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The investment case for Netflix

Jul 31 2018 13:15
Shaun Murison

Scheduled (linear) TV programming has been properly disrupted by the emergence of internet entertainment services. Why wait a week for the next episode of your favourite series or documentary when you can binge watch at times more convenient to you? Also, why do you need those decoding boxes and satellite dishes when you can achieve a similar result with an internet connection and an app?

With the evolution of technology, on-demand internet entertainment seems destined to eventually end the era of scheduled linear television. The increase in availability and speeds of the internet, combined with a higher penetration of smartphones and smart televisions, provides an ever-growing ecosystem with greater access to the world of entertainment. Netflix has emerged as a leading provider within this entertainment service category, boasting over 130 million memberships across more than 190 countries.

Netflix Origin(al)

From humble beginnings as a DVD-rental-by-mail firm in 1997, Netflix moved on to list on the Nasdaq in 2002 at $15 a share, only becoming profitable in the 2003 financial year, when it was still primarily a DVD shipping company. The introduction of streaming entertainment came in 2007, from which point revenue growth started its exponential path. The company now trades at around $370 a share, roughly 25 times its initial offering price.

Their second quarter (Q2) results for 2018 once again showed strong revenue and earnings growth for the group. Revenue increased by just over 40% year-on-year, while better operating margins equated to a more than 260% increase in operating income. Earnings per share moved from 15c* in Q2 2017 to 85c in Q2 2018.

The financials were realised more or less within previously (Q1 2018) guided estimates from the company.

However, the initial market reaction to the company’s results was negative, with a low double-digit share price decline being realised intraday. The move was on the back of lower-than-expected membership growth, although it must be said that the number of members added to the subscription base was still large at 5.2m. Of these 5.2m net additions, 670 000 were in the US (estimate 1.2m) and 4.5m were international (estimate 5.2 m).

Put into context, Netflix has seen a net addition of between 5m and 8m members every quarter since Q4 2016, exceeding its guided subscriber estimates all but two times (where misses have been marginal) over the last seven reporting quarters.

Forecast for the third quarter

The next quarter is expected to yield revenue growth of around 34% year-on-year and realise earnings per share (EPS) of 68c per share, up from 29c in the comparative quarter (2017). EPS will be lower than Q2 2018 on account of more costs of content production being realised in the second half of the financial year.

Fundamentals

At face value the fundamentals may not conform to the usual investment criteria for a long-term portfolio holding, but contextualised perhaps they do.

The company trades on a price-to-earnings (P/E) ratio of around 160 times, which is expensive. However, it is now less than half the P/E premium of December 2016 (when it was at 346 times). The earnings growth is expected to see the P/E reduced to less than 60 by 2020.

Netflix does not yet pay a dividend, and free cash flow is negative, at -$559m. It should be considered, however, that the company is making significant investments in content production, which is expected to produce high returns and further shareholder value in the long run.

The quality of the content produced has seen Netflix receiving the most Emmy nominations (112) in 2018, breaking the previously uninterrupted honour held by HBO. It must be remembered that Netflix created its first original content only five years ago. The content looks to secure and maintain viewers within the company’s ecosystem and is now being produced in 80 countries.

The investment case

While businesses like YouTube, Disney, Amazon and Apple (to name but a few) are all investing within the internet entertainment services space, Netflix has had the first move advantage in the subscription-based online video streaming industry.

The future scope of the industry remains enormous, with enough room for competitors to co-exist profitably. Consumer demand remains high with increased accessibility, better data mobility and connectivity further helping to feed the appetite for on-demand online entertainment.

Investors looking for a growth stock and tech sector/e-commerce addition to a long-term portfolio might find Netflix a worthy consideration.

*All cent values denote US currency.

Shaun Murison is a market analyst at IG.

This article originally appeared in the 2 August edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

netflix  |  tech stocks  |  streaming service
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