Netflix (NFLX) has been on a wild ride: Surging as it became the Street's darling, falling as it ticked off subscribers, and surging yet again as bears started realize that the fundamentals aren't all that bad.
Yes, Netflix has considerable secular challenges from Hulu, Amazon (AMZN), and other players that could easily penetrate its business. But the bear story has largely overwhelmed the media. As an investor relations consultant, I understand the effect that negative press can have on shareholder value. So worrisome is the effect that the overly-maligned CEO, Reed Hastings, even felt compelled to write a piece on Seeking Alpha here dismissing the shorts.
It is only a matter of time before the Street picks up on Netflix's value. In this article, however, I will run you through my DCF analysis on Netflix and then triangulate the results with an exit multiple calculation and a review of the fundamentals compared to Time Warner (TWX) and Amazon .
First, let's begin with an assumption about revenues. Netflix finished FY2011 with $3.2 billion in revenue, which represented a 48.2% gain over the preceding year despite all of the chaos. Analysts model a 17.4% per annum growth rate over the next five years, and this seems fairly reasonable. We will factor in the risk with weighted average cost of capital (WACC).
Moving onto the cost side of the equation, there are several items to consider: Operating expenses, capital expenditures, and taxes. I expect cost of goods sold to eat 64% of revenue versus 17% for SG&A, 7.5% for R&D. These figures are roughly in line with historical 3 year average levels. Capex is the big kicker. However, fortunately, it has fallen from 14.3% in FY2009 to 4.2% of revenue in FY2011. I model it falling from 9% in FY2012 to 8.5% in FY2017.
Taking a perpetual growth rate of 2% and discounting backwards by a WACC of 10%, yields a fair value figure of $130.51, implying a 22.7% upside.
All of this falls under the context of the elephant in the room: rising content costs. At the fourth quarter earnings call, Netflix's CEO, Reed Hastings, stated:
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.
From a multiples perspective, however, Netflix appears to be substantially overvalued at a respective 25.5x and 41.9x past and forward earnings. On the other hand, Amazon, which very few seem to criticize, trades at a respective 135x and 69x past and forward earnings. Time Warner, the most stable of three, is grounded more on planet earth and trades at respective 13.4x and 10x past and forward earnings. Assuming a multiple of a 30x and a conservative 2014 EPS of $4.64, the rough intrinsic value of Netflix's stock is $139.20.
Consensus estimates for Time Warner's EPS forecast that it will grow by 10.7% to $3.20 in 2012 and then by 14.1% and 15.9% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $50.82, the rough intrinsic value of the stock is $50.82, implying 39.2% upside - not bad for a company that is considerably safer than both Netflix and Amazon. Time Warner is led by top management that has delivered solid execution. Fourth quarter results were strong with Turner licensing growing 16% y-o-y and EPS solidly beating consensus.
Amazon, on the other hand, is highly risky. The firm still has plenty of room to penetrate with Kindle Fire, but I am more optimistic about Barnes & Noble's (BKS) Nook. Amazon delivered disappointing weak fourth quarter results and a full recovery will reduce the company's low-cost appeal. In light of the challenges to value creation for large companies like Amazon and Netlflix, investors should consider breakout revenue opportunities in smaller firms like Hastings Entertainment (HAST) and Quickflix (OTC:QKFXF), which both have impressive fundamentals. I believe it is only a matter of time before their attractive stories get put into play by Netflix and Amazon.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.