Numbers Show A Disconnect Between Netflix’s Market Valuation And Business Growth Trajectory

Netflix‘s (NASDAQ:NFLX) stock is currently trading at over $410 which implies that our $250 price estimate stands at a discount of about 40% to the market. Taking into account the current market valuation, consistent growth assumption, weighted average cost of capital of 11% and terminal growth rate of 3%, we conclude that Netflix will need to generate roughly $2.65 billion in free cash flows by 2020 in order to justify the current market price. Is this possible? It is virtually impossible for the company to achieve this target without significantly expanding its revenues or EBITDA margins (earnings before interest, taxes, depreciation and amortization), or both. This is going to be an arduous task given the growing competition, mounting content obligations and relatively low customer loyalty. This becomes even more apparent when we backtrack the implied revenue or margin growth. Let’s see how Netflix is doing and what incremental growth is required to justify the current market valuation.

See our complete analysis for Netflix

The Growth Is Still Strong

Netflix gained 2.33 million domestic streaming subscribers in Q4 2013, which was near the high end of its guidance and implies year-over-year growth of nearly 14%. ^[1] This can be attributed to the continued uptake within the online streaming industry, the company’s improving content library and enhanced marketing campaigns. During the quarter, Netflix  launched additional original programs including the second season of Lilyhammer, the first original animated series for kids, Turbo F.A.S.T., and original comedy specials. The breadth and freshness of the content has improved over the last few quarters and is a major differentiator for Netflix against its competitors. In Q1 2014, Netflix expects to gain roughly 2.25 million subscribers, which again represents a healthy growth over the same period in 2013.

But The Figures Indicate A Disconnect Between The Market Price And Business Fundamentals

The table below shows the implied cash flow trajectory that will justify Netflix’s current market valuation of close to $25 billion. We have assumed weighted average cost of capital (discount rate) of 11% and terminal growth rate of 3%. We conclude that Netflix will need to grow its annual free cash flow to the firm (FCFF) from $910 million in 2013 to $2.65 billion by 2020, implying a compounded annual growth rate (CAGR) of 16.5% for 7 years. These are some very bullish assumptions considering the risks the company faces. The cash flow growth would result in annual revenues jumping from $4.38 billion in 2013 to almost $16.3 billion in 2020, assuming that our forecasts for margins, capital expenditures as a percentage of revenue, and net-working capital as a percentage of revenue hold. Sounds unbelievable, does it not? Our current revenue forecast for 2020 stands at $8.6 billion. This implies that by 2020, Netflix will need to either increase its subscriber base to 180 million as opposed to our current forecast of roughly 90 million, or double its subscription fee. Both of these seem very unlikely.

On the other hand, if our current revenue forecasts were to hold, Netflix will need to increase its cash flows as a percentage of revenue from 21% in 2013 to 32% in 2020. Make no mistake, this isn’t an easy task at all. In recent years, the figure has come down due to expansion in international markets. In fact, a 32% figure would be similar to what Facebook (NASDAQ:FB) has currently. However, the social networking giant has EBITDA margin of more than 55%, which is way more than the current or expected figure for Netflix.

Key Risks To Consider

It is very easy for customers to join and leave Netflix. This suggests that any wrong move, or significant strides by a competitor, could lead to sudden brake on its growth. As a result, the company warrants a higher risk factor as compared to other established businesses where there are enough forces at work to discourage customers from changing the service. There is no doubt that competition is growing. An analyst from Macquarie stated last year that Amazon (NASDAQ:AMZN) has confirmed it has over 20 million Amazon Prime members globally. ^[2] The company has been competing with Netflix for a long time in the online streaming business but had been mute about its membership base. The revelation suggests that it has become a force to reckon with, and could spell trouble for Netflix in the coming quarters. Amazon has also started taking advantage of its distribution capabilities to expand its streaming business and plans to sell set-top boxes of its own. This could have a mitigating impact on Netflix’s growth.

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1. Netflix’s SEC Filings [↩]
2. Amazon Says It Has 20 Million Prime Members, Business Insider, Jan 7 2014 [↩]