Should You Buy Netflix (NFLX) Stock?

Few companies have had a greater impact on how people consume entertainment than Netflix (ticker: NFLX), the world's premier streaming video service. Having shown an ability to transform consumer behavior in a long-term, sustainable way, it's no surprise that Netflix's stock price has grown exponentially since its initial public offering in 2002.

Netflix became a household name by mailing DVDs. In hindsight, it's easy to see how the company could've quickly become another bygone relic of business models past, a dinosaur of Silicon Valley relegated to Wharton case studies.

Instead, Netflix casually pioneered and successfully navigated the pivot to streaming TV, delivering your favorite content in a matter of milliseconds, not business days.

Due to its first-mover advantage, Netflix quickly made mincemeat of Blockbuster. Today, it dominates the streaming TV market.

But does its early lead spell continued success for NFLX stock, or has the epic run-up of its share price over the years been too aggressive?

Here are five pros and five cons to consider before buying Netflix stock.

Pro #1: Subscriber growth. It's no surprise that subscription-based business models rely on subscriber growth to increase revenue. Other than raising prices, that's the only way to grow the top line. Luckily for NFLX shareholders, Netflix is doing both, with standard subscription prices now at $12.99 a month for its standard plan, the most popular.

That's up more than 50% from its introductory price of $7.99 in 2010, which stood stagnant until its first-ever increase of $1 per month in 2014.

Broadly speaking, consumers are on board with that value proposition: Netflix, which now has more than 182 million paid subscribers worldwide, was still growing revenue by 27% year over year through the first quarter of 2020 on the heels of 22.8% subscriber growth.

More fundamentally, recurring revenue businesses like NFLX are revered by shareholders because, at their best, they pay once to acquire a customer, then enjoy an eternal stream of increasing future cash flows for their troubles.

Con #1: Subscriber growth (recent deceleration). Yes, one of Netflix's greatest virtues for investors also happens to be a double-edged sword. There can be hell to pay when quarterly subscriber growth doesn't meet the market's expectations.

That happened when NFLX reported second-quarter earnings in 2019. Netflix itself had projected global paid members to increase by 5 million in the quarter, but instead the true number came in at practically half that: 2.7 million. Shares instantly lost more than 10% after reporting the figures.

Although Netflix enjoyed a substantial bump in memberships in the first quarter of 2020 -- growing by 15.8 million subscribers against projections for just 7 million -- the company warned in a letter to shareholders that it expects "viewing to decline and membership growth to decelerate as home confinement ends, which we hope is soon." The company goes on to say:

"Hopefully, progress against the virus will allow governments to lift the home confinement soon. As that happens, we expect viewing and growth to decline. Our internal forecast and guidance is for 7.5 million global paid net additions in Q2. Given the uncertainty on home confinement timing, this is mostly guesswork. The actual Q2 numbers could end up well below or well above that, depending on many factors including when people can go back to their social lives in various countries and how much people take a break from television after the lockdown. Some of the lockdown growth will turn out to be pull-forward from the multi-year organic growth trend, resulting in slower growth after the lockdown is lifted country-by-country."

In other words, while virus-based lockdowns have benefited Netflix for now, in the long term, it's anybody's guess how the pandemic will affect future membership figures.

Pro #2: Expanding operating margins. Recall the two core drivers of Netflix's business: subscriber growth and subscription cost. These figures govern the top line.

But the way to hyper-charge profits is to increase operating efficiency. Enjoy the cost advantages of scale by spreading fixed costs over a larger and larger base of paying members.

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This is the magical business model opportunity that software provides, and which some of the world's most valuable tech companies -- Microsoft Corp. ( MSFT), Alphabet ( GOOG, GOOGL), Facebook ( FB), Alibaba Group Holding ( BABA) and so on -- have ridden to riches.

Netflix is doing the same, and its operating margins are increasing accordingly, growing from 10.2% in the first quarter of 2019 to 16.6% in the first quarter of 2020.

Con #2: Valuation. In theory, Netflix should be easy to value: All you have to know is future cash flows and the rate of return you require. Excel can do the rest, and spit out a fair current price for NFLX stock.

The problem merely lies in determining the precise value and timing of future cash flows. Small changes in inputs like membership growth, average revenue per user and margins can have massive implications on a company's current value. Netflix currently has a forward price-earnings ratio of 70.4, a number that has climbed steadily from 48.7 as of six months ago -- and given the strength of its first quarter 2020 earnings, in the near term, Netflix will only get more expensive.

Pro #3: International expansion and strategy. Netflix has conquered the North American market, with more than 69 million paid subscribers in the U.S. and Canada. Considering one Netflix account can be easily shared between multiple people, plus the fact that there are only 127 million households in the U.S. to begin with, even the theoretical limit to Netflix's growth in the U.S. isn't too far off.

All the growth now lies abroad, where Netflix began an aggressive international expansion campaign in January 2016, entering 130 new countries in a crazy ambitious global rollout. That campaign has been a success by practically any measure: International subscribers have skyrocketed from 27.4 million to 112.89 million in the years since.

Efforts to "localize" content that is custom-made for certain regions, languages and cultures are paying off big time, and the company's targeted content strategy is complemented with varying subscription plans and prices. For instance, the company has gone so far as to add a lower-priced mobile-screen plan in India to help seize market share in the country of 1.3 billion.

Con #3: Increasing competition. The first-mover advantage that put Netflix on the map and made a fortune for early shareholders has largely paid its dividends already. Competitors have taken notice and are now investing major dollars in megatrends like cord-cutting, the on-demand economy and the de-bundling of entertainment options.

Amazon ( AMZN) Prime Video, Hulu, HBO Go and YouTube have been Netflix's most notable rivals in recent years, and none are backing down anytime soon. The appearance of newer competitors in the streaming landscape like Walt Disney Co. ( DIS), Apple ( AAPL), WarnerMedia and NBCUniversal means that the streaming wars are quickly reaching a fever pitch, leaving Netflix little room for error.

Pro #4: Great management team. Reed Hastings has become one of the iconic CEOs of Silicon Valley and is universally regarded as an extremely competent executive. He founded his first company in 1991 at age 31. By 1995, he had taken the company public.

As the company's founder, investors can be sure their interests are aligned with the CEO's. Chief Content Officer Ted Sarandos is the second key piece in this dynamic duo, having led content acquisition at Netflix since the year 2000. The long-term importance of the company's shift into original programming in 2013, overseen by Sarandos, can't be overstated.

Hastings has also built a company culture of radical transparency, high expectations and open feedback -- a philosophy that seems to produce very nice results.

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Con #4: Losing vital content. Netflix is nothing without its content, and while the real challenge for subscription-based models is getting the initial subscriber, the model only works if you retain your customers. Betting on the stupidity of the millions paying your salary each month isn't savvy: Netflix must constantly justify its $13/month price tag.

Unfortunately, Netflix had to deal with the staggering loss of Disney's content as the House of Mouse took the plunge and launched its streaming service, Disney+, in late 2019 with its enviable content arsenal. That means many popular Disney titles, including the Marvel movies and the "Star Wars" franchise, are now exclusively available on Disney Plus, instantly making the service one of Netflix's biggest competitors.

On top of that, all three of Netflix's most popular titles -- "The Office," "Friends" and "Parks and Recreation" -- are leaving Netflix by 2021, as the company was outbid by rivals for the future rights. With the explosion in the number of rival streaming services comes fewer intellectual properties for Netflix to put on its own service. But that's where the next "pro" comes in.

Pro #5: Stronger original programming. The aggressive move into creating its own content beginning in 2013 was essential: Original programming is indeed the only way for Netflix to differentiate itself in the long term.

Netflix quickly proved an ability to produce its own critically acclaimed content, which is no small feat. "House of Cards" led the way, and a dizzying pace of titles followed, including "Orange Is the New Black," "Black Mirror," "Narcos," "Stranger Things," "Ozark," "The Crown" and many more.

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Crucially, Netflix has access to individualized content preferences for every subscriber, an extremely valuable data trove competitors simply can't use to predict popularity. NFLX, on the other hand, can drill down, discover tastes it knows it can monetize and strike the appropriate deals.

What companies have the financing and willpower to compete with that long term? Wads of money, ability to take risks and a long-term vision are prerequisites, which narrows down the field of blue-chip competitors. Apple, Disney, and Amazon.com seem like the biggest threats on that basis.

Con #5: Content costs. Of course, there's a flip side to the original content coin. You have to spend a ton of money up front to take a risk on something that might not land -- something Netflix often won't know until months after it has filmed a show. Netflix minimizes that risk, but actors, directors and special effects professionals don't pay themselves. The growing number of streaming services means more competition to hire the best, and that means higher costs.

And the company's reliance on debt financing isn't negligible, at $14.6 billion. Going forward, the company plans to use high-yield debt to keep financing its projects. Unlike many companies, Netflix hasn't accessed its revolving credit line (worth $750 million). The company assured investors in its Q1 2020 shareholder letter that its cash flow, available funds and access to financing are enough to meet cash needs for the next 12 months, but considering the uncertainty of credit markets and the effects of SARS-CoV-2, management may need to be more cautious going forward.

Given the pause on production of new content thanks to SARS-CoV-2, Netflix forecasts a negative free cash flow of $1 billion for 2020 -- that's well below the negative $3.3 billion free cash flow in 2019, and the original expectation for 2020 was negative $2.5 billion. But it's a number that will increase over time as virus-related production restrictions are lifted, and investors should keep a close eye on it over the year.

In addition, with more and more competitors entering the fray, demand is driving up costs and making previously doable content unreasonable. Most recently, Netflix acted to fill the content gap left by the tried-and-true trio of "The Office," "Friends" and "Parks and Rec," spending an undisclosed sum -- but reportedly well above $500 million -- to secure exclusive rights to "Seinfeld" for five years starting in 2021.

In the end, Netflix is a well-run, fast-growing business with some enviable advantages over rivals. But shares have always traded at rich valuations, and its debt-fueled strategy is facing its first truly major external threats right now. Netflix has operated more or less undisturbed for years, but the loss of key content and the entry of the heavyweights into the game means all but the most risk-tolerant investors should wait for a lower market cap than $185 billion before placing bets.

Mark Reeth is a contributing writer for U.S. News & World Report, where he writes about anything and everything to do with investing. Prior to U.S. News, Mark covered consumer goods, technology, and telecom stocks for The Motley Fool. When he's not writing about investment strategies Mark is busy running his own small business, which has given him a better appreciation of the personal finance trials and tribulations of entrepreneurs everywhere.

Mark is a graduate of the College of the Holy Cross, where he studied History and Education. You can connect with Mark via LinkedIn, or follow him on Twitter.