Stock markets have come in for some serious pain in recent days amid fears of slowing growth. But someone apparently forgot to tell Netflix.
The video-streaming juggernaut is scheduled to report third-quarter results after the close on Wednesday, and it has plenty to crow about: the recent four-picture deal with Adam Sandler, the ambitious expansion into France, Germany and other European countries; and – perhaps most impressive – Netflix's resilient share price.
Even as the broader market has tumbled, Netflix's shares have been largely unscathed: Year to date, the shares have produced a total return of about 24 per cent – roughly four times the gain, including dividends, of the S&P 500.
And the third-quarter results will likely bring more cheer for Netflix bulls.
According to analysts surveyed by FactSet, Netflix is expected to earn 91 cents (U.S.) a share for the three months ended Sept. 30, up from 52 cents a year earlier and topping Netflix's own guidance of 89 cents. Revenue is seen rising to $1.41-billion from $1.1-billion.
Investors will also pay close attention to Netflix's subscriber growth numbers, which in past quarters have been known to drive the stock. At the end of the second quarter, the company had roughly 50 million subscribers globally, and it predicted that another 3.69 million would join during the third quarter.
With growth like that, what's not to like in the Netflix story?
For starters, there's the stock's rich valuation. Netflix trades at a multiple of more than 100 times estimated 2014 earnings per share. Clearly, investors aren't buying Netflix for the modest profit it produces today; they're buying it on the expectation that Netflix will become an earnings gusher in the years ahead.
As the accompanying chart shows, the price-to-earnings multiple drops to about 67 based on 2015 estimates, and it falls to about 44 based on 2016 estimates. Those are still high valuations by any standard. What's more, they are based on earnings projections that could well turn out to be too optimistic.
Michael Pachter, analyst at Wedbush Securities in Los Angeles, is skeptical that Netflix can grow earnings quickly enough to justify its current valuation. He points out that Netflix's cumulative free cash flow has been negative over the past nine quarters even as net income has been growing.
The discrepancy between cash flow and earnings reflects the manner in which Netflix accounts for programming costs. The impact may be minimal now, but eventually these costs will put a dent in Netflix's bottom line, he said in an interview.
"What they did was they spent money buying content and they've deferred the amortization of that expenditure, so in future periods they'll take expenses that will hit their net income," he said.
"Each quarter this looming expense recognition gets bigger. There's going to be a day when it has to hit the income statement."
When that happens, Netflix's sky-high P/E multiple could come back to bite the stock. That explains why he has a 12-month price target of $245 on the shares – 46 per cent below Friday's close of $452.08.
Netflix's valuation isn't Mr. Pachter's only concern. The company also faces intensifying competition from Amazon Prime, which has dramatically improved the offerings of its streaming service. Moreover, Netflix's content costs will only rise as rivals enter the bidding for new programs, and as content providers demand higher prices commensurate with the growth in Netflix's subscriber base.
To be sure, Mr. Pachter's bearish views have been dismissed by Netflix bulls, who have continued driving up the shares. But he's far from the only analyst urging caution.
According to Bloomberg, of the 45 analysts who follow the company 19 have "buy" ratings, 19 have "holds" and seven have "sells". The average price target is $463.90, indicating that, on average, analysts expect the stock to go nowhere over the next 12 months.
Among those in the "sell" camp is Cyrus Mewawalla, managing director of CM Research in London.
"Netflix is the world's most successful video streaming platform, so it is one of the biggest beneficiaries of the Internet TV theme. But it could see costs rise disproportionately if the [Federal Communications Commission] relaxes Net neutrality rules," he said in a report. That could force data hogs such as Netflix to pay Internet service providers that carry its traffic.
"Moreover, it is too expensive, given the threat from powerful new entrants wishing to compete with it," he said.
John Heinzl