Netflix: a great company (but not at this price)

Share

Netflix Inc. has a lot of things going for it, but a sensible stock price isn't one of them.

Just ask the company's chief executive, Reed Hastings, who attributed the stunning move in the share price so far this year to "momentum-investor-fuelled euphoria."

Most executives like to talk-up their stocks as undervalued investments worth betting on – so talking-down a stock is not only unusual, but probably a good indication that something isn't quite right here.

For sure, there's no disputing the shares have had a great run: Netflix is the second-best performer in the S&P 500 this year, with a gain of 248 per cent.

The company has also emerged as a seriously disruptive force in how we view movies and television shows. From its roots as a mail-order DVD-rental company, it now delivers online streaming of shows – from Breaking Bad to original content such as House of Cards – offering a compelling reason to unplug cable television and cut your viewing bill to just $7.99 a month.

People are now doing this in droves. The number of subscribers worldwide has grown to 40 million, and it isn't hard to envisage that number growing substantially as more consumers see the advantages of online streaming.

But how many additional subscribers would Netflix need to justify the current level of its share price? Probably more than it will ever have.

The shares trade at a remarkable 190 times estimated earnings, according to Bloomberg, implying that those estimates would have to rise tenfold just to get the stock's valuation in line with, say, Google Inc. – which itself isn't exactly a bargain stock.

In the third quarter, Netflix generated net earnings of about $32-million (U.S.) or less than $1 per subscriber. Agreed, earnings can grow exponentially with additional subscribers, since many costs are fixed.

Still, it isn't clear where the deluge in earnings is going to come from. Netflix sees the U.S. market rising as high as 90 million subscribers, or just three times the current level. That's a best-case scenario, and it could take a while: Subscriber growth was just 4.3 per cent in the third quarter, and that includes freebie trial subscriptions.

There is considerably more potential outside the United States. But with just 9.2 million subscribers, it isn't clear that Netflix has gained much traction in these markets yet. The company estimates overseas subscriptions will rise to 10.5 million in the fourth quarter, which is hardly runaway growth.

At the same time, growth comes with costs. Owning and developing content is a big part of Netflix's strategy for becoming a must-have service that consumers will want to pay for continuously. To pay for this content, Mr. Hastings has warned that Netflix may have to raise money, potentially diluting existing shareholders if the money is raised through a share offering.

It is tempting to dismiss these issues because of Netflix's impressive share price performance. If the shares are going up, then some investors must be able to see opportunity through that ridiculously high P/E ratio.

But keep in mind that Netflix has been here before, and the followup hasn't been pretty. In 2003, the shares rose sevenfold, and then fell 75 per cent within a year. More recently, the shares fell 80 per cent between mid-2011 and the end of 2012.

This, then, is a stock given to fits of euphoria and howls of disapproval, making it a painful investment for anyone who has a difficult time recognizing one state from the other.

The chief executive of Netflix has helped out this time with his thoughts on valuation – and they were enough to send the share price sliding about 17 per cent from its intraday high on Tuesday, as momentum investors turned skittish and moved on.

Consider it a warning: Just as momentum drove Netflix higher over the past year, it now looks set to weigh on the share price. Based on valuation, the downside could be nasty.