Netflix Stock Analysis – The EV to EBITDA is so high

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Netflix is an amazing service that provides one of the greatest values in media. For just $7.99 a month, subscribers receive access to an endless supply of content including TV shows and movies. In addition, Netflix began producing their own programming in 2013 with House of Cards and has produced more successful shows and movies since. Does this great product mean the stock is a good investment? That’s what I’ll examine in this Netflix stock analysis.

Netflix Stock Performance

Almost any chart showing the history of Netflix’s stock performance is likely to show a nice return. The stock has been on a nice trend higher over the past 10 years.

That’s not to say it hasn’t been volatile. The stock tends to react very strongly to earnings announcements. For example, the one-day moves for the recent quarters were as follows:

Q3 2016: 19.03%

Q2 2016: -13.13%

Q1 2016: -12.97%

Q4 2015: -0.14%

Netflix Financial Statement Analysis

Income Statement

Netflix has grown revenue 28% for the 9 months ended in September over the same period last year.

Although earnings per share improved over that time, operating income declined due to higher expenses. Operating margin fell from 4.9% to 3.5% over the same time period.

Interest expense is also on the rise as a result of their$2b in debt issuance this year.

The main takeaway to me is the net income relative to their current market cap. The current market cap is around $53 billion with only $163 million in net income.

This puts the price-to-earnings (P/E) ratio at a very high 335x. This is the 6th highest in the S&P 500.  Investors are willing to pay a substantial amount for shares of Netflix based on the potential for future earnings. This, in part, explains the volatility around earnings. Slower subscriber growth can substantially alter future revenue and earnings projections.

Netflix Income Statement

Click image for larger image (Source: NFLX 2016 3Q 10-Q)

Balance Sheet

Neflix has $10.2 billion in total assets with $2.3 billion in cash and short-term investments. As noted above, they just issued $2b in bond this year so their debt to total assets is 23%. Their long-term debt rating is B1 by Moody’s and B+ by S&P. Despite the substantial liquidity, the debt to earnings before interest, tax, depreciation & amortization (EBITDA) ratio of 7.75x  is keeping their debt rating from investment grade. Their EBITDA to interest expense coverage of 2.77x is also fairly low. Netflix’s 10 year bonds maturing on 11/15/26 are currently yielding 4.77%.

Netflix’s EV to EBITDA Ratio

Netflix is currently trading at an enterprise value (EV) to EBITDA ratio of 157x. This is the third highest in the S&P 500.

The enterprise value is the sum of the market cap (market value of the shares outstanding), the preferred stock, the total debt outstanding and subtracting out the cash. The EV provides an estimate of the takeover value of a company.

The EV to EBITDA multiple allows us to compare the valuation of Netflix to other companies and their peers.

While Netflix is not the most expensive, it is currently in the top 5 based on their current EBITDA.

Netflix EV / TTM EBITDA vs. S&P 500

TickerCompanyEV/EBITDA T12M
CXOCONCHO RESOURCES555.83
COPCONOCOPHILLIPS258.74
NFLXNETFLIX INC157.7
APCANADARKO PETROLE135.67
SLBSCHLUMBERGER LTD84.57
LUKLEUCADIA NATL75.06
CRMSALESFORCE.COM70.46
PXDPIONEER NATURAL65.42
MURMURPHY OIL CORP60.15
MROMARATHON OIL51.65

Comparing Netflix to other media companies in the S&P 500 we can see that based on current EBITDA Netflix is quite expensive. The average EV/EBITDA of 31.52 is pulled higher by Netflix’s outlier of 157.7x.

Why is this?

Well one reason is these other companies have valuations being hurt by their ties to the old cable TV model. These media companies sell their channels in packages to cable and satellite providers. More and more people are cord cutting and choosing Netflix, Amazon Prime, or YouTube for video content.

Disney continues to struggle with falling ESPN revenue. Viacom who once had their grip on the young television viewer with channels like MTV and Comedy central has also declined. It seems as though this trend will continue as more and more people take advantage of the mobile convenience of tablets and phones to stream video content.

Netflix EV/TTM EBITDA vs. Peers

TickerCompanyMkt Cap (USD)EV/EBITDA T12M
Average57.50B31.52
NFLX NETFLIX INC53.31B157.7
TWX TIME WARNER INC73.10B11.88
DIS WALT DISNEY CO/THE165.37B11.09
CBS CBS CORP-CLASS B NON VO27.75B10.93
DISCA DISCOVERY COMMUNICATIONS17.01B10.33
FOXA TWENTY-FIRST CENTURY FO51.77B9.92
VIABVIACOM14.19B8.80

Can Netflix’s high EV/EBITDA be justified?

Since Netflix is still in “growth” mode we can look at a more mature company’s average EV/EBITDA to see where Netflix should eventually trade as it matures.

Disney would not be a great choice to use since along with their media business they also have theme parks, resorts, and other products.

Fox is closer to a pure media company. The average EV/EBITDA for Fox over the past 10 years has been 11x.

So we can take that EV/EBITDA as a terminal ratio to use for Netflix. Assuming at some point in the future Netflix trades at 11x EV/EBITDA, what would EBITDA need to be? We take the  current market cap of $53.308 billion and divide by 11. That would be an EBITDA of $4.8 billion.

Netflix currently has 44.7 million subscribers in the US and 30 million international subscribers.

Netflix expects to grow to between 60 million to 90 million US subscribers.

We think we can grow to 60-90 million members in the US, based upon our trajectory to date and the continued growth of Internet TV. (Source: Netflix’s Long-term View )

Some analysts predict international subscribers could surpass US subscribers by 2018. The model I created is a bit more conservative.

Netflix Stock Analysis

I went with the low end of Netflix’s estimate of 60-90 million subscribers as the rate of subscriber growth has began to slow. I have international subscribers surpassing US subscribers in 2020. Based on these assumptions, I have Netflix growing to $1.9 billion EBITDA by 2020. Given today’s enterprise value of $54 billion, that is a forward EV/EBITDA multiple of 28x which is still not a good value.

Some of my assumptions:

US Subscriber Model:

Subscriber growth will slow to 6% a year

Average monthly subscription revenue per user will grow at a 4% rate

Profit margin improves to 39%, Netflix believes they can achieve 40% by 2020.

International Subscriber Model:

Forecasting their international growth is more difficult. Netflix grew international subscribers at a rate above 60% in 2014 and 2015.

International subscriber growth will fall to 10% by 2020

Average monthly subscription revenue grows at a more moderate pace of 2.5%

Profit margin is lower due to higher cost of revenue and marketing.

DVD Subscription

I see the DVD subscribers continuing to fall. DVD subscribers fell over 15% from 2014 to 2015. I used a constant 10% rate of decline in lost DVD subscribers. Profit margins remain high though.

Conclusion

There is no fundamental analysis that would make me feel comfortable buying shares at these high multiples but I thought it would be worthwhile to try to make it work. I much prefer value stocks or growth at a reasonable price (GARP) stocks. I don’t view Netflix as either of these two.

Netflix growth can continue and the stock might continue to rise on speculation of future earnings. The reward does not seem worth the risk. If expectations of future subscriber growth fail to materialize, then the stock is considerably overvalued.

 

 

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