Pros and Cons of Buying Netflix, Inc. (NFLX) Stock
Few companies have had a greater impact on how people consume entertainment than Netflix, Inc. (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 the Netflix 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.
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Due to its first-mover advantage, Netflix quickly made mincemeat of Blockbuster, and 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 150 million paid subscribers worldwide, was still growing revenue by 26% midway through 2019 on the heels of 22% 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. Netflix itself had projected global paid members to increase by 5 million in the quarter, instead the true number came in at practically half that: 2.7 million.
This miss is just as substantial as it sounds; in its last 14 quarters, this was only Netflix's fourth disappointment. The 46% shortfall easily stood out from the previous three misses, the largest of which was 27%.
Shares instantly lost more than 10% after reporting the figures.
Moreover, Netflix lost 130,000 members in the U.S. in the second quarter, where subscribers are far more profitable than they are abroad.
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.
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 11.8% in the second quarter of 2018 to 14.3% in the second quarter of 2019. Its "contribution margins," defined as the percentage of revenue not absorbed by variable costs, are also on the rise, especially internationally.
Netflix improved international contribution margins 66% year-over-year in the second quarter of this year, improving from 9.8% to 16.3%.
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. But as indicated by Netflix's mid-2019 subscriber miss, even the top brass at the company itself can be off by 46% on membership estimates just three months out.
Small changes in inputs like membership growth, average revenue per user and margins can have massive implications on a company's current value. Even if earnings per share clear the hurdle of growing 234% between 2018 and 2021, Wall Street's consensus estimate, Netflix is currently valued at 31 times those 2021 earnings.
Keep in mind: this is after Netflix shares declined 25% from their 52-week high.
Pro #3: International expansion and strategy. Netflix has conquered the U.S. market, with 60 million domestic paid subscribers. 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 91.5 million in the three-and-a-half years since.
Netflix's international contribution margin swung from -19.2% in the last quarter before that roll out to 16.3% in the second quarter of 2019.
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Efforts to "localize" content that's 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. The company just announced it is adding a lower-priced mobile-screen plan in India to help seize market share in the country of 1.3 billion.
On top of that, NFLX stock has roughly tripled since beginning its global rollout, further beefing up its international resume.
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, HBOGo and YouTube have been Netflix's most notable rivals in recent years, and none are backing down on the streaming market. It would be easier to name the major players about to enter the fray with Netflix, but Walt Disney Co. ( DIS), Apple ( AAPL), WarnerMedia and NBCUniversal are all entering the direct-to-consumer streaming market within the next year.
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 31, and 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.
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, 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.
On top of that, a possibly even bigger blow is the staggering loss of Disney's content as the House of Mouse takes the plunge and launches its streaming service, Disney+, in late 2019 with its enviable content arsenal.
By not renewing a 2016 licensing agreement with Netflix, Disney is betting on itself. That means many popular Disney titles, including a number of Marvel movies and the "Star Wars" franchise, will become exclusively available on Disney+.
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.
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 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 upfront money to take a risk on something that might not land. Netflix minimizes that risk, but actors, directors and special effects professionals don't pay themselves.
Thus, content costs are soaring, jumping 35% to $12 billion in 2018. They're on pace to rise another 25% to $15 billion this year. And the company's reliance on debt financing isn't negligible, at $12 billion. Going forward, the company plans to use high-yield debt to keep financing its projects.
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Netflix forecasts a negative free cash flow of $3.5 billion for 2019, and with more and more competitors entering the fray, demand is driving up costs and making previously doable content unreasonable.
Most recently, 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 the $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 valuation than $125 billion before placing bets.
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