Netflix (NFLX) is underappreciated using conventional valuation measures such as P/E or EV/EBITDA as the company operates near financial break-even in order to more aggressively grow its brand. Often those inexperienced in understanding valuation measures will cite the high earnings multiples as justification that the stock is overvalued and thus a justifiable short. My intent is to show how much long run earnings power Netflix’s current user base represents given Netflix has the ability to substantially raise prices from the current level. How much they are able to raise the price is outside of the scope of this analysis. I will simple remind readers that HBO currently costs subscribers between $15 and $20/month, and the highest price scenario in my analysis is $3/month higher than current rates, or $10.99/month.
In the real world of difficult to value growth companies, the market assigns this company a value based on a terminal scenario of where it judges earning power. The Netflix of today is very different than the high flier of several years ago, the last time it was at these seemingly nose-bleed price levels. The user base is much more massive, ending the 2013 year with 31.7 million US streaming users. Growth is still substantial. The product offering is nothing like the Netflix of a few years ago – shows such as House of Cards and Orange is the New Black make today’s Netflix more directly comparable to HBO than ever before. The impact of Netflix’s aggressive children’s line-up along with exclusive Disney offerings in the future is underestimated. Anecdotally, when my 5 year old son says ‘I love Netflix’ when getting ready to watch whatever cartoon he prefers, I realize Netflix is not just an earnings engine – it is a brand here to stay because it is a habit of a new generation of future consumers. Netflix won the spoils as a first mover in streaming, and is successful now because it has executed and proven itself as able to develop its content offerings to make it a lasting and formidable media player.
Granted, headwinds exist – lack of net neutrality and bargaining power threaten to increase their cost structure. Other streamers will of course try to chip away at their platform advantage – Amazon prime amongst them. But the new paradigm of television watching is one where we pay for several streamers and ditch the cable networks of the past. If Apple makes in-roads in its rumored arrangement with Comcast, the endgame is not necessarily one where media buyers ditch Netflix for Apple. The endgame and new media consumption paradigm is one where individuals subscribe to several streaming services to avail themselves of content they want, perhaps leaving more conventional sources of television media such as cable and satellite.
Shifting focus back to the original premise of this piece, it is underappreciated how significant an earnings power Netflix already has. At $7.99/month for streaming services, I joke with friends they could charge $15/month and I’d be pressed to ditch the service. While I can respect many other consumers are much more price sensitive, I believe demand is somewhat inelastic at the current price offering, and thus Netflix has significant wiggle room to adjust prices without meaningfully denting growth prospects. It is my intention to just present several price increase scenarios to reflect how much value Netflix’s current user base represents. The model will be oversimplified, based on the following assumptions for 3 price increase scenarios: ~15% paid streaming user base growth over 2013, an expectation of 15% increase of cost of revenues for 2013, a 10% increase year over year of T&D, G&A, and Marketing costs, a breakeven for the international business, and a 10% decline in the DVD business contribution margin.
Let me note: The purpose of this analysis is merely to demonstrate the stock isn’t as expensive as it may seem. This is not a multi-period model and minimal effort was put into the creation of forecast assumptions. While the quality of these forecast assumptions leaves room for improvement, I do attempt to factor in some of the current narrative we’ve already heard. For wherever I may be overly optimistic, it should be balanced by the fact that I am assigning no value to the international streaming business (which is overly pessimistic). It should be remembered this forward view is meant merely to show the enormous operating earnings leverage to subscription rates that Netflix’s common equity represents.
The bottom line: in a world where Facebook’s exuberant spend of $19 billion doesn’t result in its common equity falling in half, I hardly see Netflix’s $22 billion market cap trading at a forward PE of 20 ($9.99/month pricing) as a screaming short, especially considering such a valuation assigns zero value to its international streaming business. At $9.99/month versus $15 minimum for HBO, I see this as an attainable revenue point. If the market is willing to put a 30 multiple on a tech company such as Google with questionable upside to growth potential (just restricted by their size alone), I see no reason why Netflix won’t be able to reach above $560 levels and still justifiably not be worthy of being called a ‘bubble’. This business isn’t going anywhere, and its risk premium will reflect this over time.
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