Chris Umiastowski is the growth investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.
When we launched Strategy Lab in September, 2012, I scooped up some Netflix shares for $58 (U.S.). As I write this, the stock is hovering around $571 , a few dollars away from a 10-fold return on investment.
How is it possible to make such an enormous return on investment with a well-known, large capitalization stock? Shouldn't the market know enough to fairly value big companies? If you read enough about investing you'll come across numerous articles about market efficiencies and the unfavourable probabilities of outperforming an index fund. I'm all for index funds, but I believe long-term investors can outperform by owning some common stocks in their portfolios.
Regular readers know I don't believe I have any special abilities with respect to market timing. I'd rather poke myself with a sharp stick than try to time my trades. I invested in Netflix because, while it was widely known as the biggest and best Internet TV company on the planet, I saw a future 10 or 20 years down the road where broadcast TV would disappear. This thesis has not changed.
Last week, Netflix stock rallied sharply because the company posted strong subscriber growth numbers for the first quarter. They've grown to just over 60-million subscribers around the world, with two-thirds of these subscribers in the U.S. There is still, in my view, an enormous untapped global market and Netflix is investing heavily to capture this growth. The company has consistently told Wall Street to expect close to break-even financial results until the global rollout of Netflix is done.
Not only does Wall Street have a short-term memory, but it also has a short-term investment horizon that is completely incongruent with the way Netflix is running its business. This, in my opinion, leads to a stock market that cycles between near-term disappointment on quarterly profits and new levels of optimism driven by subscriber growth and contribution margin.
Netflix doesn't make any meaningful profits and it is burning through cash as it grows. How can I dismiss cash burn and feel so good about the company's future? Easy. I understand and believe in the concept of customer lifetime value, and I think Netflix is smartly spending a lot of money to acquire new customers at a price less than their long-term value.
If you were running a business and you discovered you could spend $1 in advertising and bring in significantly more than $1 in gross profit from that advertising dollar, how much money would you spend on advertising? Assuming you understand how your fixed costs scale, the only reasonable answer is that you'd spend every dollar you could get your hands on.
But how long can we let this go on? I think it all comes down to how long the business is growing. Look at how Amazon is disruptive to traditional bricks-and-mortar stores. Amazon has never published meaningful profits, and I agree with CEO Jeff Bezos's strategy. Amazon has been public since 1997, or almost 20 years. The company has grown based on amazing free shipping deals and continually expanding its product catalogue. The result is simple: The next generation of consumers is being trained to just go to Amazon and hit the "buy" button. There is enormous power in training your audience to think of your business as the default place to spend money. Then, once you're finished training customers to buy from you, you monetize that customer base.
Just as Amazon is becoming the default way to conduct online shopping for so many people, I believe Netflix will become the default Internet TV service for perhaps 200-million households by the end of this decade. The bargain price of under $10 per month for access to a vast and growing content library is a no-brainer that can lead customers to quickly consider it a required part of their entertainment budget.
Consider what happens when Netflix has 200-million users and raises its price by a measly $1 per month. Pre-tax profit could rise by up to $2.4-billion depending on the price elasticity of demand. Netflix has a market capitalization of $34-billion today, and the extra profits from this theoretical $1-price increase could justify the company's market capitalization all by itself.
Sure, Netflix stock looks expensive – especially if you are staring at a historical stock chart and thinking about what you should have done years ago. I prefer to focus on the years still to come, and I believe the stock will break $1,000 before the end of this decade.
Chris Umiastowski