After Netflix (NASDAQ: NFLX) announced it’s third-quarter results on Monday, stock shares of the Los Gatos, California-based company closed at an all-time high of $354.99.
The next day analysts tempered expectations and investors retreated; shares fell 9%. Close followers of Netflix are all too familiar with this volatility, but are the better-than-expected earnings and stellar subscriber growth enough to consider Netflix a buy? Let’s take a closer look.
The Rise and Fall and Rise of Netflix
Netflix was started in 1997 as monthly subscription DVD-by-mail service. Do you remember those little red packages that made video rental late fees a thing of the past? If you don’t, don’t worry. The executives at Netflix barely do either. Netflix now touts itself as the world’s leading internet television network.
When Netflix went public in May 2002, it opened at $15 per share. In 2003, Netflix shares rose to $55 and was the highest performing stock on Nasdaq. It plummeted down 80% to $11 in 2004.
In January 2007, it introduced video streaming over the internet and traded at around $25 per share. By 2011, shares skyrocketed around the $300 mark only to drop 80% in 2012. The drop is greatly attributed to the poorly handled announcement to split its service and the loss of subscribers due to a price hike. Its subscriber base, at the start of 2012, was around 25 million.
Fast forward to 2013 and the stock is back trading over $300 with third-quarter results showing a year-on-year revenue growth of 22%. The subscriber base also nearly doubled with 40 million subscribers at quarter-end. Netflix reported that it added 1.3 million domestic streaming subscribers in Q3.
It’s the continuing growth in the subscriber base that Netflix executives want investors to focus on. They added in their letter to investors, “We do our best to ignore the volatility in our stock.”
During the earnings interview, CEO Reed Hastings noted that if growth is consistent with 2013, at 6 million domestic additions, then the margin expansion can continue to grow at 400 basis points of contribution margin improvement quarter-over-prior-year quarter.
The Netflix Growth Strategy
Subscriber growth exceeded expectations, according to the letter to their shareholder, because of the strength of their content and the success of their original programming, first introduced in 2013. The company plans on spending nearly $3 billion in licensed content in 2014.
Critically acclaimed shows like Orange is the New Black and House of Cards have transformed Netflix from a content distributor to a content creator. House of Cards was nominated for 14 Emmys; it won in one category. Orange is the New Black, their most popular original show, is said to rival the top linear TV shows in viewers. Netflix plans to double its investment in original programming to 10% of their spending.
Competitive streaming video providers Amazon (NASDAQ: AMZN) and Hulu are also increasing spending for original programming. Amazon green-lit the production of six new pilots for kids and three new half-hour pilots. Customers will be invited to help determine which pilots will be produced as a series to air on Prime Instant Video and Amazon’s UK streaming provider, Lovefilm. TV networks HBO, CBS (NYSE: CBS) and BBC are ramping up their streaming offers.
Netflix also announced plans to use its domestic profits for their international expansion. In their long-term view statement they said, “One of the reasons we are investing so heavily in international expansion is we believe that once a subscription video service has achieved profitability and scale in a market (20% to 30% of the households), it is very likely to be able to sustain that profit stream for many decades.”
The Positive: Creating and Recreating Momentum
The recent headlines and analysis regarding Netflix sounds eerily like 2003–4 and 2011–2. The popular commentary: It’s a momentum stock. It’s overpriced. The valuations don’t make sense.
What is impressive is that Netflix has historically done what is quite difficult to do: recreate momentum in such a short period of time, multiple times. High-flying stocks, like Netflix or Tesla (NASDAQ: TSLA), are popular among retail investors because, well, they’re popular. Retail appetite for these stocks is usually driven by the belief in the product or service, not by its underlying valuations or market metrics. Any sort of misstep and loss in this momentum and stocks prices drop.
While value investors typically look for the low price, low price may indicate a lack of enthusiasm to buy, driving the price down even more. High-priced or perceived overpriced stocks are not seen as attractive but there can be significant gains earned in high-flying stocks, if you know what indicators to look for that signal upward trends in momentum. Valuations should not be one of the indicators as valuations of momentum stocks are rarely attractive. Netflix’s P/E ratio is many times that of market comparables.
Two indicators to use are the earnings estimate revisions and earnings surprises. Netflix has had consistently positive earnings surprises in 2013 and analysts have been largely positive regarding earnings estimate revisions for 2013 and 2014 yearly and quarterly earnings results.
By these indicators, Netflix is a strong pick.
What are your thoughts on Netflix?