Is This Internet Stock a Good Buy?

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

Netflix (NASDAQ: NFLX) is up over 150% year to date, in the latest development in the stock’s roller coaster ride (it is in fact down 11% from its levels two years ago).

The company’s entry into original programming has had mixed results. It is quite popular among the media infovores who already have Netflix subscriptions, but it’s uncertain that the programming initiative will in fact prove sufficient to offset the reduction in Netflix’s value-add as its content library shrinks. In addition, with earnings remaining low, shareholders remain dependent on blockbuster growth from the company in the future.

Netflix’s recent results

In the second quarter of 2013, Netflix’s revenue grew by 20% versus a year earlier and 4% on a quarter to quarter (q/q)  basis, suggesting high but somewhat steady growth on the top line. Higher marketing and technology expenses held down the earnings to 49 cents per share for the quarter. At a current stock price of over $240 per share, that means that Netflix is valued at over 100 times annualized earnings from that quarter. Wall Street analysts are forecasting $3.17 in Earnings Per Share (EPS) for 2014, an average quarterly figure of 79 cents, up about 60% from what the company is currently doing. Even that yields a forward P/E is 76. These growth rates shouldn’t be ruled out, but it does seem speculative to buy the stock depending on high growth to continue. According to the most recent data, 17% of Netflix’s float is held short.

Who owns it?

Insider Monkey tracks quarterly 13F filings from hundreds of hedge funds and other notable investors as part of our work researching investment strategies (we have found, for example, that the most popular small cap stocks among hedge funds earn an average excess return of 18 percentage points per year). According to our database, billionaire Carl Icahn owned over $1 billion worth of the stock at the end of March (find Icahn's favorite stocks) though it should be noted that he bought these shares mostly in the Fourth Quarter (Q4) of 2012 at considerably lower prices. Coatue Management, managed by Tiger Cub Philippe Laffont, reported a position of 1.4 million shares at the end of the first quarter of the year (see Laffont's stock picks).

Comparing the company to its peers

Netflix can be compared to Amazon (NASDAQ: AMZN), which has its own instant video library and is moving into original programming as well. Amazon has something of a strategic advantage over Netflix in that it can bundle instant video access with its Prime membership, which also offers shipping benefits to frequent Amazon customers. Amazon is actually unprofitable on a trailing basis, but by an incredible coincidence analyst consensus is for it to earn $3.18 per share next year- essentially even with the EPS forecast for Netflix. Amazon is valued at a premium to Netflix, at a forward earnings multiple of 94, and investors should be skeptical of bullish assertions that the company will soon be able to cut costs in its retail unit and rake in massive profits. It too seems like a risky growth stock.

Another peer for Netflix is Outerwall (NASDAQ: OUTR), formerly known as Coinstar, which is the owner of movie rental kiosk company Redbox. At a forward earnings multiple of only 11, Outerwall at least appears stunningly cheap compared to Netflix and Amazon. Of course, it is at something of a disadvantage in the market as it is dependent on physical inventory (which considerably limits growth prospects) and customers traveling to a physical location. Partly as a consequence of this, the Redbox unit has been seeing flat sales and lower operating income going by recent reports. The rest of its business is delivering low to negative profits.

Conclusion

Outerwall does not need high earnings growth, but it does need to hit analyst targets for next year which reflect an expected increase in earnings per share. Investors should be skeptical that the company’s fortunes will reverse and so that stock should be avoided for now.

As has been suggested, buying Netflix or Amazon is risky in a different way: certainly these companies will continue their high revenue growth, but analysts are setting a high bar with their forward earnings projections and even if these two businesses perform in line with forecasts they will still require high earnings growth for several years after that to justify their current valuation. As a result investors should feel free to use these companies’ services, but opt out of owning the stock.

The television landscape is changing quickly, with new entrants like Netflix and Amazon.com disrupting traditional networks. The Motley Fool's new free report "Who Will Own the Future of Television?" details the risks and opportunities in TV. Click here to read the full report!


This article is written by Matt Doiron and edited by Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article. The Motley Fool recommends Amazon.com and Netflix. The Motley Fool owns shares of Amazon.com 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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