Over the last few weeks I’ve added shares of Facebook and Tesla Motors to my Strategy Lab model growth portfolio. To raise the cash for these new positions I’ve trimmed back on my holdings of Netflix Inc., one of my biggest winners to date.
Does this mean I think Netflix is getting too pricey for comfort? The answer depends on whether you’re asking for the short-term or the long-term.
Netflix has been an astonishing performer for me so far. I’ve watched it climb more than 500 per cent, from $58 (U.S.) a share to over $360, since Strategy Lab began in September, 2012. I don’t think the ride is over yet.
Let’s consider where the stock could go in coming years.
As a starting point, remember that it has been only three years since Netflix first expanded its streaming video business outside of the United States. Canada was its first international market in 2010, followed by Latin America, the Nordic nations, the U.K., Ireland and the Netherlands.
“I don’t think there’s anything fundamental that’s different about the U.S.,” Netflix CEO Reed Hastings said during the company’s last quarterly earnings call. “If you look at YouTube usage, it’s about 80 per cent international. If you look at Skype revenue before they were acquired, it’s about 83 per cent international.”
Mr. Hastings’s comment makes perfect sense to me. People all over the world love to watch TV shows and movies, and Netflix is amassing a huge library of excellent content. I think Netflix’s revenue outside of the United States will eventually be far, far bigger than its domestic business.
In the U.S. market, Netflix brought in $701-million in revenue from streaming customers last quarter. That’s about $2.8-billion on an annual basis. (This figure ignores the company’s shrinking DVD-by-mail business.) Even though the U.S. streaming video business posted annualized growth of 26 per cent, let’s pretend it stops growing right now. Then let’s say the international market grows to the point that it represents 80 per cent of total streaming revenue.
In this fictitious example, Netflix would have revenue of about $14-billion. With global scale and falling bandwidth costs, let’s assume the company can deliver 20 per cent net margin for a profit of $2.8-billion per year.
What would the stock be worth in this scenario? A valuation somewhere between 20 and 30 times earnings seems reasonable. This translates into a market capitalization of between $56-billion and $84-billion. The company’s current valuation is about $22-billion. That’s a significant opportunity any way you slice it – and remember it ignores any remaining domestic growth.
In reality, growth in the U.S. market hasn’t stalled out yet, and we have no idea how many years it might take for the international market to reach the point where it accounts for 80 per cent of total revenue. For argument’s sake let’s assume it takes a full decade for Netflix to painfully negotiate video streaming rights for each and every country. Still, according to the scenario I outlined above, Netflix would at that point be worth double or more what it is now.
If the stock merely doubles over the next decade, it’s probably not going to beat the market. But if it triples or better, which I think is entirely possible, it probably is going to do better than the index.
So investors have to assess their own willingness to ride out this story. At today’s price, Netflix is clearly not as absurdly cheap as it was when I added it to my model portfolio, but it still could be a bargain for those willing to hold it for a decade or more.
If it should tumble in the next few months I would find it even more tempting.