Netflix has been a high-flying stock as of late, with its shares up 250 percent since the start of the year. The firm now has a market cap of $9.3 billion, which has got some folks, like Whitney Tilson, founder and Managing Partner of T2 Partners, believing the stock is bound for a fall. In a public post, Netflix CEO Reed Hastings publicly responded to Whitney Tilson’s thesis on why his firm is shorting Netflix, arguing that many of Tilson’s arguments are short-sighted and won’t necessarily affect Netflix in 2011.
The back-and-forth inspired me to look at Netflix’s price-to-earnings ratio vs. some of the firms investors think it might replace. Netflix trades at a whopping 67 times earnings. Compare that to the big cable guys: Comcast trades at 17 times earnings, Time Warner Cable trades at 19 times earnings and Cablevision trades at 31 times earnings. Satellite TV firm DirecTV trades at 23 times earnings, while Dish Network trades at just 9 times earnings.
It’s clear Wall Street doesn’t think of Netflix as a multichannel video player, or its stock would be priced accordingly. But maybe that’s a good thing; after all, each of the pay TV operators listed above — except one — saw their subscriber numbers fall during the last quarter. But at the same time that cable firms’ subscriber counts are in decline, Netflix is quickly gaining customers.
The movie rental and streaming service added 7 million new users in the past year alone, and its growth trajectory continues to accelerate. With more than 200 connected consumer electronics devices supporting it (not to mention Oprah’s endorsement!), you can expect Netflix will be a popular holiday gift, possibly driving customer growth to record numbers. As more of its users move to streaming, its margins should also improve. Wall Street is clearly betting on the growth to continue, and for Netflix’s earnings to grow as well.
Another advantage Netflix has against cable firms is the ability to manage its costs. Its increased content costs — including reported nine-figure deals with Epix and Disney — have some investors worried it might overspend on streaming rights relative to the number of subscribers. But Netflix has done a good job of managing what it pays for content to date, and we can expect it to continue to do so. Hastings explains in his piece:
“[I]f content costs rose faster than we expected, then in practice we’d have less content than otherwise, rather than less margin. This would ultimately show up in less subscriber growth than we wanted from a not-as-good-as-it-would-otherwise-be service; it would not likely show up as a sudden hit to margins. Management at Netflix largely controls margins, but not growth.”
At the same time Netflix is able to choose which content to pay for — or not — cable firms are largely hamstrung by existing relationships with networks that continue to drive costs up. Every year, cable subscribers see their bills increase, due largely to increased programming costs. Meanwhile, cable companies are seeing their margins gradually decline. That’s got some pay TV firms — like Time Warner Cable — deciding to roll out lower-priced plans, while others — like AT&T and DirecTV — are doing away with less popular networks.
Netflix has so far held up against criticism of its business, due to strong management and a pretty seamless transition from a DVD-by-mail rental business to a streaming video company — but can it continue to do so? At the heart of Tilson’s argument aren’t necessarily the risk factors associated with Netflix over the coming year, but the fact that — at 67 times earnings — Netflix is wildly overvalued.
In this respect, Tilson might have a point. After all, very few firms are able to carry that kind of multiple. One firm that has succeeded in doing so and continued to confound bears for years is Amazon.com, which today trades at 73 times earnings. But as Tilson points out, Amazon succeeds due to its wide selection of merchandise and low prices. But Netflix has an entirely different value proposition: While its low subscription prices provide subscriber value, its selection of streaming content is still pretty limited.
In the short term, Netflix will continue to be buoyed by massive growth and a content acquisition plan that allows it to effectively manage its profit margins. But in the longer term, as subscriber growth slows or content costs rise, the subscription video firm will likely run into some of the same issues facing the same businesses it’s looking to disrupt.
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