Is Netflix's New Subscriber Data A Turning Point?
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Netflix (NASDAQ: NFLX) CEO Reed Hastings recently announced that Netflix subscribers "watched a total of 1 billion hours of video for the first time in June." If we do a back of the envelope calculation, this would equal more than an hour of video per day for each subscriber. Based on the Nielsen data, average viewers in the US watch about five hours a day. This means that subscribers spend 20% of their viewing time on Netflix. This also means that an average subscriber spends 38 hours per month, higher than the 28 hours that subscribers spent last year.
According to Mr. Hastings, the robust data can be attributed to its ongoing investment in its content. For example, the company will launch House of Cards later this year. The upcoming series is a political drama and based on the BBC miniseries of the same name. It will also release the first 10 new episodes of Arrested Development in the first quarter of next year, available to United Kingdom and Ireland subscribers. Mr. Hastings shared his optimism on these new programs. He believes they will drive viewership even higher.
The recent increase in viewership is primarily due to Netflix's engaging content. It has started to build a reputation of offering new and exclusive content to its subscribers. Meanwhile, its closest competitors are still stuck with traditional content.
So far, its strategy has been paying off. Netflix continues to offer new content through its partnership with entertainment companies Twentieth Century Fox, Hasbro (HAS), Warner Brothers, to name a few. This clearly gives them a strong competitive position against the likes of HBO, Amazon (AMZN) and cable companies, such as Verizon (VZ), Dish Network (NASDAQ: DISH), and Comcast (CMCSA).
At present, it is continuing to boost its content library, which contains different types of documentaries, movies and original shows of various genres. Notice that House of Cards is a political thriller while Arrested Development is comedy. Moving forward, this will help them differentiate from the traditional media companies.
Subscription Price Hike Still a Concern
Recall that last year, Netflix decided to increase its subscription prices. This triggered mass customer cancellations, and the decline of subscriber growth spooked investors. Netflix was able to revive its subscription growth this year as it came up with a strategy for improving its content.
The company has increased its prices as much as 60% in line with its plan to phase out its DVD-by-mail rental service and raise more money to license TV shows and movies for its increasing internet video library. I believe that the company is preparing for the eventual demise of DVD's and the shift to more online video consumption.
Its subscription price hike is an effort to maintain and increase its margins, even at the expense of subscription growth. Its operating margins have improved from 6.5% in 2006 to 11.7% in 2011. However, they still appear lower compared to its competitors. For instance, DirecTV (NASDAQ: DTV) has operating margins of 16%. Other media companies like Dish Network and Time Warner (NYSE: TWC) carry operating margins of 20%. The reason is that Netflix has been spending to attract and retain subscribers. On a historical basis, I see that this is an improvement on its profitability and cash flow generation ability. Its free cash flow is at $1.7 billion a year and expected to be higher as it moves into aggressive acquisition on content.
Fortunately, Netflix was able to bounce back from the temporary setback. As of the first quarter, Netflix reported 26.1 million US subscribers. This is higher than the 24.6 million subscribers it had prior to the price hike announcement. This translates to a recovery of 700,000 subscribers between last year and this year. The bulk of these subscribers are now paying only for internet streaming. The company said that the streaming service appeals a lot to its subscribers as it adds more titles.
Subscribers will be assured that it will continue licensing content. As of the end of the first quarter, it signed contracts that will require the company to pay $3.6 billion for the next five years.
The concern is that this is really a large sum of money relative to its cash generation ability. It has a current cash balance of around $800 million based on the latest quarterly filing. Given that its debt is at 60% of equity, I expect that Netflix will increase its debt further as it continues to invest in content. A larger concern is how much incremental return it will generate for the company. In my estimates, it could produce incremental earnings of around $300 to $500, or equivalent to a modest return of 8% to 13%.
Valuations
At present, the stock is trading at 28 times earnings. Over the last five years, it has traded between 16 times and 59 times earnings. The PEG ratio is at 45 times based on forecasted 5-year growth of 16%.
This is higher than its peers. Coinstar (CSTR) is valued at 13 times, while Dish Network trades at 9 times earnings. DirecTV is also priced lower at 13 times earnings, while Time Warner is at 14 times earnings. Despite the premium, the stock price has not yet recovered from its 70% decline following the decision to hike subscription rates.
I believe that the higher valuation is attributed to expectations that it faces significant tail winds on higher internet video consumption in the future. Analysts have mixed expectations on the stock. Citigroup analysts believe that concerns are overblown while Wedbush Securities cited that the company is becoming unprofitable as content owners will charge more for their products in the future. This in turn will have an impact on the margins.
It will take a lot of strong quarterly reports before investors will be confident enough to plunge into the stock. The consensus price target is at $92.52, implying a limited upside of 8% from the current price levels.
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