produce quality content that will make customers renew their subscription, there are no guarantees there. I do believe, however, that Netflix carries a bit of an advantage currently as it has the best software and apps for most smart TVs, something HBO and Fox Play is lagging behind.
Netflix also has better international reach than both Fox and HBO.
Episode 3: The end
I think that Netflix is a great company, but it is very highly priced.
Netflix's valuation right now is a house of cards since small changes in growth numbers will have the perceived effect of nudging down future earnings significantly. The valuation shows a very optimistic bias that will only be valid if current linear extrapolations do come true and Netflix is able to produce superior content for a long time compared to its competitors. Raising subscription prices heavily seems like a dangerous game because competitors are setting their prices in the same range.
Answering or estimating correctly the questions posed in episode 1 is the key to give a correct valuation for Netflix.
Small changes in the growth outlook will have dramatic consequences for the share price. It seems like a stock mostly suited for short-term speculative plays.
However, consolidation in the streaming business might be a game changer that could increase pricing power.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.