Netflix Analysis

After yesterday (11/22)’s news that Netflix is introducing streaming service in US for $8/month I feel the need to study the stock more carefully. It’s supposed to be priced in already but the stock still soar up 8%. I think Netflix is such a good example that valuation sometimes really doesn’t matter. It has PE around 70 now after a great run since latest earning release. Till last quarter (9/30/2010) Netflix has 16.9 million subscribers! 

(collected from quarterly and annual statements)

In the above graph you can see the total subscriber of Netflix is increasing pretty much linearly over the past six quarters: ~ 1.3 Million per quarter. These are the people stick with Netflix so far. If you look at the gross subscription addition graph you can see the fresh addition subscription is ~3.1 Million every quarter.  And the trend is up. In the same graph you can see the acquisition cost per subscriber is trending down which is mainly due to the increasing subscriber number and relative stable marketing expense. With this high level of subscription, the churn rate is stable: around 4% and paid subscriber is around 94% (however, it is showing downward trend. Not a big deal as you see the growth of gross subscriber addition and decrease of acquisition cost.) R&D spending is also quite stable: ~7.3% of revenue. What is concerning is the average revenue per subscriber per month. It is obviously showing a downward trend. The main reason for that is the increase of “low end” subscription and decrease of “high end” subscription. Product mix shift will continue as Netflix introduces the streaming services. On the other hand, it can be compensated by lower cost since Netflix will eventually eliminate the DVD mailing service which is more costly than online streaming.

How about Netflix’s financial health in our ratios’ term? It definitely has sound financial ratios. I list the quarterly ratios and some of yearly data for your reference. You should be able to see most of the lines are showing upward trend.

Now let’s take a look at Netflix’s historical earnings and stock prices. Interestingly enough, as EPS increases linearly its stock price is exploding exponentially. This surely demonstrates the enthusiasm of investors. Can the price be justified? I don’t think so. But again, valuation doesn’t matter here. I think investors for Netflix are focusing on subscribers and some relevant cost only.

I’d like to do a little reality check here. US has population of 310.7 Million and average number people per household is about 4~5. So let’s use 4.5 people per household then I estimate there are 69 million households in US. Let’s say with Netflix’s super first-mover advantage it can have a market share of 80% (like IntelJ), which gives us 55 million. Netflix already has 17 million so there are only 38 million left. If Netflix is adding 1.3 million subscribers per quarter it will take Netflix 29 quarters, ~7 years to have all these customers. In the meantime, average monthly revenue per customer will decrease gradually due to the product mix shifting to low price service and intense competitions from Hulu, Apple, Google, and Amazon. It may eventually just have one price for all services to compete. Going a little extreme here, if the price is about $8 per month per subscriber, the total revenue for Netflix in 7 years will be 55 million * 8*12=5.28 billion. Only about three times what it has now (1.67 billion). Well, if Netflix is really doing well and keeps current $12 level. The revenue in 7 years will be 7.9 billion. Assuming profit margin stays around 7% then the earnings is about 7.9*7%=553 million (five times 2009 earnings). To simplify my estimation, from there I will say Netflix will be a large cap with steady cash flow but not much growth and it will give out all the earnings as dividend to investors ( using current number: 55 million). So at that point (7 years later), the stock price should be (553/55)/7% (discount rate: simple WACC calculation): ~$143. This is the price after 7 years within this 7 years you can still discount some earnings to the present day plus the discounted value of the year 7 price. However you do it I couldn't get around $190.

Of course, we all know that Netflix just initiated streaming service in Canada. International expansion can be the further growth catalyst. But it’s hard for me to imagine Netflix can go to other countries and expect to gain main market share easily. In addition, as internet distribution of TV/movie contents become more and more popular the competition is gonna be brutal. Not only distributors like Amazon, walmart, Apple, and Google will try harder, the content providers have to figure out way to make more money through more channels. The key competitive advantage for Netflix is the broad contents and first mover advantage. How long will those last is a question. For example, if Apple is going with subscription model and push for collaborations with content providers, it could potentially beat up Netflix and Hulu easily as it has popular iphone/ipad platform to get people use Itunes. Or if internet TV such as Google TV catchs up main stream and they can provide easy delivery of contents and Netflix may not be the best choice any more. (I do think this will take a while)

Again, all above are just my own current opinion. Netflix might transform into other sort of media firms which can justify its stock price before its growth slows down. I don’t know but I’ll keep close eye on it since Netflix is such an interesting growth stock.

I'll conclude with analysts opinion stats and let's see how high the market can take Netflix to.