Netflix stock – watch your money grow

The success of video streaming has made the Netflix stock a “tenbagger” within just a few years. Back in fall 2013, the price of the Netflix stock was 50 dollars. Today it is worth 540 dollars. That translates into an annual return of 40 percent!

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However, Netflix’s success has attracted several strong competitors such as Walt Disney and Amazon, who want to claim their piece of the pie. Netflix remains at the top of the streaming industry, having the largest subscriber count out of any service. This article analyses if the Netflix stock still has potential despite the rapid price increase and fierce competition.

Netflix stock
Logo
Country	USA
Industry	Internet
Isin	US64110L1061
Market cap.	223 billion $
Dividend yield	–
Dividend stability	–
Earnings stability	0.71 of max. 1.0

The business model: This is how Netflix earns its money

Netflix is the leading streaming provider for movies and tv shows. On the name giving platform, customers can enter a monthly subscription to get unlimited access to all of the content. Several plans are offered, which differ in price and quality.

The cheapest costs USD 8.99 per month and does not allow for simultaneous streaming on multiple devices. Furthermore, the streaming quality is limited. In contrast, the premium membership for USD 15.99 allows streaming in 4K resolution on up to 4 devices simultaneously. In between there is an option for USD 12.99, which allows simultaneous streaming on 2 devices in HD quality. The prices for these three options vary from country to country. Overall, however, the pricing model is designed to be affordable to the masses, which is reflected in Netflix’s high subscriber count of almost 200 million.

Netflix is easily affordable for the broad population in most nations (Source: bit.ly/NetflixPricesMap)

Netflix mainly derives its revenues from its streaming subscriptions.  However, most people are probably unaware that Netflix has a second – albeit modest – source of income. In 1998, Netflix began renting out DVDs. The business model was supposed to be an alternative to renting DVDs in video stores. Instead of having to go to a store, the DVDs were sent to the customer by mail. At the beginning, customers had to pay for each DVD individually. Later, the company switched to a subscription model, where customers paid a fixed amount and could then rent an unlimited number of movies. Netflix continues to operate this business today and earned USD 297 million from it last year (Annual Report 2020, page 20). This represents approximately 1.5 percent of total revenues. However, revenues from DVD rentals have been declining for years. Although the rental business does not contribute much to total revenues, it is a welcome service for people in rural areas without access to (fast) internet, of which there were still 24 million in the US in 2019.

Revenues of Netflix by segment (Source: FactSet Workstation)

The Corona Effect

Unlike many other companies, Netflix has benefited enormously from the Covid-19 Pandemic. Especially at the beginning of the pandemic, many people had to spend more time at home, which is why Netflix gained significantly more new subscribers in the first two quarters than in the same period in 2019. In the second quarter of this year, the number of subscribers rose by more than 10 million to just under 193 million. In the first quarter of 2020, the increase was even higher at just under 16 million (Quarterly Report, page 20). By comparison, in 2019, the increase was 9.6 million and 2.7 million new subscribers in the first and second quarter respectively.

Subscriber gain in the second quarter of 2020 (Source: quarterly report, page 20)

The number of new subscribers in the first half of 2020 was almost as large as the entire gain of 2019. The pandemic has been a good boost to Netflix’s growth. The additional subscribers are extremely important in order to spread the cost of new movies and series over as many customers as possible. Since these costs are mostly independent from the number of subscribers, a high number of paying customers is crucial for the profitability of the company.

Subscriber count of Netflix (Source: Company Filings)

In the report for the second quarter, Netflix has already issued a forecast for the third quarter. The company expects, “only” 2.5 million new subscribers in the third quarter. Management believes that many new subscriptions have been pulled forward into the first half of the year due to the pandemic.

Update: Netflix published 3rd quarter results after this analysis was written. New subscriptions came in slightly below the company’s expectations at 2.2m versus 2.5m expected.

Competition from Amazon and Disney

Although Netflix is the leading player in the streaming business, it must still defend its standing against competitors. There are several other companies who are growing their subscriber counts at impressive rates. Currently, Netflix is number one with 190 million subscribers, followed by Amazon Prime with 150 million subscribers. Although not all Prime customers subscribe to the service for the movies and shows, they have access to them and are therefore unlikely to enter an additional Netflix membership. Disney+ is another competitor that has reached 60 million subscribers within a short period. With the launch, Disney has removed its content from the Netflix platform, which was a blow to Netflix. Disney also owns other streaming platforms such as Hulu and ESPN+. In total, those services have over 100 million subscribers.

The crucial factor for the success of streaming companies will be whether customers will only be subscribed to one service or subscribe to several different services at the same time. The latter would substantially reduce competitive pressure. Since growth has not slowed down despite the presence of competitors, I suspect that multiple providers will be able to coexist to a certain extent in the future.

Streaming competitors as alternative investments

In addition to Netflix, we recently analyzed the two major competitors Amazon and Walt Disney. Click the link to get directed to the respective stock analysis.

How profitable is Netflix?

Netflix profits increased by 1400% from USD 0.43 to USD 6.19 since 2016. Since the number of outstanding shares has increased during this period, the actual earnings growth was even higher. Despite the profit, the cash flow has been consistently negative for many years.

Development of profit and cash flow of Netflix

The negative cash flow is due to the high expenses for content. The production of movies and series is expensive.  Most of these expenses are due before the content is available to customers. Once finished, new productions are an asset that Netflix then amortizes over several years (usually within 4 years). Amortization is similar to depreciation but is used for intangible assets. This amortization is recognized as an expense in the income statement, which means it reduces the profit. In recent years, the expenses for new content have increased much faster than the amortization of old content. Since content is amortized over several years, the growing expenses are a bigger burden on cash flow than on profit. When licensing third-party content, the expenditures are allocated more evenly over the years.

As mentioned above, Netflix’s profits have risen sharply since 2016. This increase can be divided into two separate effects. One effect is the increase in revenue in recent years. The second effect is the increase in profitability, measured by the operating margin. In the chart below you can see that sales have increased from USD 8.83 billion to USD 22.63 billion in the last 4 years which is a 150 percent increase. Higher sales at constant profitability will also translate into higher profit. However, Netflix’s profitability has not remained constant, but has also improved during this period. Back in 2016, the operating margin was 4.3 percent. In the past 4 years it has quadrupled to 16.6 percent. Roughly, 2.5 times the revenue and 4 times the operating margin means 10 times the operating profit. The target for the current year is an operating margin of 16 percent. By the end of 2021 Netflix wants to increase the margin to 19 percent (Shareholder newsletter page 3).

Development of revenues and the operating margin of Netflix

In case you are wondering why the earnings per share have increased 14-fold and not 10-fold: The final profit includes other factors that are not yet included in the calculation of the operating profit.

Financing content with debt

Although Netflix does not pay a dividend, its amortization power has been negative ever since 2014. The reason for this is the negative cash flow mentioned earlier. Without positive cash flow, Netflix is dependent on fresh capital to finance new projects. That is why debt has increased every year. The debt ratio is currently at 75 percent, and the interest on this debt has eaten up around 25 percent of the operating profit in 2019 (Quarterly report page 24).

Debt, cash and amortization power of Netflix

No doubt, spending money on new streaming content is necessary to attract new customers and keep existing ones satisfied. However, the status quo is not sustainable. Sooner or later Netflix will need to be able to keep the expenses within acceptable limits without sacrificing the quality of the content library. Positive cash flow is important to be independent of the capital markets. Only with positive cash flow is it possible to internally finance new projects. In addition, positive free cash flow is necessary to be able to repay debt at some point in the future and possibly pay a dividend somewhere down the road.

Another import aspect is the influence of content spending on profits. Since the amortization of new content begins with a time lag, a permanent increase in expenditure in subsequent years will have an impact on profits in the form of higher amortization. It is essential for profitability that Netflix gets the content spending under control. Fortunately, management is aware of this problem and expects an improvement of the cash flow situation in the near future.

Is the Netflix stock fairly valued?

The Netflix stock is difficult to value because the company is still in a growth phase and has a high P/E ratio. In addition, the P/E ratio fluctuates heavily from year to year. For these reasons, a valuation based on historical averages is not as helpful as it would be for an established company. Furthermore, the operating cash flow is useless for determining a fair value because Netflix has always generated a negative cash flow in recent years. Netflix also does not pay a dividend, so the fair value dividend cannot be used either. This leaves the fair values for profit and adjusted profit. Personally, I prefer the adjusted profit because it better represents the delayed effect of content spending. I choose a 3-year time period, starting in 2018, to reflect the latest developments. This still gives us an average P/E of 105, and from this point of view, the Netflix stock seems to be fairly valued according to the fair value of the adjusted earnings.

Netflix in the dynamic stock valuation

However, the prediction for the coming years should be treated with caution. Due to the high P/E ratio and the optimistic forecasts, the fair value prediction is extremely high. Personally, I am skeptical whether the stock will maintain its high P/E ratio forever. As soon as growth rates decline, investors will probably also assign a lower P/E ratio to the stock.

Since the valuation using historical averages is not that helpful, I also performed a Discounted Cash Flow (DCF) valuation. This involves discounting the expected future cash flows and adding them up to obtain their present value. With a growth rate of 25 percent annually for the next 5 years and an operating margin of 19 percent starting in 2021, a value of $590 USD for the fair value of the Netflix stock is returned. Therefore, the DCF analysis also concludes that the Netflix stock is fairly valued.

DCF valuation of Netflix

Nevertheless, you should be aware that a DCF valuation is also associated with uncertainties. The determined fair value very much depends on the assumptions made in the model. With the help of the following table you can get an idea how the current fair value in my DCF valuation depends on the assumptions for the revenue growth and the operating margin.

Sensitivity matrix for Netflix

I would like to point out another aspect at this point. In my opinion, much of the value of Netflix depends not only on the revenue growth, but on the ability to control the content spending over the long term. To do this, Netflix must be able to retain its subscribers without having to spend horrendous amounts of money on new content. Subscriber growth should help in this regard, as the cost of content is then spread across more users.

Conclusion: The Netflix stock is for risk-tolerant investors

By buying the Netflix stock you invest in the leading player in the video-streaming industry. Subscriber growth has received another push from the Covid-19 pandemic and does not show any signs of slowing down. In addition, Netflix is already profitable, unlike many other growth companies. Nevertheless, there are also negative aspects. Due to high costs for new content, the cash flow has been negative for years. However, the high expenses are necessary to attract new subscribers and to keep existing subscribers on the platform. Keeping these costs under control will be vital for Netflix in the coming years. Only if this is successful Netflix will be able to pay off its debts, which have been steadily increasing. If the company ever wants to pay a dividend to shareholders, they also need positive cash flow. The stock is not cheap. However, considering the high growth rates, the price seems justified, but keep in mind that valuing the Netflix stock is associated with a lot of uncertainties. This is why the investment also carries higher risk than other alternatives. In my opinion, conservative, risk-averse investors should steer clear of the Netflix stock.