Even At Twice The Earnings This Stock Would Be Expensive

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

It's rare when a company would have to double earnings, and even then its stock would be considered expensive. However, that's exactly the situation at Netflix (NASDAQ: NFLX). Even if you look at what the average analyst expects for full year 2013, the stock trades for about 174 times earnings. While I'm sure there are cases where a company traded for a high P/E ratio like this and investors benefitted, I tend to believe this puts a roadblock up to good returns. Famed investor Peter Lynch once said, that the P of the P/E ratio can't get too far ahead of the E or something has to give. Let me say this outright, I love Netflix the service, and I've owned the stock before, but at these prices investors need to exercise more caution.

What Makes Netflix The Service Great:

The Netflix service is great, and while it has morphed over the years from a DVD by mail business, to a streaming media company, the value is excellent. My family uses Netflix multiple times a day, and the company made a very smart move by creating Netflix for Kids. My three year old watches shows from some of his favorite characters through Netflix, and honestly, we would be hard pressed to change services unless the competitor offered similar content. Another positive is Netflix is beginning to realize that it can't rely on movies to bring in subscribers, because quite honestly it's too expensive. Instead the company has been licensing more and more television shows, and creating its own content as well. Nearly every Internet connected device I've seen lists Netflix as the first streaming media option. With over 23 million domestically streaming customers, and over 3.6 million internationally, the service is attracting a lot of attention.

Competition Is Getting Better And A New Entrant Is Poised To Steal Market Share:

Netflix investors need to be realistic though. The service has a lot of customers not because it has the best content, or is available on more devices, but because it was first. This is the reason the company is moving so aggressively to expand to different countries internationally. However, this quest to be first is costing the company money, and as the company's DVD subscribers leave, there is less cash flow to support this expansion. In addition, Netflix competition has gotten smarter, and there is about to be a new entrant that the company should pay more attention to. Amazon.com (NASDAQ: AMZN) is probably the most direct competitor, and CEO Jeff Bezos isn't afraid to spend money to take over new markets. The Amazon Prime service offers a cheaper streaming alternative with the additional benefit of free 2 day shipping. While Amazon's streaming catalog isn't up to par with Netflix, it may just be a matter of time. Hulu is also getting better by gaining exclusive licenses to more television shows.

I find it short sighted that Netflix management isn't mentioning Redbox Instant by Verizon as a competitor yet. This joint venture between Coinstar (NASDAQ: OUTR) and Verizon will be a complimentary offering to the Redbox kiosks that millions already use. This partnership has the potential to disrupt the industry, because Verizon generates significant free cash flow that can be used on content acquisition, and Redbox has over 35,000 points of presence with their Redbox kiosks. If this service is priced anywhere near Netflix, the combination of streaming and more current movies at Redbox could seriously challenge Netflix and Amazon.

It's One Thing To Love The Service, The Stock Is Another Story:

It's been a long time since I've seen a stock as seemingly overvalued at Netflix. When a stock can make Amazon look cheap by comparison, you know investors have high hopes. Netflix has made clear that the future of the company is streaming. However, if that is really the case, the company needs to at least double its users and profits, and that's just to be as expensive as Amazon. I honestly believe both companies are currently overvalued, but at least Amazon has a clear path to making its stock worth the risk. Amazon is growing by leaps and bounds when it comes to general merchandise sales. In the company's recent quarter, merchandise sales jumped by 39%. Amazon is spending money building out its infrastructure, but at some point those expenses will subside. Netflix is expanding, but even with double the users the stock still might not be worth the risk.

At current prices Netflix trades for about 174 times forward earnings. Analysts expect EPS growth in the next few years of about 21%. In order to bring the company's PEG ratio down to match Amazon, Netflix would need to generate EPS of about $1.05. With 23.8 million paying subscribers domestically, these customers generated about $91 million in contribution profit on $556 million in revenue. Since the company is constantly entering new markets, it will probably be years before international subscribers can give Netflix the contribution margin that domestic subscribers can. If Netflix made $0.13 per share with over 27 million worldwide paying subscribers, it's not a reach to assume they could make $0.26 per share if they had 54 million subscribers. However, even with double the users and double the EPS, the stock would still trade for about 74 times earnings. While 74 times earnings sounds better than the current multiple, this would still represent a PEG of 3.48 with an expected growth rate of 21.28%. Amazon by comparison, sells for about 130 times forward earnings, but is expected to grow by over 37% in the next five years. This means Amazon already sells for a PEG of 3.49, and Netflix would have to double earnings to just match Amazon's relative valuation. If you realize that at a 21.28% growth rate it would take Netflix over 3 years to double earnings, you can see just how expensive the stock is.

Conclusion:

The bottom line is, Netflix's stock seems extremely expensive at current prices. If you are a high risk investor, Amazon seems like a better value, and is growing faster. For value investors, Coinstar could be a good alternative. The company's Redbox unit is posting solid growth, and if Redbox Instant by Verizon is at all comparable to Netflix or Amazon Prime, this could be a huge competitive threat. Given that Coinstar sells for just under 9 times forward earnings, and is expected to grow at over 17% in the next few years, this could be the best value of all. Netflix service is top notch, and my family won't change unless Redbox Instant or Amazon Prime can catch up. However, at these prices, and with analysts’ projections where they are, I wouldn't touch Netflix stock with a 10 foot pole.

Interested in Additional Analysis

If you’re an investor in retail stocks, you have to look at Amazon.com, the company intent on disrupting the entire sector. Whether you’re researching Amazon itself or one of the companies it's taking sales from, you need to understand the company and its prospects. That's why the Fool has created a new premium report on Amazon, sharing everything investors must know. The report also has you covered with a full year of updates, so click here now to get started.


MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and Netflix. Motley Fool newsletter services recommend 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.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus