Netflix Looks Like a Bargain Again
In my previous article, I concluded that Netflix (NASD: NFLX) will not demonstrate the type of growth that they have in the past. It is more likely that they will continue to grow at a steady pace, capturing at least a majority of any new rent-by-mail customers. One of the benefits of Netflix reaching a more mature stature as a company is improved cash flow or owner earnings.
A Year in Review
After Netflix reported second quarter numbers, they made the decision to lower their prices and reduce their advertising spending. This change really had a minimal impact on earnings as reduced revenue was offset by reduced marketing spending.
Slowing growth did provide greater insight into the amount Netflix needs to spend on DVD purchases to maintain their current subscriber base. Because there was little growth between the second and third quarter, it is reasonable to assume that Netflix needs to spend between $30-$35 million per quarter to meet the needs of their current subscribers. This is illustrated in the table below:
| (millions) | Total | 4Q 2007 | Q3 2007 | Q2 2007 | Q1 2007 |
|---|---|---|---|---|---|
| Revenues | $1,205.3 | $302.4 | $294.0 | $303.7 | $305.3 |
| Cost of Goods Sold | $786.2 | $200.1 | $194.5 | $196.7 | $195.0 |
| Gross Profit | $419.2 | $102.3 | $99.5 | $107.0 | $110.3 |
| Marketing & Advertising | $218.3 | $51.7 | $49.2 | $45.3 | $72.1 |
| Other Expenses | $109.7 | $30.5 | $28.8 | $23.5 | $27.0 |
| Total Operating Expenses | $328.0 | $82.2 | $78.0 | $68.7 | $99.1 |
| Other Income | $20.3 | $4.9 | $5.1 | $5.0 | $5.4 |
| Taxes | $44.5 | $9.3 | $10.9 | $17.7 | $6.7 |
| Net Earnings | $67.0 | $15.8 | $15.7 | $25.6 | $9.9 |
| Depreciation & Amortization | $225.0 | $60.8 | $54.0 | $56.1 | $54.0 |
| Capital Expenditures | $44.3 | $9.9 | $7.4 | $9.0 | $18.0 |
| DVD Libray Acquisition/ Sale | $200.1 | $52.5 | $34.7 | $50.0 | $62.9 |
| Percent Maintenance | 77% | 75% | 80% | 80% | 75% |
| Growth Capex/DVD Aquisitions | $56.0 | $15.6 | $8.4 | $11.8 | $20.2 |
| Owner Earnings | $103.6 | $29.8 | $36.0 | $34.5 | $3.2 |
Overall, I feel pretty good about using a starting owner earnings number of $103.6 million. I will apply this number in the valuation scenarios below.
Valuation
One of the issues many seem to overlook regarding Netflix is that they have $385 million or $5.75 per share in cash on their balance sheet. The assumptions that I make regarding owner earnings and growth rates may be fairly subjective, but I am confident that $5.75 per share in cash is worth $5.75 per share.
In my discounted cash flow analysis, I assume starting owner earnings of $103.6 million. I will apply a variety of growth rates to this starting number and then assume a reversion at the end of 10 years. I discount all of these cash flows back at 10%.
My first scenario will be the most bearish. This should be a true gauge of risk. Assume that the DVD-by-mail market is soon to decline. Netflix misses their guidance and grows earnings at only 8% in 2008. Their streaming solution is a bust, so this is followed by 5% growth for years 2-5, then a 3% decline in years 6-10. At the end of year 10, the company is sold at a P/E of 9. In this scenario, shares are worth $16 per share. Add cash of $5.75 and Netflix is valued at $21.75, or about where shares are today.
My second scenario assumes that Netflix meets their guidance and grows at approximately 17% in 2008. In years 2-5 they grow at a 9% rate. Then in years 6-10, they grow earnings at a rate of 5% followed by a sale at a P/E of 12. This results in a value of $28 per share. Add cash of $5.75 and Netflix is worth $33.75 per share. This scenario also assumes that the DVD-by-mail market is fairly mature, though Netflix still has some growth remaining.
Finally, let’s assume that Netflix still has some room to grow and that they gain some traction in their streaming video solution. The amazing growth of the past is history, but in ten years they have about 25 million subscribers. Earnings grow at a rate of 17% in 2008, followed by 15% for years 2-5, and 9% for years 6-10. The reversion is based on a P/E of 22, resulting in a value of $54 per share. Add the $5.75 per share in cash, and Netflix is valued close to $60 per share.
Conclusion
Very recently I had noted that competition may limit the upside that I was hoping for when I purchased Netflix several years ago. Competition has been a consistent theme for this company with no end in sight. Still, take a look at their revenue and subscriber growth. Despite all the competition and perceived competition, they have continued to grow.
I think the most plausible scenario above is the second. If I discount my intrinsic value by 25% before adding back cash, I get a value of $21 per share for the business. Adding back cash results in a value of $26.75. Despite the continued competition that Netflix faces, their current share price assumes some pretty poor results going forward. I think it would be a mistake to sell Netflix anywhere below $25, but it would take a rise to north of $30 for me to part with my shares.
Read Part I of this series
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