Is Netflix Overpriced?

| About: Netflix, Inc. (NFLX)

Summary

Netflix has an extremely high P/E of over 320.

Competition has become more fierce.

Company faces a lot of risk.

Netflix (NASDAQ:NFLX) has been the rave of investors recently. Thanks to the success of its original shows such as Narcos and Stranger Things, Netflix has seen substantial growth in its subscribers. With all this growth, there are signs of slowing. I will touch on several key metrics that signal that Netflix is overvalued and faces high risk. But first, I will address why it has become so hard for other investors to properly value Netflix.

Netflix is in a sector of its own as it has almost no identical competitors. Time Warner (NYSE:TWX) and Disney (NYSE:DIS) are two close ones, but their revenue distribution is far different to that that of Netflix. Another similar competitor is Amazon (NASDAQ:AMZN), with an equally inflated P/E. But Amazon is a completely different beast with revenue coming in from a wide range of different areas. For the purpose of running a relative valuation, I have tried to find competitors most similar to Netflix. Netflix directly faces Hulu and Amazon for the same market share. Shows like Game of Thrones have caused spikes in demand for HBO Now. Time Warner announced that HBO Now is nearing over a million subscribers as of this last summer.

Relative Valuation:

Company

P/E

P/B

EV/Revenue

EV/EBITDA

Profit Margin

ROA

ROE

Leverage

Netflix

323.7

22.4

6.97

140.73

2.11

2.00

7.61

5.07

Amazon

192.2

21.64

3.12

36.46

1.64

3.97

13.93

3.99

Time Warner

17.1

3.0

3.37

11.76

15.75

15.75

26.27

2.71

Disney

19.3

4.0

3.44

11.28

16.88

10.03

20.40

2.13

Fox

20.7

4.2

2.62

10.85

10.45

7.96

19.57

3.52

AVG

114.6

11.2

3.9

42.2

9.37

7.94

17.56

3.48

All values taken from Yahoo! Finance

We can see from the relative valuation that Netflix on the surface is not performing as well as its peers. It has an incredibly high P/E ratio, which is almost three times the industry average. Netflix also has an extremely low profit margin compared to its peers. The low profit margin can be explained by its low subscription prices. However, such a low profit margin leaves very little room for increasing costs that we will touch on later. One such expense could be a rising interest expense. Netflix is extremely leveraged compared to its peers. This leaves it vulnerable during times of rate hikes.

Yellen has already said that if Trump continues with deregulation and tax cuts, the Fed could be forced to raise interest rates more rapidly. This is a major risk for Netflix. While NFLX did not release how much interest expense would increase if the Fed hiked the rates 1%, you can see that its interest expense has increased 13% the last year. This liability is something that management has addressed in its 10-K as well. Netflix has over 6 billion in content liabilities. While this is not entirely discouraging to an investor, this amount does not include streaming content commitments that do not yet meet the criteria for liability recognition. Management still believes that these amounts are very significant and will have a material effect on the company's balance sheet.

Litigation Risks

The company is in several litigation matters than could cause alarm to investors. In its 10-K disclosures, the company mentions it is facing litigation concerns. Management doesn't believe they are materially important yet. However, the view of management may change in the future. To a bullish investor, these statements may seem promising. But a neutral investor looking at Netflix may be concerned. Its fundamentals are very shaky. There are several reasons why management did not disclose any information about these litigation matters. First and foremost, the litigation may not be severely impactful. However, there is the very good chance that management is waiting to disclose its views so that the disclosure could not be used against it in court for acknowledging a contingent loss. If there was a low probability of losing these lawsuits, Netflix would not be required to disclose this matter. This disclosure shows that it is somewhat probable that Netflix could face a material loss. GAAP requires that you disclose and accrue the loss if its highly probable, disclose it if there's a medium probability, and requires no disclosure or accrual if there is a low probability.

International Market Risks

Netflix's new target market is international streaming. It has most of its future riding on how well it can target these different regions. When you look at market segmentation, you see how expensive it has been to expand to these markets.

International streaming already makes up 47% of NFLX's streaming membership and yet only makes up for 38% of its streaming revenue. Investors should be concerned that the membership growth in domestic markets is greater than in foreign. If you then factor in the fact that international streaming makes up over 50% of streaming expenses while only contributing only 38% of the revenue, you can see that the company is over its head when it comes to foreign markets. Netflix spends 2x as much in international marketing than it does domestic. In 2016, the international streaming was not profitable for Netflix and resulted in a ($308,000,000) loss. Netflix has not found a way to integrate into international markets and remain profitable.

Accounting Risks

Similarly, the company in the coming year(s) has to modify its record keeping and adopt several accounting standards. One such accounting standard is the ASU 2016-09, Improvements to Employee Share-Based Payment Accounting. According to the company, this standard will have a material impact on net income, earnings per share, deferred tax assets, and net assets. The company is unable to estimate the impact of the accounting change, but expects it to be materially impactful. This is a risk that an investor must be aware of. Netflix is already highly leveraged and has an extremely high P/E ratio. Anything that will have a material impact on the EPS is worrisome.

Competition Risks

Netflix is also facing increasing competition and new additions for subscribers are starting to slow.

From 2015 to 2016, new additions decreased by (17%). It is also worth mentioning that Netflix could be reaching a maximum amount of target consumers. This slowdown is alarming when you see that Netflix's increase in cost of revenue was $335 million, likely due to the increasing cost of new streaming content. A decreasing rate of new subscribers combined with rising cost of revenue will be devastating for Netflix. Services like Hulu, HBO Now, and Univision NOW are gaining momentum.

US downloads of HBO Now, Amazon Video, Hulu and Showtime apps via Apple's (NASDAQ:AAPL) App Store and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) Play together surpassed those of Netflix last April for the first time, according to app analytics firm Sensor Tower. Amazon has also ramped up the competition in original content. This could really spell trouble for Netflix. Over the last year, Netflix raised its price for HD subscribers over 11% to combat increasing expenses. Netflix is unable to estimate the damages that raising its prices will have on consumers. However, if prices rise too much, we will begin to see other competitors steal subscribers. Netflix is also experiencing marketing myopia. Marketing myopia is when a consumer is too focused on the want than the need of the consumer. Netflix is very specialized. This product focused mindset can be the ultimate downfall of Netflix. Being too product focused forces a company to not be in line with the consumers' needs. This can lead to a lack of innovation in a changing environment.

Political Risks

Trump's administration can also be problematic for Netflix. The major debate about net neutrality comes forward with the new FCC pick Ajit Pai. While Netflix doesn't think this will have any adverse effect on its company, management has acknowledged that without strong net neutrality regulations, job growth and innovations are at risk.

Also at risk are expanding international relations. Netflix has a lot riding on international subscribers. It is this potential market that justifies Netflix's current P/E. Trump puts this at risk with his push for American goods and services. There are several international relations that are currently being damaged. With the potential of tariff wars, the future is uncertain for companies trying to expand into foreign markets. We have already seen earlier the amount of money that Netflix is spending to expand in the international market and all of this can be put in jeopardy. Similarly, the outspokenness of Netflix CEO Reed Hastings can easily put the company in high water with the newly sworn in president. We have already seen Trump attack companies that oppose his policies with the most recent being a boycott of Starbucks (NASDAQ:SBUX).

Conclusion

While there are a lot of reasons to remain bullish on Netflix, the risks are too overwhelming. Netflix has too much of its future riding on international subscribers. With the way the Trump administration is operating and the offensive attacks that Netflix's CEO has made on Trump, the future in international markets is very unclear. Without complete growth in these international markets, earnings will not grow enough to justify its current valuation. Similarly, increasing competition poses a serious threat for Netflix. While focusing on moving internationally, Netflix should be very concerned about losing domestic subscribers with an 11% increase in price over the last year. Pending lawsuits and high leverage are also very alarming.

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.

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