Netflix (NFLX, Financial) appears to be expensively priced when looking at the key valuation multiples like the P/E and P/S ratios compared to industry averages. However, its stock price continues to rise. This indicates a contradicting view from investors. So what are they looking at?
It looks as if investors are fully convinced that Netflix's growth level compared to its potential is still in its infancy, which means that there is more upside to come in the near future. Investors are looking at the company's newly added revenue sources (following the geographical expansion) alongside key improvements in Europe and North America.
According to recent surveys in the U.S., subscribers also appear to be less concerned about the recent subscription price increments, and they are willing to continue with the company while its content choice continues to improve.
Netflix specializes in the provision of TV and film streaming services across the world. The company started as a DVD-by-mail service in 1998, and it began streaming via web platforms in 2007. Currently, Netflix’s streaming service can be accessed via web platforms, smartphones and tablets in 190 countries. In April, Netflix reported more than 81 million subscribers worldwide, including over 46 million in the U.S.
Netflix shares initially plunged as much as 15% from $111 per share to about $94 per share after releasing first quarter results in April. However, the stock has since regained some ground to trade at about $98.
The initial decline was triggered by Netflix’s announcement that it expected to add just 2 million new subscribers outside the U.S. in the second quarter this year, which was short of the 3.5 million analysts had expected. The figure also shows a fall from its 2.4 million members added to the company's international streaming service during the first quarter of 2016.
Netflix has been investing heavily in its expanding international footprint and has informed investors that it could run at break-even profitability levels until the end of 2016 as it continues to roll out services abroad while improving its content offering.
The company’s efforts of rolling its services worldwide are also likely to face various challenges including tough business conditions in some of the countries on its target heat map.
For instance, the company expressed pessimism in its efforts to launch services in China noting in the letter that "we are continuing discussions but have no material update on our approach or timing. Whatever we do will have only a modest financial effect in the near term."
With regards to U.S. subscriber additions for the second quarter, Netflix actually raised its expectations, despite noting that over half of its U.S. subscribers would be affected by a coming price hike:
"With respect to unĂ‚Âgrandfathering, currently, more than half of our U.S. members pay only $7.99 or $8.99 for our $9.99 HD 2Ă‚Âscreen plan. We will phase out this grandfathering gradually over the remainder of 2016 with our longestĂ‚Â tenured members getting the longest benefit."
Initially, analysts expected this to have an adverse effect on the company’s potential growth in revenues in the U.S., in which case rivals Amazon (AMZN, Financial) and Hulu would be waiting to capitalize on Netflix defectors unwilling to step up to the $9.99 monthly package.
However, the company’s subscribers appear to be ready to continue with their subscription regardless of the changes in subscription prices. This has resulted in several analysts backing the stock to continue on a strong run.
For instance, analysts from Piper Jaffray maintained their “overweight” rating on the stock with $122 price target, making reference to its positive survey results. Other analysts have a price target of as high as $140 per share.
"We recently conducted a survey of 2,000 internet users in Brazil and Mexico (1,000 each country) and found awareness of Netflix as well as a high intent to subscribe," Piper Jaffray wrote in a note addressed to investors. "We believe these survey results bode well for growth in those new markets."
The firm also believes that Netflix is capable of reaching over 141 million subscribers globally by 2020.
Illustratively, Netflix is expected to add 17 million paid users and a total of 20.5 million total members during fiscal year 2017. The company’s revenues are expected to grow by 26.2% from its 2016 revenue estimate to about $11.1 billion in fiscal year 2017.
The company’s expected cost of sales is estimated at about $7.39 billion during fiscal year 2017 while its projected number of subscribers for the year is seen as a significant catalyst for boosting non-GAAP EPS. Currently, the full-year 2017 non-GAAP EPS consensus estimate is $1.15, which is an increase of 322.9% over its 2016 non-GAAP EPS estimate.
This bodes well for the company’s growth predictions, in which case it would explain why investors are willing to pay such a hefty premium on the stock when compared to industry averages.
Conclusion
Netflix’s current P/E ratio of 341x compares adversely to the industry average of about 27x while its P/S ratio of 5.85x is also weaker when compared to 2.17x for the industry (from the perspective on buying the stock).
As such, it only makes sense when you look at the company’s growth potential having already laid down the framework for international growth.
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