Netflix stock is currently trading at high valuation multiples warranting a cautious investment approach.
Over the last one year, the FAANG group of stocks continued to garner market's undivided attention with their highly abnormal returns and sky-high valuations. Netflix Inc (NASDAQ:NFLX) stock has even outperformed its other peers in the FAANG group over the past year. Shares of the streaming giant got a major boost after the first quarter earnings. The bullish narrative around the company has sent Netflix stock up by over 70% this year. However, as usually what happens with most of the rapidly gaining tech stocks, there are concerns about the company's valuation.
Source: Netflix stock price chart by amigobulls.com
Streaming video is "going mainstream."
For investors, the most important number in Netflix's earnings is the subscriber growth. The company has been trying to gather investors attention towards other metrics such as operating profit but without much success. Investors continue to live and die by the company's net subscriber addition. And over the past couple of quarters, Netflix has managed to report better than expected subscriber growth causing investors to push the stock price northward. In the previous quarter, total subscriber addition was 7.41M, against 6.32M consensus estimate. The figures were higher both in international and domestic markets.
With more and more consumers cutting the cord and joining the streaming world, the subscriber numbers will continue to grow. The video streaming penetration rate is low, even in the advanced economies. Even in the U.S where the video streaming industry is reaching maturity level, there is still scope for growth as demonstrated by Netflix in the previous quarter. According to a Deloitte survey, 55% of U.S households now subscribe to at least one video streaming service. U.S. consumers collectively spent $2.1 billion per month on SVOD (streaming video on demand) services in 2017. This gives an indication of the size of the market. The advent of 5G and better programming content will continue to drive up subscriber numbers in the U.S and around the world.
Original programming is the key.
There are over hundred video streaming services in the U.S alone, vying for a share of streaming market. This makes Netflix's job that much more difficult. The streaming service industry can be divided into two groups, services that are just broadcasting normal TV over the Web and companies which are investing in original content. The later group which includes Netflix and Amazon Prime is pulling ahead of the competition. According to Nielsen, hit originals on SVOD streaming services, such as Netflix’ House of Cards and Orange is the New Black, achieve ratings comparable to the most popular series on HBO and Showtime, such as Game of Thrones. And they are increasingly becoming the key determining factor in the subscription decision. This is an even bigger factor for Netflix. Over 42% of Netflix subscribers cite original content as the reason they pay for online video subscription.
This is the reason why both Netflix and Amazon are spending billions of dollars on original programming content. In the previous year, Netflix spent $6.3 billion on content and Amazon spent around $4.5 billion while traditional media giant Walt Disney (NYSE:DIS) spent $7.8 billion. A large chunk of Netflix's and Amazon's content spending went towards original programming. This year, Netflix is expected to spend $8 billion while Amazon is likely to spend around $5 billion on content. Continued migration towards online streaming and original programming will keep Netflix's subscriber addition growing.
High capital spending and debt burden.
While high content spending is giving Netflix an edge over its competitors, it is also driving up its financial leverage. The streaming giant is raking up huge content bills but is not able to produce enough cash to cover those bills. The company's operating cash flow in 2017 was negative $1.7 billion. To meet its cash requirements, the company has been approaching the capital markets on a regular basis.
For most parts, it has raised money through debt offerings. Last year alone, the company raised over $3 billion from debt sale. This has pushed Netflix's leverage very high. In the last five years, Netflix's debt-equity ratio has almost doubled from 0.83x to 1.62x. And going by the company's investment plans, Netflix will continue to need billions of dollars in cash. There are two ways in which the streaming giant could meet its cash requirements, internal cash flows and capital raise. Netflix management has famously said that profitability is not its immediate concern. Which means that the company will be slow to raise the subscription rate. As a result, the company will continue to rely on debt for financing its investments.
Netflix has already announced $1.5 billion debt plan for this year. Given the rising interest rates, continued reliance on debt could prove costly. Also, high debt level in long-term is unsustainable. Investors should keep an eye on the company's leverage which could prove costly if growth takes a hit. Given its stock price, Netflix would do better to take the equity approach right now.
Netflix stock valuation warrants caution.
In addition to the balance sheet risk, Investors must also be cautious about the company's valuation. Netflix stock is trading at stratospheric levels. Netflix's trailing twelve months PE is around 262x, meaning that if at the current level of earnings it will take you 262 years to get back your investment in the stock. Of course, the expectation is that Netflix's earnings will not remain at the same level but see a rapid growth. This growth will be driven by revenue growth as well as improvement in margins. In the first quarter, Netflix reported 40% YoY revenue growth, one of its best performance in the recent decade. This clearly indicates that the company still has the ability to grow at a rapid pace.
It is not just revenues. Previous quarter's operating margin and return on equity numbers were best in the last five years. This points towards improving financial and operating positions of the company. Netflix also has high ability raise its subscription prices, given the popularity of its content and relative inexpensiveness of its subscription rate when compared to the cable bill. However, despite the strong operational and financial outlook, investors must be cautious while investing in Netflix stock. Most of the good news is already baked into the stock price.
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