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Manuel A. Salceda's  Instablog

Manuel A. Salceda
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Investor, Property Developer and Hotel Owner. Ardent Follower of Buffett and Munger's principles. Interested in Micro and Small Companies at or below intrinsic value with little or no debt. A business easy to understand and not related to a rapidly changing enviroment (as technology). If it's... More
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  • Netflix’s stock is priced for perfection 0 comments
    Feb 13, 2011 11:04 PM | about stocks: NFLX
    Too much has been said about Netflix and its future prospects. The stock has been flying high lately, making it one of the biggest gains of 2009, 2010 and year- to -date, with more than a 750% stock price increase during such time period.
     
    Is this justified?
    I think the answer is NO. Netflix is a good company with good management –until now it looks like these two assumptions are certain and accurate- but let’s make an effort to estimate future revenue and net income in order to arrive at an approximated value of the company at some point in time in the future. After all, like Mr. Buffett says: it’s better to be approximately right than precisely wrong.
     
    First a few assumptions that I’m sure will prove me wrong some day in the future, after all, we have to make informed guesses in order to arrive at an approximated value:
     
    Average number of paying subscribers: 35 million.
    Average yearly revenue per paying subscriber: $120.
    Net profit margin: 10%.
    No. of shares outstanding: 45 million.
     
    Brief explanation about these numbers: First, the number of paying subscribers. Netflix’s target market ranges from people aged 17-50 years old that have internet access, which guarantees a near-future constant market potential of 125 million people in the US (census.gov/popest/national/arsh/NC-EST2009-sa.html). Now, with Netflix shipping DVD’s or some other type of packaged media I would assume a very high market share –at least during an initial period- but now that technology is pushing the business to streaming and digital delivery, I find it more difficult to assign such a high market share to a single company, more so when considering the almost-ready-platforms that telephone, internet, cable and satellite companies already have and will certainly use to grab a piece of the pie. Ah! Let’s not forget about Amazon, Hulu and many others who are already in the market or about to enter. For that reason I think that a 30% market share of total market potential is a lot for a single company, but let’s assume for a moment this is possible for Netflix because of the brand and its subscriber base within the US.
     
    Second, revenue per paying subscriber. Netflix’s monthly revenue per paying subscriber has been dropping year after year. In 2005 it was $17.94, in 2007 $14.95, in 2009 $13.30, and for the 3 month period that ended September 30, 2010 it was $12.12, which does not bother me that much because its net income improves as the company size grows, even when rev/paying subscriber goes down. This has been happening because of Netflix’s marketing strategies and because digital delivery is not the same as packaged delivery in terms of warehousing and distribution. And for that reason, I assume that a $10 per month revenue per paying subscriber is a number that will prove to be more or less accurate in a not-so-distant future.
     
    Third, its net profit margin. Netflix’s net profit margin has been improving year after year and I think it will continue to do so until reaching 10% or so. The reason is size and platform. As the company’s subscriber base grows, the same technology platform serves as conduit for delivering products, which increases margins in all entries of the company. This obviously is not infinite but I think that there’s still margin to improve a little more.
     
    And fourth, the number of shares outstanding. The company has been repurchasing shares –which is possible for Netflix, with so much internal and external growth and because of retained earnings- however, I consider it to be a bad use of investor’s capital at current prices. Regardless, these repurchases have done more than only mitigate the effect of stock options, and I think that the company will continue to reduce shares outstanding at its current pace.
     
    Well, now that I have explained my sure-to-be-wrong assumptions, I think it’s clear where the company could go from where it stands right now, which is to achieve yearly earnings of $9 per common stock (just do the math with the 4 assumptions already explained above). And don’t get me wrong, I’m not saying this is going to take place, I’m just saying that it’s possible and it can happen in a few years or so. And what would the result be after all this? I don’t think that the current business model can offer more potential than that for the company within the US. Yes, there’s still a whole world out there but outside the US, Netflix is just another company, without brand or moat to expose so much potential, so I wouldn't price that possibility into the equation until the company proves me wrong achieving similar results in other markets. For now, there’s Canada and too much to wish for but nothing more. By the way, there’s always the possibility of another income stream like advertising, but as with international expansion I will say that until a real and tangible possibility emerges, everything else is nonsense speculation.
     
    Conclusions
    With last yearly-reported net earnings of $1.98 per common stock, and 2010 net earnings estimates of $3.10 per common stock, I think that the $9 threshold is more or less 5 years away, and this is if everything goes as it has until now: if no new and/or better competitors enter the market, if marketing and corporate expenses are maintained in current proportions, if movie rights and cost of product don’t change much, if technology changes don’t disrupt the market, and if so many other variables don’t move the industry and the company from current trends.
     
    So, I think that assigning a P/E multiple of 27 –for 2015 earnings personal guesstimate at current prices- to a company that pays no dividend, reinvests all of its earnings, and that seems like it has not much more growth potential than those $9 per common already counted for, is a very high multiple that’s pricing the company for perfection. Below $120 I may be a buyer –well, that may be an overstatement- but at current prices I would have sold my shares yesterday.
     
    So, I’m short Netflix. And about that, I will like to add that I consider shorting is speculating and far from investing, something I have never done before in my investment lifetime. After all, I’d rather speculate with things I can estimate my odds with precision, even though I don’t speculate even under those conditions. Shorting directly carries big-hard to measure risks and doing it through options carries less risk but hefty premiums, so as with everything in the stock market there’s no magic formula. Today I have closed my 2013 nflx puts since as we all know: the market can maintain ridiculous valuations longer than investors can stay solvent, but that does not change my thinking about the company’s valuation, which I consider far away from intelligent investing.
    .


    Disclosure: I am short NFLX.
    Stocks: NFLX
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