Is Netflix a Bubble That Will Burst Soon?

Anindya is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Internet usage continues to grow disproportionately in one direction in the United States. It’s up 120 percent since 2011 on fixed-line networks, according to Sandvine. But, do you know exactly what kind of Internet traffic is fueling this explosive growth? It’s streaming video. Netflix (NASDAQ: NFLX) is leading the industry of streaming video for quite some time followed by Google (NASDAQ: GOOG). Netflix is expected to continue dominating the Web’s traffic going forward. But does its stock deserve a buy rating at the current price? Or is it a bubble that’s going to burst soon? 

Streaming Video Facts

  • Netflix dominates North American fixed networks accounting for 33% of peak period downstream traffic. 
  • In second place overall is Google’s YouTube with 13%. Old-fashioned HTTP Web browsing garners just under 12%, BitTorrent 10.3%, and Apple’s (NASDAQ: AAPL) iTunes has 3.4% to complete the top five. Facebook (NASDAQ: FB) sits in ninth place with 1.5%.
  • Other video services on North American fixed networks include Amazon (NASDAQ: AMZN) with 1.8% of peak period downstream traffic, Hulu (1.4%) and Time Warner’s HBO Go (0.5%).

Audio and video streaming account for 65% of all downstream traffic from 9 pm - 12 am and half of that is Netflix traffic (on North America fixed networks). Prioritizing real-time applications like live audio and video is critical to maintaining a high quality of experience. 

Sandvine expects Netflix to generate "two times the bandwidth of YouTube and 10 times that of competing services" by 2015. That’s the reason why activist investor Carl Icahn bought nearly 10 percent of the company's shares recently in an attempt to takeover the company.

Netflix: Where’s Value?

Netflix is currently trading at an astronomically high PE multiple of 108 for the trailing twelve months. Let’s focus on some important metrics for judging whether Netflix warrants such a high multiple on its stock.

Revenue, Operating Margin and ROIC

While Netflix’s revenue continues to be impressive, operating margin has been deteriorating. Escalating costs result in erosion of operating margins. Free cash flow growth is slowing as expenses are beginning to outpace growth in revenue.

<img src="" />

NFLX Revenue Quarterly data by YCharts

Escalating SG&A expenses can be a serious problem for almost any business. Reported on the income statement, SG&A expenses equal the sum of all direct and indirect selling expenses and all general and administrative expenses of a company. Examining this figure can give some idea of whether management is spending efficiently or wasting valuable cash flow. 

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NFLX SG&A Expense Quarterly data by YCharts

Along with declining operating margins, Netflix’s ROIC (return on invested capital) is no longer a source of cash generation and value creation. This will eventually show up in shrinking bottom-line and declining earnings per share even as revenue continues to grow.

Netflix’s ROIC Relative to Industry Peers

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NFLX Return on Invested Capital data by YCharts

Let’s now compare Netflix’s ROIC with that of Google and Apple. As seen in the chart presented above, Netflix’s position is far worse than Google and Apple on the capital front. The problem lies in the management’s inability to keep expenses under control. A good management team will always attempt to keep expenses under tight control by reducing corporate overhead (i.e. cost-cutting, employee lay-offs). This is the reason why Carl Icahn is attempting to takeover the company. He believes Netflix can be a better performer with an efficient management team.  

The Bottom Line

Netflix is grossly overvalued at current price. Despite the company’s tremendous growth prospect in the streaming media business, I would recommend selling the stock on every rise from here. Google is a far better play in the same industry and betting on Google will provide greater margin of safety. 

Anindya7 has long positions in Apple and Google. The Motley Fool owns shares of Apple,, Google, and Netflix. Motley Fool newsletter services recommend Apple,, Google, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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