When Netflix, Inc. (NASDAQ:NFLX) released third quarter 2016 results, the company announced that it brought in 370,000 net subscribers in the U.S. The company guided for 30,000 U.S. and the consensus estimate from analysts was for a mark of 304,000. During the second quarter, the company added 160,000 domestic subscribers. Net international subscriber's growth came in at 3.2M vs. 2.0M consensus.
This international market is where we believe the major opportunities for Netflix lies. Q3 total streaming contribution margin rose 120 bps Q/Q to 18.8%. The contribution margin rate in the U.S. came in at 36.4% The Company sees a Q4 U.S. contribution margin of 36.9%.
Netflix has now un-grandfathered ~75% of its members and has seen the added benefits of revenues coming from these additions. They should also continue to see added benefits as the percentage of outstanding grandfathered in subscribers dwindles closer to zero.
Discussion of Comparative and Common Sized Income Statement with Year-over-Year Percent Change
When looking at the comparative analysis for the income statement, we noticed that revenues and cost of revenues are growing at a similar pace. Noticeably, revenue growth has been outpacing the growth in cost of revenues, primarily due to the rapid growth in subscriber growth. This can be seen as Year-over-Year (YoY) percent change in revenues and cost of revenues, as FY 2012 to FY 2013 growth was 21% and 18%, for revenues and costs of revenues, respectively.
Revenues from 2012 to 2015 grew at a compounded annual growth rate of 23% while cost of revenues grew at a slower clip of 20%, in the same period. As mentioned earlier, this can be attributed to the fact that revenues for Netflix are highly correlated to how much the company invests in expanding to new markets, developing more original content, and the fact that licensing costs have skyrocketed due to the bidding up of licensing contracts. The increasing licensing costs comes amid the emergence of similar streaming offerings, such as those from Amazon (NASDAQ:AMZN) and Hulu.
Noticeably, operating income grew at a CAGR of 83% from 2012 to 2015. Through our analysis, we attribute the robust growth in operating growth to the simple fact that early in the period we are analyzing, the company experienced abnormal growth in operating income, as seen in the income statement below, at times growing over 1500% on a yearly quarter-over-quarter basis. Operating income growth starting in Q2 of 2014, started to trend downward attributed to a mix in increases in marketing, technology & development, and general & administrative expenses.
For example, operating income in the fourth quarter of 2014 decreased a surprising -21% compared to an increase of 319% growth for the same quarter of 2013. Most notably when comparing the growth in expenses for Q4 of 2014 to Q4 of 2013, we see the following trends: marketing expenses rose 59% in Q4 2014 compared to 21% in Q4 of 2013 and general & administrative expenses in Q4 of 2014 grew 64% compared to 34% in Q4 of 2013.
The beginning of the analyzed period skewed the operating income CAGR towards the upside, due to the reasons explained above. Going forward, we believe that operating income will decrease in fiscal year-end 2016, to $301,145, on the back of increasing cost of revenues and G&A. However, we expect that these increasing investments in revenue and content creation will moderate in 2017-2019 allowing for a return to growth in operating income. This scenario is dependent on the company offsetting stagnating domestic subscriber growth with the potential for robust international penetration, particularly in Europe.
Turning the focus to the adjustments on the income statement, we would like to highlight that after fiscal year 2013, we felt that no adjusting was needed due to the company's relatively simple and straightforward business operations and financial reporting. However, in Q1 of 2013, we added back ~$25 million due to a rare one-time cost associated with the early extinguishment of debt.
This adjustment brought net income from $2,689 to $27,818. For the third and fourth quarters of 2013, we noticed a decrease on the gain on disposal of DVDs. However, these numbers did not materially move the needle on the income statement; hence our decision to not adjust for it.
Net income has experienced a similar pattern of accelerated growth as operating income in the front end of the analysis period. As we got closer to present year, we noticed interest expenses on a quarterly basis trended upward significantly. Most noticeably, from FY 2014-FY 2015 interest expense jumped 164% to $132,721 in 2015 from $50,221 in 2014. This was due to increases in their interest-bearing debt. In the same time, interest and other income (expense) increased 923%, burdening net income even further.
As noted above, when looking at the common sized income statement, it further cements our observations that cost of revenues are steadily decreasing as a percentage of revenues YoY. We also cite a steady increase in general and administrative expenses. Overall, the common sized income statement was not helpful in pointing out any trends. However, it gave us more confidence in our analysis and conclusions that we derived from the comparative income statement and the YoY percent change.
Discussion of Comparative and Common Sized Balance Sheet with Year-over-Year Percent Change
In turning to the balance sheet, we noticed that comparatively, total current assets are growing at a relatively steady rate from Q1 of 2013 until we see a significant jump in Q1 of 2015 of 54% to $5,630,117 from Q1 2014 $3,661,010. This can be attributed to the significant increases in cash and cash equivalents and net current content assets, growing at 112% and 35% YoY on a quarterly basis, respectively.
We attribute the increase in cash primarily to the robust issuance of long-term debt used to fund the investments in content assets, which has fueled their robust subscriber growth and has allowed for deeper penetration in international markets.
To put the robust growth in long-term debt into perspective for the period analyzed, we turn to the percent change on YoY growth based on quarterly data. Most notably, in Q4 of 2014, long-term debt grew 80% to $885,849 from $491,462 in the same quarter of the previous year. When looking at the long-term debt growth in Q4 of 2015, which grew 168% YoY, we can see why cash and cash equivalents along with net current content assets grew 62% and 34%, respectively. These increases are most likely paying off in the most recent quarter of 2016, as subscriber growth was greater than analysts' expected which led to EPS of $0.12 versus the $0.06 consensus, which signifies growth of 71% over 2015's third quarter.
A negative trend that we spotted was the significant increase in common stock that the company issued in the time analyzed. This can also be attributable to the large increase in cash and cash equivalents used to fund their investments in current content assets, which are highly value creative. Most noticeably, from Q1 of 2013 to Q1 of 2015, we see common stock grow 200% from 369,857 to 1,109,388 in Q1 of 2013 to Q1 of 2015, respectively. We see this as a burden to EPS growth.
Judging by the common-sized balanced sheet analysis, it is clear to see how current content liabilities are trending downward in the back half of the analyzed period. We attribute this decline to the fact that further investments in content assets would come at marginal costs to already implemented content and would distract from expanding and growing current streaming content. We believe management is exercising prudence when it comes to further developing content assets. Going forward however, as competition steepens and old content becomes yesterday's news, we see investments in content assets increasing in the coming years.
Turning the focus to the adjustments on the balance sheet, we would like to highlight that we noted and adjusted items relating to short-term investments for all quarters in 2013 through 2015. These adjustments were made because we felt the reported numbers misrepresented the facts in terms of what they were saying in the notes compared to what was on the reported balance sheet. Aside from Q2 and Q3 of 2013, the short-term investments we adjusted to be 100,000 greater than what the company had reported. As a result, we subtracted the difference between the reported short-term investments and our adjusted short-term investments from cash and cash equivalents on the balance sheet. Our rationale being that the company is using the cash on hand to fund the increases in short-term investments.
In turning to ratio analysis, we would like to focus on two key metrics when analyzing Netflix. These metrics include the current ratio and the DuPont Analysis. The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations. To gauge this ability, the current ratio considers the current total assets of a company relative to that company's current total liabilities. The current ratio can be used to take a rough measurement of a company's financial health.
The higher the current ratio, the more capable the company is of paying its obligations, as it has a larger proportion of asset value relative to the value of its liabilities. A ratio under 1.00 indicates that a company's liabilities are greater than its assets and with a ratio 1.54; this suggests that Netflix would be more than able to pay off its obligations if they came due at that point. While a current ratio below 1.00 shows that the company is not in good financial health, it does not necessarily mean that it will go bankrupt. Noticeably, Netflix has boasted a very healthy current ration in 2013, 2014, and 2015, at 1.41, 1.47, and 1.54, respectively.
The DuPont analysis tool is used to avoid mistakes when analyzing return on equity. The tool takes into account three main components, net profit margin, return on assets, and the equity multiplier or financial leverage. Essentially ROE is broken down into net profit margin (how much profit the company gets out of its revenues), return on assets (how effectively the company makes use of its assets) and equity multiplier (a measure of how much the company is leveraged).
When looking at these metrics for Netflix we find that from 2013 to 2014 net margin and return on assets both increased 170 basis points to 4.85% from 3.14% and 124 basis points to 3.79% from 2.55%, respectively. When looking at the financial leverage or equity multiplier of the company, we found that it went from 4.05x in 2013 to 3.79x in 2014. We see this as an encouraging sign because Netflix was able to increase their return on equity to 14.36% in 2014 from 10.31% in 2013. It is a good sign when a company is able to increase their ROE while simultaneously increasing their net margins and return on assets while decreasing financial leverage.
However, when looking at data from 2014 to 2015 we find that net margin decreased 304 basis points to 1.81% in 2015 from 4.85% in 2014. ROA decreased 259 basis points to 1.2% in 2015 from 3.79% in 2014. Financial leverage went up to 4.59x in 2015 from 3.79x in 2014. Noticeably, ROE also decreased even as leverage increased.
This tells us that management is not trying to mask their true ROE by increasing their leverage. This analysis further proves what we stated above, in that the company is significantly increasing their capital base through the robust issuance of long-term debt, which cuts into the net margin as interest expenses increase significantly as well.
Finally, we used a target multiple analysis to derive the fair value of NFLX's share. We assigned the forward price to earnings multiple of 250x and used the lower end of 2017 earnings per share consensus of $.55 to derive a fair value of $138 per share on a forward P/E basis. We proceeded to assign more conservative multiples for EV/EBITDA and Price to Sales - as we do not believe that NFLX is still a high growth company but rather a company that has been slightly maturing but still with promising opportunities internationally.
We believe that NFLX's share should be trading at or around $122 in the next 12-18 months. This is based on a triangulated multiple analysis based on similar competitors and multiples that we believe the company can achieve once they return to robust profitable growth, stemming from their expansions in international markets. We assign a 30%, 50%, and 20% weighting for P/E, EV/EBITDA, and Price to Sales, respectively.
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.