Ultimately the value of a stock depends on all the future profits of the underlying company. When a stock trades at a high P/E ratio this means that the market expects earnings to rise rapidly in the coming years. Sometimes, however, this gets out of hand. Expectations become so inflated that people stop considering whether or not their estimates are even possible. Netflix, Inc. (NASDAQ:NFLX) is a good example of this phenomenon.
Netflix, Inc. (NFLX) used to be a DVD mail-rental company, and in that market it was dominant. The company had both a distribution network and a DVD catalog that went unrivaled. But the world is moving away from physical media and towards digital distribution, so Netflix began expanding its streaming service. I became a Netflix subscriber back when the streaming service was nothing more than a handful of terrible movies no one had ever heard of, and I’ve remained a subscriber to this day. But just because you like the product does not mean that you should automatically like the company. It’s easy to form a bias in favor of a company simply because you use its products. What matters from an investment perspective, though, is the profitability of the company.
The business model
Netflix has a recurring revenue business model, where customers pay regular monthly fees to access the service. This is good for the company because it creates a reasonably predictable revenue stream. Netflix, Inc. (NFLX) currently has about 33 million worldwide subscribers, and based on the $3.6 billion in revenue for 2012, this comes out to about $9 per subscriber per month on average.
The most profitable part of Netflix’s business is actually the DVD mail-rental portion, which has now entered a continual decline. Domestic streaming is profitable but with far lower margins, while international streaming operates with a comparably sized loss.
In 2012 Netflix, Inc. (NFLX) recorded EPS of $0.29, down from $4.16 the year before. The international segment is the culprit here, as the company is spending heavily to expand its presence worldwide. Free cash flow was $-1.14 per share in 2012, down from $3.39 per share in 2011. Revenue rose 12.6% to $3.6 billion.
A common argument in favor of Netflix is that the company is spending a lot of money on expanding and eventually will become very profitable. It is spending a lot on expansion, but is there any real reason to believe that massive profits will follow?
Netflix, Inc. (NFLX) streams content owned by others, meaning that the company must license that content. These licensing deals have gotten expensive as Netflix has grown, and the company recently announced plans of a debt sale to finance these deals. The streaming industy has become more competitive, with Amazon.com, Inc. (NASDAQ:AMZN) building its video service, scoring exclusive deals for shows such as the popular British drama “Downton Abbey.” Amazon.com, Inc. (NASDAQ:AMZN) offers the Amazon Prime service for $79 per year, which includes streaming of content as well as free two-day shipping.
Another competitor is Verizon Communications Inc. (NYSE:VZ), which has partnered with Redbox to launch a streaming service very similar to that of Netflix. The service cost $8 per month, comparable to the cost of Netflix, but also includes 4 free rentals at Redbox kiosks. This offers a compelling value, as the kiosks have many newly-released movies that streaming services typically don’t offer right away.