Why Netflix Is Still Undervalued Feb. 19, 2018 1:35 PM ET 34 comments About: Netflix, Inc. (NFLX), Includes: DIS Ziyadd Manie, CFA Summary Netflix s first mover advantage in an industry with structural tailwinds has created a huge moat. The company continues to supply high quality original content, bringing in new subscribers in their droves. The pricing point is too low to compel subscribers to cancel, meaning churn will be virtually non-existent going forward. I can plausibly (and arguably conservatively) foresee a scenario where Netflix has grown to over 400m subscribers, with a corresponding market capitalization of over $300bn, within the next 10 years. Introduction When I first started seriously evaluating Netflix (NFLX) as a potential growth stock for my portfolio, it was already trading at over $100 per share. I thought to myself that the company was surely a hype stock that had appreciated well beyond its intrinsic value, after conducting a cursory review of typical earnings multiples, the strength of the balance sheet (or lack thereof) and its negative quarterly cash flow generation.
Being someone who does not watch a great deal of television series, I saw the value proposition as relatively limited and susceptible to unfavourable negotiating power with their content providers, and therefore did not do too much further due diligence. I decided that on balance, given the seemingly aggressive valuation multiple, Netflix was not worth the risk and had been priced for perfection. If only I had invested a bit more time... and some money. Experiencing The Product It would take over a year for me to finally subscribe for a Netflix account, given that just about the only TV series I had really watched between 2010 and 2017 was Game of Thrones, and Netflix did not even offer it. At $9.99, with the added benefit of a one-month free trial, there was really very little to lose. Further, it was incredibly easy to set up an account. To get started, I did a simple Google search of Best TV series 2017 and came across Netflix s highly rated and critically acclaimed original content show Stranger Things. Now, I do not want to bore the reader, so I will cut to the chase and say that between my wife and I, we believe we have received exceptional value for money, and therefore will likely never cancel our Netflix account. The company has invested heavily in original content, which greatly reduces its reliance on Disney (DIS) licensed shows like Daredevil, Jessica Jones, the
Defenders etc., which will ultimately be unavailable on Netflix from next year. Netflix has also shown a wonderful ability to supply a constant stream of interesting new TV series content, as well as movies like Bright and Annihilation, which creates a cycle of positive reviews. Although Netflix now spends over $1.2bn per annum on marketing, these positive word-of-mouth reviews are ultimately the best form of marketing, and have likely contributed to the accelerating subscriber growth investors have seen in recent quarters. Source: Telegraph So What Does This Mean? The above makes me strongly believe four key positive points, which is backed up by Netflix s quarterly financial reports (Investor Relations Netflix, Inc.).
1 Netflix has created an excellent brand that is easy to use, enticingly cheap and widely available even outside of the US. This has led to robust subscriber growth and dominant market share with over ~117m subscribers as of Q4 2017. 2 The subscriber growth has created a positive cycle where an increasingly large portion of the overall population is talking about Netflix and advocating its high quality original content, which only fuels growth further. This means that Netflix's subscriber growth continues to accelerate, even as revenues now exceed $11bn. 3 Importantly, users who do not consume a great deal of Netflix s content feel that there is very little money to save by cancelling given the low monthly cost. This means there is very little churn in Netflix subscription numbers. 4 The seemingly never-ending supply of content means that Netflix will, over time, have less dependency on third party content providers, thus improving their negotiating power. This means Netflix will be able to control costs better over time, and benefit from economies of scale to achieve robust free cash flow generation.
Major Risks Netflix will experience increasing competition in the space from next year given Disney s stated intention to compete more aggressively in the video streaming industry. Disney is a formidable competitor with a highquality library of content. This is likely to be even more of a concern for Netflix with the addition of 21 st Century Fox s entertainment and sports assets. However, I also expect Netflix to be approaching 150m subscribers by the time Disney suspends its relationship with Netflix in favour of its own streaming services (Hulu, or a new Disney only streaming service). This is a huge gap to close. My sense is that Netflix will continue to be must-have with one of Disney s streaming services, Amazon (NASDAQ:AMZN) Video or another service being a second add-on option for the average household. The pricing points remain low, so it could just be that increasingly more chords are cuts rather than any Netflix accounts being cancelled. I consider the financial risks associated with Netflix's increasing debt load (and negative cash flow generation) to be manageable for now and likely to be a non-issue provided Netflix continues to deliver subscriber growth (which would over time translate into robust positive free cash flow). Further, I would regard the risk of Netflix being unable to place debt in the market at next to nil, especially with the enormous implied equity buffer. As a worst case, they could place equity in the market for ~R5bn (maybe at a slight discount), which would be less
than 5% of Netflix's existing market capitalisation, to improve the strength of the balance sheet. Both of these risks are also mitigated by the outstanding management team at the helm of Netflix, whom I deem to be amongst the best in the market. Netflix In 10 Years Time I have been told on previous articles that forecasting 10 years out is an exercise in futility. However, not doing so originally with Netflix, I was effectively ignorant to the stunning potential profits (and future cash flows) of Netflix. It is difficult to look past P/E ratios as it is regarded as a quick-and-easy method to try to establish whether a company is well-priced (from an investing perspective). The problem is that it inherently disregards future profit potential, which can only really be gauged by making a reasonable attempt at forecasting growth. Based on what I believe to be plausible projections, I have forecast Netflix to grow subscribers at an average CAGR of ~13.2% to 406m users by the end of 2027 (i.e. an average of 29m new subscribers per year). Due to moderate price increases linked to inflation, this would be coupled with an average monthly subscriber fee of close to $15 (or $180 per annum) at the time (2027). Further, I expect net profit margins to improve to about ~19.0% by 2027, assuming gross margins of about 40%, due to the benefits of economies of scale and there being no material variable cost assigned to new subscribers
outside of costs of revenue. I expect this margin to remain relatively consistent thereafter, if not upwardbiased. The below demonstrates these forecasts on the income statement. Figure 1 This compares to the following analysis consensus projections on Nasdaq: Figure 2
In the medium term, I do not expect Netflix to be generating sufficient cash flow, and will in fact likely need to keep raising debt in the next 3-5 years to finance their substantial investment into a mix of original and licensed content. However, by 2024 will begin de-gearing rapidly and repurchasing an increasingly higher number of shares to improve earnings per share metrics. Figure 3 Looking at the financials of Netflix in 2027 under these high-level assumptions, this would equate to the following salient terms in 10 years time: ~$67.6bn of revenue for the company
~$27.1bn gross profit ~$12.8bn of PAT ~$58.5bn of content assets ~$17.2bn of net cash Given the strong free cash generation that the company would achieve at the time, the annuity nature of the income and dominant market position of the service in a structurally attractive industry, I believe that Netflix would be valued at anywhere between a 20x to 30x P/E ratio. For purposes of my analysis, I will assume 25x. This would mean a market cap of ~$322bn, or a share price of $735 per share. For those investing at the current share price, it would achieve a ~10.2% base case IRR, which I deem healthy given my expectations for the broader market to grow at between 5-7% and especially factoring in the exceptional rally in Netflix s share price in the last 18 months. However, it is not as attractive an investment as Facebook (FB) in my opinion. Out of the FANG stocks, I believe Facebook is the most attractive (risk-adjusted) investment in the current market. Conclusion Although Netflix s share price has continued to rise to dizzying heights, shareholders can still expect a solid return over the next 10 years based on what I deem to
be reasonable financial forecasts. Any company whose share price has increased almost 100% in the preceding 12 months would be considered potentially overvalued. I still (however) think that Netflix is undervalued. Having said that, I typically look for about 12% base case IRRs before making an investment, and thus would look to open a position in Netflix around $235-$240 per share. Selfishly, I really hope it drops to that level again soon, but I would be surprised if it did especially after the incredibly strong Q4 results. I may just end up buying at wherever the share price is at the time I have adequate new money to invest. Trying to time an entry point into a high-quality business run by strong management teams in an attractive industry has seldom been a winning strategy. Therefore, I will be following Netflix closely over the next few months, praying that Netflix is a victim of a broader market sell-off so I can get an opportunity to share in the terrific growth trajectory of the market-leading video streaming company in the world.