I have already posted my previous analysis of Netflix as of July 2007. I have to say that I did not expect negative subscriber growth in their fiscal second quarter. Netflix has since lowered their prices and produced some positive subscriber growth. Blockbuster has faded from this market by raising some of their prices for Total Access. Blockbuster has also reduced marketing of their rent by mail program.
Netflix has now successfully fended off competition from Amazon, Walmart, and Blockbuster. Yet more competitors continue to present themselves. Apple recently announced that they are pursuing a digital rental program. In addition, overall growth in the DVD rent by mail market has been pretty weak this year, growing only from 8.8 million subscribers at year end 2006 to 10.1 million subscribers at the end of the third quarter. Because of the endless competition and the slowing growth of the DVD rental market, Netflix may not present the returns I had originally hoped for when purchasing their stock three years ago.
Below I’ve updated the three year seasonality table of Netflix’s subscriber and revenue growth:
The third quarter saw a slight uptick in subscribers of 4%, but declining revenue. You can see the Netflix is projecting 5% quarterly subscriber growth and 2% revenue growth for their fourth quarter.
Analysis of Current Earnings
In order to build an annual proforma income statement, below I’ve presented Netflix earnings over the past 4 quarters. Click to enlarge:
I think it’s interesting in looking at this table to see how earnings have grown despite revenue and subscribers flattening out. This is largely a result of lower spending on advertising and marketing. I’ve always viewed this spending line almost as a capital item. It is an investment in future growth. It has represented a cushion of cash flow that Netflix was free to invest due to their light business model. In the face of competition, Netflix has lowered their prices and reduced marketing expenditures. This has had the effect of reduced revenue, but fairly equivalent earnings.
The other item that I want to focus on here is the capital expenditure and DVD acquisition line items. The decline in growth has caused spending for DVD acquisition to decrease by about $15 million per quarter based on the information above. There may be some seasonality in the purchases, but it appears that spending has declined from about $50 million to $35 million. This decline ends up producing $15 million in excess cash flow for Netflix. Slowing growth may be providing a baseline for Netflix’s cash flow when they are not pursuing growth through advertising spending and DVD acquisitions. This has increased current cash flows. Still, it appears that growth will be slow if it even continues at all for Netflix. Due to competition from Apple and other entertainment choices, Netflix may find that subscriber growth and revenue growth are much more difficult to produce.
Another item to consider is the current writer’s strike. I am wondering if this produces an uptick in subscribers in the coming quarter. This could boost Netflix’s subscribers in the short term. We will have to see how this plays out in a couple of weeks.
In determining a value, I’m going to look at a couple of scenarios. The first assumes that Netflix does not have significant growth over the next ten years. I start with owner earnings of $91 million, assume 3% growth for 10 years and then assume a sale at a P/E ratio of 12. I discount these cash flows back at 10%. This results in a DCF value of $17.00 per share. Then add $5.50 in cash and short term investments for a value of $22.50. This analysis assumes that Netflix’s growth is pretty much stopped.
A second analysis assumes 8% growth rate for five years followed by a 5% growth rate for five years. This assumes that growth continues at roughly the same rate as it did this year. Some quarters will be positive, some negative, but over the course of the year they demonstrate some growth. I then use a P/E of 15 for the reversion and discount the cash flows back at 10%. This results in a value of $24.50 for the business plus the $5.50 in cash for a total value of $30 per share.
Finally, I want to use growth rates that more approximate current analyst estimates of 18.5%. Here I use a 15% growth rate for five years followed by a 8% growth rate for five years. I use a reversion based on a P/E of 24 and discount the cash flows back at 10%. Here I arrive at a value of $48 per share. Then, add cash for a total value of $53.50 per share.
Netflix’s management has done a pretty remarkable job fending off competition and growing their company in the past. However, it now seems that the DVD by mail market is maturing more quickly than they expected. Netflix will have to grow earnings at a rate of 15% or more for this investment to make sense. Otherwise, higher returns can be achieved elsewhere.
I am interested in seeing what kind of subscriber growth that Netflix will post in three weeks. If it is a big number, I will also be interested to see if it holds up or if Netflix loses those additions once the summer starts.
I think that the relentless competition that Netflix faces will continue to limit growth in the future. At best, I think they can grow at a 12% rate, which will likely give them very little upside. Uncertainty from competition will continue to hold down shares for the foreseeable future.
I will hold Netflix through the next quater report, and then likely determine an exit point. Now it looks like the rent by mail market is nearing maturity.
Disclosure: Long NFLX