Outrageous Expectations: The Netflix Story

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

Ultimately the value of a stock depends on all the future profits of the underlying company. When a stock trades at a high P/E ratio this means that the market expects earnings to rise rapidly in the coming years. Sometimes, however, this gets out of hand. Expectations become so inflated that people stop considering whether or not their estimates are even possible. Netflix (NASDAQ: NFLX) is a good example of this phenomenon.

Avoiding bias

Netflix used to be a DVD mail-rental company, and in that market it was dominant. The company had both a distribution network and a DVD catalog that went unrivaled. But the world is moving away from physical media and towards digital distribution, so Netflix began expanding its streaming service. I became a Netflix subscriber back when the streaming service was nothing more than a handful of terrible movies no one had ever heard of, and I've remained a subscriber to this day. But just because you like the product does not mean that you should automatically like the company. It's easy to form a bias in favor of a company simply because you use its products. What matters from an investment perspective, though, is the profitability of the company.

The business model

Netflix has a recurring revenue business model, where customers pay regular monthly fees to access the service. This is good for the company because it creates a reasonably predictable revenue stream. Netflix currently has about 33 million worldwide subscribers, and based on the $3.6 billion in revenue for 2012, this comes out to about $9 per subscriber per month on average.

The most profitable part of Netflix's business is actually the DVD mail-rental portion, which has now entered a continual decline. Domestic streaming is profitable but with far lower margins, while international streaming operates with a comparably sized loss.

In 2012 Netflix recorded EPS of $0.29, down from $4.16 the year before. The international segment is the culprit here, as the company is spending heavily to expand its presence worldwide. Free cash flow was $-1.14 per share in 2012, down from $3.39 per share in 2011. Revenue rose 12.6% to $3.6 billion.

The future

A common argument in favor of Netflix is that the company is spending a lot of money on expanding and eventually will become very profitable. It is spending a lot on expansion, but is there any real reason to believe that massive profits will follow?

Netflix streams content owned by others, meaning that the company must license that content. These licensing deals have gotten expensive as Netflix has grown, and the company recently announced plans of a debt sale to finance these deals. The streaming industy has become more competitive, with Amazon (NASDAQ: AMZN) building its video service, scoring exclusive deals for shows such as the popular British drama "Downton Abbey." Amazon offers the Amazon Prime service for $79 per year, which includes streaming of content as well as free two-day shipping.

Another competitor is Verizon (NYSE: VZ), which has partnered with Redbox to launch a streaming service very similar to that of Netflix. The service cost $8 per month, comparable to the cost of Netflix, but also includes 4 free rentals at Redbox kiosks. This offers a compelling value, as the kiosks have many newly-released movies that streaming services typically don't offer right away.

The future of the streaming industry will be one with multiple companies bidding against each other for exclusive content, leading to ever-rising licensing costs for the streaming services to bear. The companies that control the content are the real winners, not the company's that stream the content.

Now, that's not to say that Netflix won't be profitable in the future--but I think expectations have gotten a bit outrageous. In 2011 the stock plummeted from $300 per share to around $60 per share, and was trading near $50 per share late last year. Since then the price has rocketed up to $185. This price is 44.5 times earnings from 2011 and 638 times earnings from 2012. What really matters though, are future earnings. And the market seems very optimistic about the future.

Predicting earnings for a company like Netflix is very difficult. As the company adds more subscribers the cost to license content will rise, as any content-controlling company will raise the cost on renewal to account for the larger subscriber base. You also have competitors bidding up that price, making the situation even worse for Netflix. In the short term margins will probably improve as the international segment becomes profitable, but content costs are a big problem in the long term.

In response to this Netflix has begun creating its own content, spending $100 million to develop the well-reviewed drama "House of Cards" and bringing back cult favorite "Arrested Development" for one more season. In order for this strategy to work Netflix needs enough regular, high quality content for people to subscribe solely for that content. The costs are high, and the payoff is uncertain.

When the stock was trading for $50 per share I think a reasonable argument could have been made for it. But at $185 per share no such argument exists. The fact that the company provides a popular service isn't enough considering the massive content-related liabilities going forward. If Netflix were to become extremely profitable, what's stopping the content providers from demanding a bigger price upon renewal of their contracts, thus pushing profits back down? Netflix has no leverage here.

The bottom line

I don't think that Netflix is doomed, but the market's expectations are borderline insane. We've seen this show before - when Netflix hit its peak in 2011 it traded at around 70 times the earnings of that year. There's another peak coming, and I don't want anything to do with it.

Timothy Green has no position in any stocks mentioned. 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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