Should You Buy Netflix Pre-Earnings?

Matthew 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 one of my favorite stocks to follow. First, Netflix is a prime example of how the market can irrationally overreact to seemingly negative news.  Netflix climbed as high as $304 in 2011 before falling to just over $50 less than a year ago, and has now come almost full-circle. Due to some bad (but not awful) subscriber data and earnings misses, investors with the foresight to see past the noise were rewarded with the bargain of a lifetime. Also, Netflix is one of the most reactive stocks in the market to earnings reports, and since the company is set to report earnings on Monday, July 22, now is a great time to take another look at the company and see if maybe the market is now becoming a little too optimistic.

A recent history of Netflix

Netflix rose to relevance with its well-known DVD-by-mail rental service in the early 2000’s, but has evolved into so much more. Beginning in 2007, Netflix began to shift its business model toward video-on-demand services, which worked out well for the company as DVD sales have declined every year since 2006. 

At its peak in 2011, Netflix made what I consider to be its only major blunder and announced its intention to separate its DVD rental service, then reversed its position a couple of weeks later. More important than the business structure itself was the uncertainty created by the company’s flip-flopping. Around the same time, the company reported declining U.S. subscriptions and predicted further declines for the rest of the year, sending shares plummeting by around 70% over the latter half of 2011. 

Since that time, however, the market has begun to realize that things were not as bad as they seemed. In fact, Netflix’s subscriber base has grown from about 14 million in 2010 to 36.3 million currently. The company has also been very successful with partnerships with networks and other ventures, like their original programming.

Original programming

Netflix announced its intention to begin acquiring original content in March 2011, and there was a tremendous amount of skepticism in the market. However, this is looking like a gamble that will pay off, as the company’s first original series, House of Cards, recently received nine Emmy nominations. Netflix seems determined to make its original programming a competitive advantage, and have since announced several other original projects, such as a partnership with DreamWorks Animation (NASDAQ: DWA) to produce a new animated series set to air in December of this year. 

In fact, just about a month ago, Netflix and DreamWorks announced a multi-year deal where Netflix would be the exclusive home of new original series based on DreamWorks’ characters such as Shrek, Madagascar, Kung Fu Panda, and more. This could be a game-changer for both companies, as these franchises are tremendously popular and could catapult Netflix well beyond the 50 million subscribers worldwide that are projected within a few years.

The numbers…

While I am very optimistic about Netflix as a company, especially considering the (potentially) lucrative new direction they seem to be pursuing, let’s take a look at what the recent gains in share price mean for the stock’s valuation. Netflix’s earnings over the next few years are expected to be relatively low due to significant investment in their new ventures, which the market seems to think will pay off. Because of this, an analysis based on P/E or any similar statistic is relatively meaningless. 

Netflix could indeed become a $600 stock, but consider what would need to happen. Assuming a P/E of about 16 once their business is mature (about average for a company with Netflix’s financials); this means that Netflix would need to earn a profit of about $2.1 billion annually, which is certainly possible. At this point a level of profitability like this is still very speculative (Netflix earned $429 million in its best year so far), and I’m not sure that the current share price is warranted until some of the company’s newer ventures begin to produce results.

Threats

There are several companies, such as Redbox and Wal-Mart, which offer video rental services, but Amazon.com (NASDAQ: AMZN) is the only one that I really consider a threat to Netflix’s success. Amazon streams movies and TV shows on a pay-per-view basis and on an unlimited basis to its prime subscribers. Amazon has also begun to venture into its own original content; however they have not experienced the same level of success as Netflix. Although I don’t see them stealing subscribers from Netflix anytime in the immediate future, they are certainly worth keeping an eye on.

Buy, sell, or hold?

My current attitude toward Netflix has shifted from “buy, buy, buy!” to “wait-and-see” after the dramatic gains so far this year. During Monday’s earnings call, pay particular attention to any comments by the company about how their original programming is contributing to the bottom line. We know the programming is good, but is it translating into new subscribers? Also, pay attention to how they expect the DreamWorks series to help. The main point here is that the value of a stock like Netflix is in its future, so that’s what you should be listening for, even more than the current numbers.


Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, DreamWorks Animation, 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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