Monday, December 27, 2010

Rule #1 Analysis Blitz #7: Netflix (NFLX)


Just a couple of months ago, Netflix, the online movie rental sevice, became available in Canada.  Netflix had been around in the US for many years (founded in 1997).  Its initial service was DVD rental by mail.  How it worked was as a subscriber, you pay a monthly subscription fee and choose a number of movies you wanted to see in your queue.  Netflix would then ship you a DVD in your queue for viewing with no late or penalty fees.  You get to keep the DVD as long as you want and when you're done with it, Netflix would ship you the next DVD in the queue.  Depending on your subscription plan, you can get one DVD at a time or multiple DVDs at a time, and different number of DVDs per month.  Of course, if you wanted to make your subscription fee go far, you'd return your finished DVD (by a prepaid mailer) as quickly as possible, in order to get the next DVD.  This business model has been fairly successful as there has been some copycats.  In Canada, the most prominent one is Zip.ca, of which I considered joining, until Netflix came along.

Why did I go with Netflix?  Their current movie selection in Canada is actually very, very limited, but I started my 1-month free trial offer anyway, because they offered streaming to PCs and my PS3.  So, I can watch movies anywhere I want as long as I had access to a PC and an internet connection.  That sealed the deal for me.  In the US, Netflix has begun to roll out a streaming only plan for subscribers.  The movie selection in the States is superior to that of Canada.  I was willing to bite the bullet and spend $7.99/month just to have the convenience of streaming videos.  To date, I've watched about 20 movies since I started my trial in October.  That's less than $1/movie...granted, I could've probably borrowed the same movies from the library for free, but the convenience justifies the nominal fee.  I can't wait for Netflix to improve their selection.  At that point, it'd be a no-brainer for anyone to subscribe to it.

In light of this, Netflix has become a very hot stock!  In one year, the stock has risen from about $50 to $184.  Can this fantastic growth continue?  Let's find out!

Moat
You can download the completed Rule #1 spreadsheet here.

Going to the Big 5s, the ROIC, Sales Growth, and Free Cash Flow Growth all look pretty good.  The EPS growth also looks good.  The 9-year average has a negative number but only because it had a negative number in the beginning years.  The BVPS actually raises a red flag.  We will ignore the 9-year average since it had a negative BVPS in its first years.  However, even the 5-year average number and 1-year number do not pass the 10% threshold.  You'll see the details of the BVPS in Figure 2.  The BVPS started declining 2 years ago and then took a big jump downwards last year.  I dug a little deeper and found that Netflix took out $200 million worth of debt last year, which was the culprit bringing down the BVPS.  Having debt is not a big issue, as long as the free cash flow is sufficiently large to be able to pay it off relatively quickly (i.e. in 3 years by Rule #1 standards).

In Figure 1, you will see that it takes Netflix 2.8 years to pay off its current debt using the free cash flow from last year.  We'll call this a pass.  It's ok for a company to carry debt, just as it is ok for you to have a mortgage.  However, it's much preferred if the company can finance its growth with earnings and not debt.  What this shows is that the operating margin of Netflix is probably not that good.  Otherwise, money would be pouring in and it would not need to borrow cash to grow its business.  A quick check at Yahoo Finance shows a 12.85% operating margin.  Although there's no hard and fast rule how much this should be, I personally like it to be at least 20% to show that the business has a true moat (i.e. they can charge the customer a high price for their product).  For comparison sake, Apple (Ticker: AAPL) has an operating margin of 28%, Google (Ticker: GOOG) 36%, Coach (Ticker: COH) 32%.

Netflix currently has little competition in the streaming arena.  The company that comes closest is Hulu.com.  However, the content is considerably different.  Hulu focuses on TV shows and has a very limited selection of movies (even worse than that of Netflix Canada).  Apple TV and Amazon also has streaming content but are on a pay-per-view basis, although their content is better.  Youtube may become Netflix's biggest threat; Google recently announced that it was planning to offer free premium content from the biggest studios.  On the DVD rental front, Blockbuster is going down (in bankruptcy protection).  Redbox is the only real competitor at $1/rental/night.  But my guess is Netflix will eventually go all streaming and drop its DVD rentals.  All-in-all, I think Netflix has a pretty good position going forward.  As we noted, its operating margins are pretty thin and if any competitor figures out a good assault on Netflix, it could be in trouble.

Netflix gets a 7 out of 10 from me for Moat.

Moat Score: 7 / 10

Figure 1: Rule #1 Analysis of Netflix (NFLX)


Figure 2: BVPS History of Netflix (NFLX)


Margin of Safety
Netflix is currently trading with a P/E ratio of about 70!  This is like the P/E ratios of the dot-com days.  What's even crazier is that it's P/B (Price-to-book) ratio is 50!  I can tell you Ben Graham would never buy Netflix if he were still around.  Perhaps the growth justifies this valuation, who knows?  Let's take a look.  I used the analysts' estimated growth rate of 26.3% (high in itself) and also a historical P/E of 21.7.  Yes, the P/E is 70 right now, but I don't believe this can be sustained for more than a year or two.  Remember, we're thinking long term here (e.g. 5 to 10 years or more!).  The sticker price comes out to $142.93, which means the entry price is half of that at $71.47.  Netflix is currently overpriced at $185.  However, if you're willing to risk it and dial up the P/E ratio assumption to 56, then Netflix is right at entry price now.

This section is all about margin of safety.  With a P/E ratio of 56, you have little room for error.  You want to be conservative in your estimates and have a margin of safety.  When you have both, you really have a good margin of safety!  Therefore, I would rate Netflix as a risky investment right now.  It gets a 4 out of 10 for MOS.

Margin of Safety Score: 4 / 10

Management
Reed Hastings is the CEO of Netflix.  He is the founder of the company and also sits on Microsoft's (Ticker: MSFT) board.  He is quite the visionary for revolutionizing the way people rent movies, and possibly be the cause of Blockbuster's demise.  Hastings is definitely a smart guy.  There's no doubt about that.

You can also see his intelligence from his trades.  In the past 12 months, he has sold $40 million worth of Netflix stock!  He still has about 1.2 million indirect shares, which is worth about $220 million now.  As you can see, as the stock rose to lofty levels, he slowly offloaded his shares, locking in some gains.  He knows that the valuation of the stock at P/E ratio of 70 is probably a little high.  With 1.2 million shares still at stake, I believe Hastings has a good reason to run the company well.  His recent sale does not show disloyalty to the company, but rather, Hastings' prudent management of his finances.

I give Hastings an 8 out of 10 for his Management.

Management Score: 8 / 10

Meaning
Streaming video is great!  I love the convenience of it.  The only reason why I would end my Netflix subscription would be my lack of time for watching TV.  If my work day wasn't 6:30 - 6:30 (including commute time) and I didn't have a young daughter at home, and doing a part time Master's program, Netflix would be a no-brainer.  Even still, I'm planning to keep the subscription for the foreseeable future.

Are there any red flags with Netflix in terms of ethics?  Probably.  Let's dissect the business a little bit.  Netflix  rents movies to viewers.  What could go wrong there?  That was a rhetorical question!  If you're thinking R-rated movies, you've hit the nail on the head.  There are quite a number of questionable movies on Netflix, especially with some of the more sexually explicit and/or violent films.  Of course, there's no X-rated movies on Netflix, but some of the R-rated stuff are still pretty unnerving.  Although the USCCB's investment policy is not to invest in companies whose significant portions of revenues derive from X-rated films, this is still a somewhat problematic area.

Aside from this, there wasn't much dirt to dig up with Netflix.  They get a 7 out of 10 for Meaning.

Meaning Score: 7 / 10

Summary
Moat Score: 7 / 10
Margin of Safety Score: 4 / 10
Management Score: 8 / 10
Meaning Score: 7 / 10
OVERALL (not an average): 5 / 10

If Netflix were below my entry price of $71, I'd probably consider buying it.  However, at $184, the price is a little steep.  I'm not saying the stock won't continue its upward trajectory in the near term, but if it misses a quarter, there might be quite a bit of pain!  If it were to drop down to a P/E ratio of 45 (still a high value), the stock would be at $118.  Ouch!  Not my cup of tea.  I'd much rather buy a company with a P/E of 10 when it should be at 20!  Do keep your eyes on this company...if its price falls significantly, you may want to add it to your holdings.