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Netflix stock has more than tripled, and it's still undervalued

Chris Umiastowski is the growth investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

When I added Netflix to my Strategy Lab portfolio last year, I said it was absurdly cheap considering the company's dominant position in an important new market. The market has agreed, and the shares, which at the time were trading about $58 (U.S.), have now shot above $215.

So time to sell? I think not.

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Most Internet users still don't pay for Netflix. Over the next 10 years, its audience will expand enormously, in large part because the company is enriching the value of its offering with original programming. There is a lot of growth left in this story.

To be sure, Netflix is trading for more than 300 times its trailing earnings – a sky-high valuation by any standard. But it's also growing like a weed and developing a selling proposition that is hard for any consumer to turn down.

As most people are now aware, the company's core offering is an Internet streaming service that can deliver a huge variety of content to your computer screen. Sign up and you have unlimited access to a library of thousands of movies and TV shows for only $7.99 a month.

Now, the deal is getting even better. On Feb. 1, the company released an original series called House of Cards starring Kevin Spacey. The show is fantastic – but you have to be a Netflix subscriber to watch it.

Original programming like this has the potential to attract millions of new viewers. The pay-TV channel HBO has already demonstrated that there is a big audience of people who are willing to pay for smart, cutting-edge shows. Netflix wants to tap into that same market.

And the Internet streaming service has a fundamentally better business model than HBO, which must depend on cable-TV companies to carry its offering. The typical U.S. TV viewer pays $15 a month on his cable bill to access HBO; a big chunk of that monthly fee goes to the cable carrier.

In contrast, Netflix doesn't have to pay a cable company to handle distribution and billing because it has direct access to consumers through its own streaming technology. So Netflix can do very well for itself while charging far less than HBO.

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Analysts keep asking Netflix if it will raise the $7.99 price. The reply is always the same. "We're very happy with our pricing."

Consumers seem happy, too. The company has attracted over 36 million streaming customers, more than 7 million of them outside of the United States. During the most recent quarter, its international base of paying customers grew 163 per cent from a year earlier.

I think the numbers will keep growing at a fast clip as Netflix adds more and more original content. Reed Hastings, CEO of Netflix, has said he wants to produce at least five original series a year.

Is that a realistic ambition? House of Cards cost $100-million for two seasons, or $50-million per season. Assuming similar costs, five original series per year would blast a $250-million-a-year hole in Netflix's budget.

The number sounds huge – until you look at how much money Netflix is pulling in. A key metric is its contribution margin, defined as revenue minus cost of goods sold and marketing expenses. Contribution margin, as a percentage, tells us how much of every additional dollar of revenue can go towards paying for things like original programming.

Netflix's U.S. streaming business is pulling in a contribution margin of $113-million per quarter, almost double last year's figure. Its much newer international streaming business is still losing money as measured by contribution margin, but the losses are narrowing fast.

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Assuming growth continues at anywhere close to the current frantic pace, which has seen revenue double over the past three years, Netflix should be able to shoulder the cost of developing original programming, which will, in turn, help attract even more subscribers.

The company has already proven there's a huge market for delivering entertainment through Internet streaming. HBO has already demonstrated that original programming can draw subscribers. Putting the two models together is a no-brainer.

Which is why I believe Netflix is set to continue to grow at double-digit rates for several years to come. It's not as cheap a stock as it was back in September, but I still see a lot of value in it.

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About the Author

Chris Umiastowski, P. Eng., MBA, has over a decade of professional experience analyzing technology stocks as a former top ranked equity analyst on Bay Street. Prior to that, he worked as an engineer in the telecom industry. His deep technology and analytical experience help him identify investment opportunities that come from sweeping change in tech-centric industries. More

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