What Justifies A $700 Price Tag For Netflix?

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Netflix’s (NASDAQ:NFLX) stock has witnessed a phenomenal run-up in the last few months and has risen more than 95% year to date. The stock is currently trading at around the $700 mark whereas our $549 price estimate for the company stands at a discount of about 20% to the market. This begs the question – what does the current market price represent in terms of Netflix’s future growth? In this analysis, we try to answer this question by looking at certain fundamental business and valuation drivers that have high levels of uncertainty associated with them. We find that in order to justify a market price of around $700, Netflix will have to accelerate its profit growth in international markets, resort to further price increases and demonstrate business stability.

See our complete analysis for Netflix

Higher Growth In Average Revenue Per Subscriber In The U.S. (+$45)

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While Netflix’s subscriber growth in the U.S. is as good as it is going to be, there exists upside potential from higher growth in average monthly revenue per subscriber. At a base package of less than $10 per month, Netflix’s subscription fee is considerably cheaper than an average pay-TV plan, which is generally in excess of $60 per month. As a result, Netflix has enjoyed some pricing power and was able to raise its subscription fee in 2011 [1] and in 2014 [2]. Unfortunately, the recent crowding of the online streaming market reduces Netflix’s pricing power. Content providers such as Dish Network, Sony, Apple, HBO, CBS, etc., have all announced the launch of their own streaming service within the last year or so. These services will be priced somewhere in between the subscription fees charged by traditional pay-TV providers and Netflix. These services will have an advantage over Netflix as they will broadcast live content whereas the same content will be made available on Netflix after it is syndicated. Keeping all this in mind, we have taken a conservative growth estimate for the average revenue per domestic subscriber, which we believe will grow from a current value of $7.88 to $9.75 by the end of our forecast period.

However, Netflix has an advantage of its own as it functions more like a repository and users can access much older content which might not be readily available on other streaming services. Additionally, Netflix has a tendency of being viewed as a complementary service rather than a competing service to various pay-TV operators. The end users could potentially form the same opinion of the company when it is compared to other streaming services in the future. Netflix hopes to increase its attractiveness further on the basis of its original content. The company plans to build on the success of its original shows, such as House of Cards and Orange Is The New Black, by growing the percentage of its spending dedicated to original content in the coming years.  The exclusivity of its future original content, along with its repository and complementary services, could keep the competition at bay and help in increasing the company’s average revenue per domestic subscriber at a faster rate. If Netflix is able to increase its average monthly fee per domestic subscriber to $11 by 2021, it will add roughly $45 (roughly 8%) to our price estimate.

Acceleration In International Profitability (+$20)

The subscriber growth in Netflix’s International segment has been very robust so far, with the subscriber base increasing from 1.9 million customers in 2011 to approximately 21 million as of March 31, 2015. [3] Netflix has no intention to take its foot off the gas in this regard and plans to provide services in 200 countries by the end of 2016. [4] Going forward, Netflix’s international expansion could have a significant impact on its contribution margins. The company’s international operations are still unprofitable as the company continues to invest heavily in its expansion. However, the markets that Netflix launched into prior to 2014 (Canada, Latin America, the UK, Ireland, the Nordic countries and the Netherlands) became profitable on a contribution basis in Q3 2014 and continue to grow. [4] The company acknowledges that progress has been so strong that it now believes it can complete its global expansion over the next two years while managing to still be profitable. This is possible as Netflix will start experiencing operational efficiencies as it grows operations in the target countries. The marketing expenses will also come down as a percent of sales once the company establishes itself in these countries. We believe that Netflix’s international segment will start to break even by 2017 and will start having positive contribution margin from 2018 onward. It will then stabilize at around 31% by the end of our forecast period. Nevertheless, if Netflix has to justify its current market valuation, it will need to accelerate international contribution margins at a faster rate, which could be achieved through reduced marketing expenses and better operational efficiencies. If this figure reaches 35% within the next six to seven years, it will add just $20 (about 4%) to our current price estimate.

Lower Weighted Average Cost Of Capital (+$85)

We recently revised our discount rate (or weighted average cost of capital) downwards from 10% to 9% for valuing Netflix’s stock. This is the rate at which we discount the company’s future cash flows, and is the weighted average of its after-tax cost of debt and cost of equity. This figure is a measure of a company’s risk. Netflix justified this revision as the stock’s beta has come down in the past year. Beta is a measure of company’s stock volatility relative to broader market. Netflix’s correlation to the broader market has improved, which means that the risk of fluctuations in its stock price has come down. The company has also been able to stabilize its business and increase its revenues without taking on substantial debt. Netflix’s total long term debt currently stands at $2.4 billion, which is significantly less than the company’s enterprise value of $39.28 billion as of June 19, 2015. [5] However, we believe that in order to justify a market price of $700, Netflix will have to lower its risk further such that WACC (weighted average cost of capital) comes down to 8%. The only way this can happen is if the company’s beta continues to decline in the coming quarters. If beta has to come down, Netflix will need to demonstrate solid revenue growth, stable profit margins and long-term stability.

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Notes:
  1. Netflix Introduces New Plans and Announces Price Changes, July 12, 2011, Netflix US & Canada Blog []
  2. Netflix Hikes U.S. Streaming Plan by $1 per Month for New Members, May 9, 2014, Variety []
  3. Netflix’s SEC Filings []
  4. Q4 14 Letter to shareholders, Netflix Investor Relations [] []
  5. Netflix Enterprise Value, YCHARTS []