Why We Believe That Netflix Is Still Overvalued

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Netflix (NASDAQ:NFLX) reported its third quarter numbers on October 15, 2014 and the stock has fallen approximately 25% since then. Even though Netflix delivered on the revenue guidance, the selloff has largely been due to the disappointing numbers it posted with respect to streaming subscriber additions. Our price estimate for Netflix stands at $299, implying a discount of about 12% to the market. While we believe that Netflix has a lot going on in its favor, there are some risks that warrant a conservative valuation of the stock.

See our complete analysis for Netflix

What’s Going Well For Netflix?

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On the whole, Netflix is a relatively strong growth story and has a lot of things working for it. Netflix’s revenue grew at 21% in the year 2013 and is expected to grow at 25% in 2014, which means it will cross the $5 billion mark for the first time and come in at around $5.46 billion. Its subscribers have been increasing at a good pace. The overall subscriber base crossed 50 million mark for the first time in the second quarter of 2014, and the company added another 3 million in the third quarter. The subscriber growth, in essence, is being fueled by media consumption shifting to internet. The presence of wide variety of devices available to play Netflix’s movies via internet significantly enhances customer experience. This will continue to be a catalyst for streaming subscribers in the US. Its growing focus towards original content has been paying off and shows such as House of Cards and Orange is the New Black have been immensely popular. It is considered a pioneer in online streaming and is well placed with respect to total domestic subscribers and the overall quality of content in comparison to its competitors like Hulu and Amazon Prime Instant Video. Netflix has been aggressively expanding its international streaming operations and recently launched in France, Germany, Austria, Switzerland, Belgium and Luxembourg, gaining access to a potential market of about 66 million broadband households. [1] It also officially announced that it plans to launch in Australia and New Zealand in March 2015.

However, These Risks Can Not Be Ignored:

— Subscriber Growth In The U.S. May Be Slowing Down

There are still concerns surrounding the future growth drivers of the company and the biggest concern is the underperformance in the domestic streaming subscriber additions. Netflix added a little less than 1 million subscribers domestically in the third quarter of 2014, as opposed to its earlier expectation of 1.33 million. The company increased the price of its online streaming plan from $7.99 to $8.99 and cites this as the primary reason for the decline in demand. While this may be the case, there are genuine concerns that Netflix’s US business could be entering its maturity phase and that the market could become saturated in the coming years. Incremental customer additions will become difficult for the company in such a scenario.

— International Streaming Is Still In Losses

The international streaming segment is growing at a rapid pace. The number of international subscribers stood at 15.84 million at the end of third quarter of 2014, an increase of 72% over the same period a year ago. As stated earlier, Netflix entered 6 new markets in Europe this year and has no intention of slowing down as evident from its announcement to launch in Australia and New Zealand next year. However, this aggressive expansion is coming at a cost. The international segment continues to operate at a loss. Even though the contribution margin for the first nine months of 2014 came in at -9% compared to -44% for the year ago period, the expansion into new countries will put severe stress on this number in the coming quarters. This is primarily due to the lack of operating leverage that Netflix will face in these new markets as the subscriber count will be low in the initial period and many new subscribers will be in the trial phase. Large marketing expenditure in the countries where the service has been recently launched is also unavoidable. All these factors will contribute to a period where the top-line growth will not result in profitability for the international segment of the company. Currently, we are projecting that Netflix’s international segment will just about break even in 2015 and will start having positive contribution margin from 2016 onward. It will then stabilize at current domestic levels by the end of our forecast period.

Original Content Is Expensive

Netflix has also been investing heavily in its online content, which is inclusive of the original content that is available exclusively on Netflix. Improvement in its online content has been the cornerstone of its subscriber growth for the past two years so it seems logical to invest more into content in order to draw more consumers. Buoyed by the success of original series such as House of Cards and Orange is the New Black, Netflix has planned a roster of 30+ upcoming original series to be broadcast in 2015 and 2016. However, the content costs involved with securing quality content are massive and are easily the biggest part of the cost of operations for Netflix, contributing 73% of the total costs. Netflix’s recently launched series Marco Polo, reportedly produced at a cost of $90 million, has been met with mixed to negative reviews and has failed to generate excitement among the viewers. Netflix needs to be careful not to go overboard with spending in its quest for new content as the success of its earlier shows does not guarantee the same for the ones that follow.

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Notes:
  1. Q3 14 Letter to shareholders, Netflix Investor Relations []