Poetic Portfolios

I really haven’t been following Netflix (NASD: NFLX) all that closely for the past year. A little over a year ago, I thought it looked like a bargain. I valued the shares conservatively at $33.75, and a bit more aggressively at $60 per share. After a year has passed, Netflix is outpacing my $60 per share growth scenario, yet remains valued at about $44 per share. So what are shares worth today?

The Past is Prologue

It is surprising that revenue and subscriber growth seems to be accelerating at Netflix. I’ve been tracking subscriber and revenue growth going back to 2005. I have tables for 2006-2009 below:

2006	Q1	Q2	Q3	Q4
Subscribers	4.866	5.169	5.662	6.316
Revenue	$224.10	$239.40	$256.00	$277.20
QoQSubs	16%	6%	10%	12%
YoYSubs	61%	62%	58%	51%
QoQRev	15%	7%	7%	8%
YoYRev	47%	47%	47%	42%
Market/GP	59%	53%	61%	61%

2007	Q1	Q2	Q3	Q4
Subscribers	6.797	6.742	7.028	7.479
Revenue	$305.30	$303.70	$294.00	$302.40
QoQSubs	8%	-1%	4%	6%
YoYSubs	40%	30%	24%	18%
QoQRev	10%	-1%	-3%	3%
YoYRev	36%	27%	15%	9%
Market/GP	70%	65%	42%	51%

2008	Q1	Q2	Q3	Q4
Subscribers	8.24	8.41	8.672	9.39
Revenue	$326.20	$337.60	$341.30	$359.60
QoQSubs	10%	2%	3%	8%
YoYSubs	21%	25%	23%	26%
QoQRev	8%	3%	1%	5%
YoYRev	7%	11%	16%	19%
Market/GP	52%	37%	42%	51%

2009	Q1	Q2	Q3E	Q4E
Subscribers	10.31	10.6	11	11.8
Revenue	$394.10	$408.50	$419.00	$440.00
QoQSubs	10%	3%	4%	7%
YoYSubs	25%	26%	27%	26%
QoQRev	10%	4%	3%	5%
YoYRev	21%	21%	23%	22%
Market/GP	46%	33%	41%	50%

I include this history because I think it is important. First, you can see the seasonality of growth. The first quarter often demonstrates the largest jump in subscriber and revenue growth, followed closely by the fourth quarter. Growth tends to stall out in the second and third quarters of each year.

Second, you can see when Blockbuster started to come after Netflix. Revenue growth decelerated from 47% on a year over year basis in the second quarter of 2006 to 7% in the first quarter of 2008. Netflix is now a truly dominant player in the rental business. Fending off Blockbuster and kiosk competition from players like Redbox. The acceleration of growth from 7% on a year over year basis to 21% most recently is an impressive story.

Finally, I think it’s important to track marketing spending. This is almost like a capital spending item for Netflix due to their comparatively light business model. As growth continues, you can see this number decline as a percentage of gross profit, which translates into increase profit margins even while maintaining strong growth rates.

Current Owner Earnings

In 2008, Revenues totaled $1,365MM, with gross margins of about 33% resulting in gross profit of $454MM. Operating expenses were $333MM with marketing comprising $200MM of that total. Net income was $83MM. Add back $56MM or so in depreciation and amortization, subtract capex of about $7MM and 80% or so in content acquisition of $26.5MM. I get owner earnings of about $106 million.

I only use about 80% of the content acquisition expense from the cash flow statement because I assume that the other 20% is for subscriber growth. It doesn’t make sense to me to penalize owner earnings due to growth in revenue and subscribers. Others may disagree, but I believe that some adjustment needs to be made here.

Valuation

It’s difficult to argue against strong earnings growth given the revenue growth and lower fulfillment expenses Netflix would have as more downloading and less mailing of DVDs occurs. I assume a 22% growth rate in year 1 followed by a 15% growth rate in years 2-5, 8% in years 6-10, then a reversion at a 12x P/E ratio. Discounting these cash flows back at 10% results in a value of $43 per share. Even if they grow at 18% for years 2-5, it only adds $2 per share in present value.

For now, it looks like Netflix shares are fairly valued. I have a lot of respect for the management of Netflix. They have beat back all competition in a very competitive space. I likely wouldn’t buy shares unless I could get them below $35. In the past, the market has assumed some fresh new competitor would end their run and the stock has gone on sale. Maybe history repeats itself and investors can once again buy shares cheap again.

Disclosure: I have no position in Netflix

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This entry was posted on Thursday, August 6th, 2009 at 5:40 am and is filed under Netflix, Sold Stocks. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.