Netflix Has a Valuation Issue
Netflix, Inc. (NASDAQ:NFLX) surged 20% on October 18 after reporting a blowout quarter that caught many—including the company—by surprise. It must have been tough for Netflix, Inc. CEO Reed Hastings to hide his excitement prior to the release.
I was not surprised that NFLX stock jumped, but rather surprised about the size of the ascent. Even being a Netflix, Inc. cheerleader since its inception in 1997, I question the valuation assigned by the market.
So while I welcome all of the new content added by Netflix, Inc., such as Stranger Things and Narcos, the success of NFLX stock is ultimately about the popularity of the content. The idea of content is more critical when you consider the competition from the likes of Amazon.com, Inc (NASDAQ:AMZN), HBO, and Hulu, LLC. Success and failure will in part hinge on the content, which is always a big uncertainty.
Netflix, Inc. spent about $9.5 billion on content in 2014 and is estimating that it will spend about $6.0 billion for the coming year. With levered free cash flow at around $4.37 billion, the funding should not be a problem. While the amount has declined, Netflix stock has been fortunate enough to deliver some highly rated internally produced shows, but so has HBO.
Chart courtesy of StockCharts.com
Why the Bulls are Wrong on Netflix
The third quarter was impressive for Netflix stock. The company added a whopping 3.57 million new subscribers, including 3.2 million from the key international segment, which will have to be the driver for NFLX stock going forward. The results were even more staggering, considering that Netflix, Inc. expected to add only 2.3 million subscribers. The company now has 86.7 million subscribers.
The success of Netflix, Inc. will be its ability to grow its international base, which currently encapsulates about 50 countries. Netflix, Inc. wants to be in 200 countries.
Looking ahead to the fourth quarter, Netflix, Inc. estimates it could add 5.2 million new subscribers, comprising of 3.75 million subscribers (or 72%) from the international markets. Yet, while Netflix, Inc. has launched in India, the company continues to be shut out of China, which would prove to be a massive game changer if it materializes.
The problem is that the video streaming market in China—worth tens of billions of dollars and expanding rapidly—will be hard for Netflix to conquer, given that the company will need to leapfrog domestic Internet powerhouses Baidu Inc (ADR) (NASDAQ:BIDU) and Alibaba Group Holding Ltd (NYSE:BABA). This will not be easy.
So while I’m impressed with the subscriber and revenue growth, which is pegged at 29.9% in 2016, followed by 24.7% in 2017, I simply cannot get around the valuation of Netflix stock. (Source: “Netflix, Inc. (NFLX),” Yahoo! Finance, last accessed October 21, 2016.)
NFLX stock trades at a whopping 142 times its 2017 earnings per share. The price/earnings to growth (PEG) ratio of 6.40 means that Netflix stock trades at a huge premium to its estimated five-year compound annual growth rate CAGR. The metrics are lofty, and made even worse by the fact that Netflix stock trades at 22 times its book value.
Now, while I’m a supporter of NFLX stock, I cannot ignore the crazy valuation, but that won’t stop me from anxiously waiting for the expected second season of Stranger Things.
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