Netflix Recovers 75% In 5 Months; Gone Too Far?
After more than a 80% increase since its March 16 lows of this year, at the current price of around $550 per share we believe Netflix stock (NASDAQ: NFLX) has surpassed its near-term potential. Netflix stock increased from close to $300 to about $550 off its recent bottom, compared to the S&P which increased by around 57% from its recent lows. The stock outperformed the broader market due to increased demand for streaming services due to home confinement of people during the ongoing pandemic. Though NFLX stock dropped from $550 to $500 within a week following lower than expected earnings in Q2 2020, it has recovered since, and the stock price is significantly above the levels seen during 2017-2019. We believe the company’s stock could decline by close to 15%, most likely to be led by a drop in its P/E multiple as subscriber growth slows in the coming quarters. Our dashboard What Factors Drove 173% Change In Netflix Stock Between 2017 And Now? has the numbers behind our thinking.
Some of the stock price rise between 2017-2019 is justified by the 72% rise in Netflix revenues from $11.7 billion in 2017 to $20.2 billion in 2019, led by strong growth in streaming. This effect was further magnified by net income margins rising almost 2x from 4.8% in 2017 to 9.3% in 2019. Netflix has been able to see such a spectacular rise in profitability over the years as Netflix pays for its single largest expense – content – on a fixed cost basis, i.e. for every piece of content that Netflix either licenses or self-produces, it pays a fixed dollar amount regardless of how many people watch it or how many subscribers the company has. As a result, each additional subscriber comes with very little extra cost and is therefore profitable. On a per share basis, earnings increased by a whopping 230% led by a sharp rise in revenue and margins, while shares outstanding increased only by 1.4%. Higher earnings were somewhat offset by a drop in the P/E multiple, which more than halved from 150x in 2017 to 75x at the end of 2019, as the stock price growth was lower than the increase in EPS as Netflix started losing US streaming subscribers in 2019. However, this trend was reversed with the multiple rising in 2020 and currently standing above 120x, mainly due to rising streaming demand on account of the coronavirus crisis as people are spending more time in front of the TV, thus giving a boost to demand for home entertainment options.
What’s The Downside Trigger?
The global spread of coronavirus led to lockdown in various cities across the globe which led to higher demand for streaming services. This was reflected in the first two quarter numbers of Netflix for 2020. The streaming giant added 16 million subscribers in Q1 and another 10 million in Q2, taking the total addition to 26 million in the first six months of 2020. To provide a perspective, Netflix added 28 million subscribers in all of 2019. Q2 revenue touched $6.1 billion, a quarterly high for Netflix. Despite such an impressive subscriber and revenue growth, Netflix stock dropped after the earnings announcement as Netflix reported earnings per share of $1.59, about 12% lower than both management and analysts had anticipated due to the reporting of major non-cash charges that hit the bottom line.
There are signs of gradual lifting of global lockdowns over recent weeks. Over the coming weeks, we expect continued improvement in demand and subdued growth in the number of new Covid-19 cases in the U.S. compared to the rate seen in April-May to boost market expectations. Additionally, the gradual lifting of lockdowns is also giving investors confidence that developed markets have put the worst of the pandemic behind them. Following the Fed stimulus — which helped set a floor on fear — the market has been willing to “look through” the current weak period and take a longer-term view, with investors now mainly focusing their attention on 2021 results.
As the lockdowns are lifted and people leave their houses for work and other reasons, streaming demand is likely to be lower than what was seen during the recent months of complete lockdown. The first six months of 2020 seems to be a one-time bonanza as the management has hinted at subdued growth over the next few quarters. Additionally, Netflix has left the door open for further hikes in prices for its offerings on a region by region basis. At a time when Netflix will have to face intense competition from new entrants like Disney, AT&T, and Comcast in the streaming war, a hike in subscription fee could prove to be an ill-timed move. Also, with investors’ focus shifting to 2021 numbers, Netflix is not expected to repeat its stellar performance of 2020 anytime soon, and surely not in 2021 as fresh competition will try to eat into its market share.
In a post-lockdown scenario when streaming demand is likely to come down from the levels seen during the last few months, companies such as Roku are expected to fare better as most of their money comes in from advertising and commission. Additionally, well-diversified companies like Disney are also expected to outperform as their business does not entirely depend on streaming. Subdued growth expectations, rising competition, and lack of diversification is expected to push Netflix’s P/E multiple down close to 80x which gives us a fair price estimate of $476 for Netflix’s stock, thus reflecting a downside of close to 15% from its current market price.
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