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Is This Entertainment Giant Worth Following?

Organizing your schedule to stick to your favorite TV show, or watch the movie of your preference, is a thing of the past. Netflix Inc. (NFLX) changed  the way people relate to home entertainment,  putting all contents handy for viewers to choose where, when and what to watch. This revolutionary step proved to be a hit, and Netflix subscribers have been growing steadily ever since the firm entered the market. Today, new expansion projects are underway, in an attempt to conquer new markets. However, a significant rise in operating costs, and stiff competition in the domestic market from Google Inc. (GOOG)Amazon Inc. (AMZN)Apple Inc. (AAPL) and other local providers outside the U.S. may make this giant stumble.

A Risky Expansion Seeking Ambitious Results

The slow rollout of Internet TV from traditional TV providers in the U.S., allowed Netflix to become the leader in the business. The firm added 5.99 million domestic users, and 4.88 million new subscribers over the last 12 months. And, sustained growth is expected in the paid subscriber base of the streaming segment, which represents the main source of revenue for the company. In order to keep subscribers from moving to its competitors' field, Netflix needs to diversify its content further. To this aim, the company has signed licensing agreements with various Hollywood production houses and content providers such as DreamWorks Animation Inc. (DWA)Walt Disney Co. (DISand AMC Entertainment Holdings (AMC). This allowed  the company to expand its programming portfolio to new genres, capturing a wider range of viewers.

The company has also ventured into original programming, like the successful comedy show Orange Is the New Black, winner of the People´s Choice Award in 2013. This strategic move adds to its international expansion plan, which intends to target Canada, Latin America, the Caribbean, UK and Ireland. Netflix also launched its streaming services in the Netherlands and is planning to enter several European countries in the short term. Moreover, Netflix´s applications for Apple and Android with HD video and AirPlay Streaming, offer subscribers more device options for streaming.

Of course, such a move represents a significant investment. The increments in marketing costs and investments in technology necessary to capture new markets, increased Netflix’s operating cost by 11.1%, on a year-over-year basis during the first nine months of fiscal 2013. And, its international operations (still in the investment phase) continue to report losses, due to the need for investments in content licensing. There is also concern regarding the loss of net neutrality, which allows Internet service providers to charge more for the great amount of bandwidth the company uses. Nevertheless, this is seems to be an unlikely scenario, given the bad publicity providers would get from pushing Netflix.

Not the Right Time for Entry

No doubt Netflix is a great company that is making huge earnings and has very tempting growth projections. However, rising costs and growing competition are variables that need to be carefully looked at. Thus, although earnings keep growing (beating revenue estimates by $10 million) and the number of U.S. subscribers grew by 14% year over year, the company´s potential to continue generating profits is uncertain. In the long term, cost management will play a significant role in the firm’s continued success.

Current numbers show a trailing price to earnings ratio of 322.6, compared to the industry average of 44.1. With a price of $402 per share, this means the stock is far too expensive. An earnings yield of 0.7 compared to an industry median of 7.40, as well as a poor return on equity, that measures poorly relative to industry peers, backing up my feeling that investing in Netflix is not a good idea right now. In fact, investment guru John Griffin (Trades, Portfolio) reduced his shares by 56.6% recently, in accordance with my bearish feeling regarding the firm. The future might be bright for Netflix, yet entry at this point does not seem wise.

Disclosure: Vanina Egea holds no position in any stocks mentioned.

About the author:

Vanina Egea
A fundamental analyst at Lone Tree Analytics

Visit Vanina Egea's Website


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