Is Netflix, Inc. (NFLX)’s Growth Built on A House of Cards?

Netflix, Inc. (NASDAQ:NFLX) came up with a new form of TV programming as it released the highly anticipated show named “House of Cards.” All thirteen episodes of this show became available directly on Netflix’s website. If this show will be profitable, it could mark another shift in content business. This series’ name brings to mind the recent spike in Netflix’s stock. Was it based on a fundamental improvement? Is the company’s business model of pay-per-content sustainable over advertising?

Since the beginning of the year, shares of Netflix soared by nearly 92%. This rally led the company’s P/E to spike to 614. This sharp rise was explained by analysts to be related to two main factors: 1. the much better than anticipated fourth quarter earnings report of the company; 2. the speculation that Netflix will take the place of Dell in the Nasdaq-100 index. These reasons might have some merit to pull up the company’s stock but is this spike in the stock price demonstrates an irrational exuberance behavior by investors and traders?

Netflix, Inc. (NASDAQ:NFLX)The company’s revenues grew by nearly 8% in the last quarter and by 12.6% during 2012. These numbers, stand alone, aren’t staggering and are well below the growth in revenues of other leading companies that provide, among other services and products, paid content. Apple Inc. (NASDAQ:AAPL) is another player in the paid content industry with its iTunes service that reached revenues of $3,687 million in the first quarter of the fiscal year of 2013. This represented a growth in revenues of 22%. This means, Apple’s growth in its content related sales was much higher than the growth in revenues of Netflix in the last quarter. Therefore, if you believe the direction of paid content is sustainable, then Apple is showing much more promise in terms of growth than Netflix does.

The second issue worth considering is the very low profit margin of Netflix. The profit margins on paid content (e.g. music, books, movies etc.) aren’t likely to be high. During 2012, the operating profitability of Netflix declined to 1%. In comparison, in 2011 the profitability of the company was 12%. Other companies that sell content such as Amazon.com, Inc. (NASDAQ:AMZN) also have low profitability that continues to fall: in 2012 the operating profitability of the company was 1.1%. In 2011, it was 1.8%. But the revenues growth of Amazon was much higher than Netflix’s at 27% in 2012. If the profitability of Netflix will remain around the 1% to 2% range, which is the same range as Amazon, perhaps it’s worth considering Amazon that has a much higher growth rate than Netflix and its basic business model is in the same neighborhood.

The battle between these two types of business models has been going on for a long time and it’s still unclear which model will prevail. Perhaps there will never be one model that will be inferior to the other.  Nonetheless, it’s worth considering a company that integrates both business models such as Comcast Corporation (NASDAQ:CMCSA) that has subscribers to its content and also sells advertising via its national TV channels. The company’s revenues grew in the third quarter by 15.4% and its profit margin was at 18.4%. This company has a higher profit margin and higher growth rate than Netflix and again it manages to integrate both types of business models.

I understand that the higher than expected growth in revenues of Netflix along with the speculation around its entrance to the Nasdaq-100 index are among the reasons for the spike in shares of Netflix; but when considering the fundamentals, the company isn’t showing a higher growth in revenues than its competitors, it has a very low profit margin and its business model is mostly based on paid content, which might not hold out in the long run. I think there are much more compelling companies that could keep you in the content business and won’t be so expensive.

For further Reading:

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The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.

The article Is Netflix’s Growth Built on A House of Cards? originally appeared on Fool.com and is written by Lior Cohen.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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