Not too long ago, to the surprise of many, Janney Capital Markets upgraded shares of Netflix (NFLX). In 2011, NFLX was publicly ridiculed primarily due to a decision to raise subscription prices and to separate its streaming content and unlimited DVD businesses (Netflix Press Release, "Netflix to Offer new Unlimited DVD Plans and Will Separate Streaming and DVD Plans in the U.S."). This was the precursor to an 80% decline in the stock price not withstanding last week's stellar rise in NFLX shares. I do not follow NFLX, and I'm not a subscriber to their services, but I admittedly had a negative bias of the stock as a result of the highly publicized thrashing NFLX received. Hence, I was also surprised by the recent upgrade.
Of course the recent upgrade brought out the talking-heads either praising or rebuking the upgrade. So who is right? Is it time to jump into NFLX? As a starting point, it is best to re-baseline without the hype one way or another. For a minute, put aside the sound-bites and do some individual research to get a fresh perspective. That is to say, look at a current snapshot of the company based on its fundamentals and then estimate where the company is going. The latter is not an easy task and is often where the disagreements occur between investors and traders. For example, who is to say that NFLX's entry into international markets will work out? The company's recent expansion into Latin America is fraught with competition, lower income customers, limited broadband access and limited use of credit cards - a key mode of payment for NFLX. (Netflix Expands in Latin America).
At first, let's not consider growth; simply "cut to the chase" and evaluate the intrinsic value of NFLX in a no-growth environment. From here, investors can add a premium or a discount depending on their views on growth. A popular method to quantify the intrinsic value of a stock using this assumption is Earnings Power Valuation (EPV). EPV was developed by Bruce Greenwald and described in his book entitled, "Value Investing." I will not be able to give EPV proper justice in this article, but in just a few words, EPV relies on a company's sustainable cash flow adjusted for various items in the presence of no growth.
Since EPV is based on a no-growth scenario, several items related to growing the company are added back in to earnings. A challenge with EPV is splitting costs between that needed to sustain the status quo (no growth) from costs needed to grow the company. I've discussed these adjustments in a previous article (see "Is Cisco Undervalued?") and will try to lean towards the conservative.
The table below outlines the EPV process for NFLX. A key is to ensure that a full economic cycle is covered and that averages of important metrics such as earnings margins and tax rates are used in the calculations. Don't use current values as you will not get the complete picture of how the company has operated across the span of an economic cycle. A couple of key points:
- Only 10% of the Technology and Development costs are added back and assumed attributable to growth; the remaining to support the status quo;
- Only 20% of the Marketing budget is added back. Typically, this amount would scale to the sales growth (26% over the past six and a quarter years);
- A tax rate of 40% will be used which is the highest rate NFLX paid over the past seven years;
- The Weighted Average Cost of Capital (GM:WACC) is always a point of contention. I actually calculate a value of 8.5% and have seen estimates of 9%. To be conservative, I will use 9.5%
Based on the table above, I am calculating NFLX's intrinsic value over $92 per share. With NFLX currently trading at 81.81 after last week's stellar rise, this represents a margin of safety of 12%. That is a little thin for me right now, but not bad considering this analysis took conservative steps where possible. The margin of safety at the open of 2-July 2012, was closer to 26%. Growth prospects would increase this estimate (just like negative growth would reduce this estimate).
So what does this mean? As a first check, the NFLX price drop over the past year may be overdone. This is a starting point for an investment decision; more work is needed. Interested in your comments.