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Netflix just had a blowout earnings report, but that doesn’t make them a great buy

Netflix just had a blowout earnings report, but that doesn’t make them a great buy

On Monday, Netflix, Inc. (NFLX) released their quarterly earnings report, and for the most part, the numbers blew away analyst’s expectations. The report, which was released after the market closed, spurred investors to push the stock more than $22 per share higher in overnight trading, and it closed the day yesterday more than 9.2% higher than it’s Monday closing price. As one of the FANG stocks (Facebook, Amazon, Netflix, and Google) that seems to be driving a majority of the attention about tech stocks in today’s market, Netflix’ blowout report might seem to signal a great opportunity to buy the stock and keep riding the wave, and if you only care about current market sentiment, that could be true. If you’re willing to dig into the data a bit, however you might start singing a different tune.

The Good

If you bought shares of NFLX a year ago, the truth is that you’re feeling mighty good about yourself today. The stock has really been on a tear.

A year ago, the stock closed just a little above $94 per share; as today’s close, the stock had increased in value by more than $240 per share. That’s an increase of more than 250%! The stock’s long-term upward trend actually dates all the way back to late 2012, when the stock began moving higher from a low price just above $11 per share. Long-term investors who had the foresight to start buying at this stage, and still held their shares until now have made their initial investment more than 29 times over!

Along the way, the company has made major strides in re-shaping and redirecting their business. As recently as a decade ago, NFLX’s entire business model focused primarily on DVD rentals; they didn’t begin streaming videos until 2007, and they didn’t begin producing their own content until 2012. They’ve moved aggressively to grow their original content, and in 2016 released more original films and series than any other network or cable channel, which is a principal reason that their CEO disputes their categorization in the Internet & Direct Marketing Retail category. Their focus on delivering more and more original content strongly suggests that they really fit better into the same Media category with major broadcast networks like CBS Broadcasting (CBS), Viacom Inc. (VIAB), and Walt Disney Co. (DIS).

Their ability to reform and reshape their operating model is important, because in an increasingly cloud-driven digital economy, the continued loyalty of their existing customer base, and the ability to grow that base depends on keeping people interested. In that regard, the company is unquestionably delivering in a big way. Compared on a year-over-year basis, NFLX increased their total net subscribers by more than 50%, and more than 1 million higher than their own forecasts suggested at the end of the last quarter. This naturally led to an increase in revenues of more than 40% over the same period, and a 63% boost in net income.

The Bad

If you already own shares in Netflix, you’re probably feeling pretty good about things, and you would be justified in that feeling; after all, at the stock’s current price, the company is now worth nearly as much as Walt Disney Co. Even though that studio is on track to pull its movies from Netflix’ lineup in favor of its own, competing streaming service, the company’s continued emphasis on creating its own original content seems to be paying off in giving subscribers ample reasons to stay engaged.

The problem is that the news isn’t all good. Netflix remains one of the most highly leveraged companies in either the Media or Internet Direct Marketing & Retail categories. They have more than $6.5 billion in debt, and haven’t operated with a positive cash flow since the fourth quarter of 2014. The company reported more than $1.8 billion in cash and liquid equivalents, but that number decreased by more than $200 million over the previous year, as their free cash flow was reported at negative $286.5 million for the quarter; for the year that ended in December 2017, that number was more than negative $1.9 billion, and so it stands to reason that the negative cash flow will be even worse for the twelve months that ended March 31. Furthermore, in this most recent report the CEO made it clear that they expect to continue to operate with negative cash flow for the next several years. Their debt isn’t going to go down, as he also made it clear that they will continue to borrow in order to keep creating original content.

The problem isn’t necessarily that they rely so heavily on debt; in many ways, debt acts as an important tool for businesses in practically every segment of the economy, since it can help facilitate acquisitions and expansion and provide liquidity to cover short-term needs. To me, the remarkable, and ultimately problematic, thing is that the market at large is so willing to overlook the mountains of debt that they continue to accumulate. Instead of applying the same basic fundamental criteria to Netflix that they do to any other company, such as whether or not they are actually making money, the market seems to content to assume that as long as their subscriber base continues to grow, the company’s incredibly high stock price is justified. For now, their subscriber growth looks like it’s doing a good job of keeping the hounds at bay, but you really have to ask how sustainable their current model really is. Operating with negative free cash flow can only continue for so long, since eventually they will run out of cash and liquid assets altogether. Operating on a continued negative cash flow basis puts a ticking clock on their ability to keep the business going no matter how much they keep their subscriber base growing.

The other part that makes the stock hard to justify as a new investment is, in fact its ridiculously high price. At current levels, the stock is trading almost 225 times higher than their earnings per share, and 36 times higher than their Book Value. To put these numbers in perspective, we can compare them to the average for their industry as well as to their historical average.

The average P/E ratio for the industry is 22.5, and the average Price/Book ratio is 4.6. Netflix, on the other hand carries a current P/E ratio of 225 and a Price/Book ratio of 36.27. These are numbers that should give pause to even the most enthusiastic and bullish momentum investor, because they are extremely strong indicators that the stock is extremely overvalued. Using their 5-year average Price/Book ratio doesn’t help improve the picture, either, since that number only 18.7. Their historical P/E ratio is 277 times earnings, which may suggest some continued upside, if you can stomach the idea of trading a stock at such high multiples.

If you follow the idea of buying a stock at a good price (a basic tenet of value investing, favored by people like Warren Buffet, for example), using the industry and historical averages provides an interesting counterpoint. Using the stock’s Book Value of approximately $9.26 per share as a primary point of reference, the industry average suggests that a reasonable, or “fair” value for the stock should be somewhere around $41 per share. That’s a level the stock hasn’t seen since October of 2013. Using the historical average translates to a “fair” value that is quite a bit higher, but still almost 50% below the stock’s current price, of $173.16 per share.

Netflix is succeeding at growing their subscriber base, and in the long-term their strategy of leveraging debt to fuel that growth may pay off. The real problem is that the market is giving them too much credit for the way they’re doing it. The stock could continue to keep going up, of course and drive to entirely new highs. The risk, however, is that the market will realize how overpriced the stock is, and drive it back down to more reasonable, and sustainable valuation levels. I believe that risk is increasing on an exponential basis, which is why new investors should be wary, and existing shareholders should really start to think about locking in their gains while they have them.

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