Netflix Stock: An Easy 2x

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Is Netflix’s stock (NASDAQ: NFLX) pricey, trading at about 100x earnings? Not at all. Especially if you consider the fact that the earnings could be about 4x the current level in the next few years. How is that? Firstly, we believe that Netflix revenues can double by 2025 to levels of about $45 billion from about $20 billion in 2019 and an estimated $24.5 billion in 2020, representing a growth rate of almost 15% per year (for context annual growth was about 30% over the last two years). Netflix’s international streaming business has managed excellent entry into more than 190 countries and is likely to follow the expansion playbook the streaming giant has executed so well in the U.S and Canada. Sure, revenue growth could be still higher if the Coronavirus pandemic causes a permanent shift in content consumption patterns and potentially gives Netflix better pricing power, but 2x growth in the top line over the next five years looks quite achievable as a base case.

Combine revenue growth with the fact that Netflix’s margins (net income, or profits after all expenses and taxes, calculated as a percent of revenues) are on an improving trajectory – they grew from roughly 2% in 2015 to over 9% in 2019. Netflix’s larger content-producing peers like Disney have margins around 14% and we see Netflix margins could reach and potentially exceed these levels going forward, doubling to about 18% by 2025. Why is this possible? Netflix has lower costs of customer acquisition and distribution, and fixed costs such as content amortization will be better absorbed as revenues scale-up. So is 4x growth in earnings possible in the next five years? Yes. Looks very reasonable when you combine 2x revenue growth with the 2x growth that’s possible in Netflix’s margins.

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Now if earnings grow 4x, the P/E multiple will shrink to 1/4th its current level, assuming the stock price stays the same. But that’s exactly what Netflix investors are betting will not happen! If earnings expand 4-fold over the next few years, instead of P/E shrinking from around 100x now to about 25x, a scenario where the P/E metric stays at about 45x or even 50x looks more likely. For perspective, the broader entertainment sector traded at a trailing multiple of 48x prior to the Coronavirus crisis and it’s safe to assume that Netflix will trade at least at these levels. [1] This would make a roughly 2x growth in Netflix’s stock price a real possibility in the coming years.

So yes, Netflix could, in fact, be considered to be a good buy right now – with a word of caution. Investors must evaluate Netflix’s cash flows in contrast to earnings.

What about the 5-year time horizon for our scenario? In practice, it won’t really make much difference whether it takes 3 years or 5. As long as Netflix is on this revenue and margins expansion trajectory, the stock price will likely respond in a similar way.

Separately, what if earning margins land at close to 14% or 15% instead of the 18% we estimate? We believe this risk is balanced by the upside to our 15% revenue growth estimate to come in closer to 20% or even higher given that Netflix’s history of execution in international markets resulted in about 30% growth in the last few years.

Is Netflix stock a better buy than software titan Microsoft? Our dashboard Netflix vs. Microsoft: Does The Stock Price Movement Make Sense? has the underlying numbers.

 

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Notes:
  1. PE Ratio by Sector, NYU Stern, January 2020 []