Valuentum Exclusive Analysis for the Discerning Investor

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Netflix’s results for the first quarter of 2018 showed the earnings leverage that we’ve been looking for. We’re raising our fair value estimate materially as a result.

By Brian Nelson, CFA

On April 16, streaming movie provider Netflix (NFLX) reported fantastic top-line and subscriber growth numbers during its first quarter of 2018, with the top line accelerating to 40%+ growth over the prior-year quarter and total memberships leaping to 125 million, up from ~117.6 million in the fourth quarter of 2017 and ~99 million in the first quarter of last year. Net additions to its US streaming business came in at 1.96 million, while net additions across its non-US operations leapt by 5.46 million, a slow down from the pace of growth during the fourth quarter of 2017 (+6.36 million) but faster than the net additions during the first quarter of 2017 (+3.53 million). The world’s appetite for streaming content seems insatiable, and somehow Netflix is fending off competition not only in the US but also on the international stage. It’s quite amazing.

The real story, however, and the major question for long-term investors is whether there exists earnings leverage within Netflix’s business model to justify its valuation. The company’s operating margin expanded to 12.1% during the first quarter of 2018, up 2.4 percentage points over the prior-year period, but even with the improved levels of profitability, cash flow from operations came in at -$237 million (negative $237 million) during the quarter, while free cash flow settled in at -$287 million (negative $287 million). EBITDA, however, leapt considerably to $534 million during the first quarter of 2018, up from $317 million in the same period a year ago, and Netflix may very well be showing signs that its business model has the earnings leverage needed to keep speculators’ hopes alive and well.

With a market capitalization of $133 billion at the close April 16 and a net debt position of $3.9 billion ($6.5 billion in long-term debt less $2.6 billion in cash and cash equivalents), in order for the company to garner what might be a reasonable 12 times EBITDA multiple on a normalized basis, Netflix would have to generate $11.4 billion in EBITDA on a long-term annual run-rate basis, on the basis of its current enterprise value--excluding adjusted debt related to content liabilities. On an annualized basis, Netflix is currently running between $2-$3 billion in EBITDA, which means it would need to triple or quadruple levels of profits over the long haul to come anywhere close to justifying its current valuation (and this doesn't consider the negative impact from the time value of money, or just how long it would take to achieve normalized numbers).

Though difficult, we think it is looking more and more likely that Netflix may deliver, particularly in light of the option value presented by Netflix’s cash on the books and slowing free cash flow burn (at least in the most recently-reported period). Netflix still plans to burn through $3-$4 billion in free cash flow during 2018, but we liked Netflix’s first-quarter 2018 results a lot, and we think the company’s pace of operating-margin and EBITDA expansion is encouraging for the longs. We plan to raise our fair value estimate of Netflix materially following the report (to build in greater earnings leverage over the long haul), but we maintain our view that Netflix has a lot yet to prove. From the fickle nature of consumer preferences to rivals that are only growing stronger, the uncertainty surrounding our fair value estimate remains considerable. It also bears emphasizing that Netflix is expected to be free-cash-flow negative for at least a few more years, and with a junk credit rating, we doubt its equity will hold up well in the event of any cyclical downturn that causes consumer spending to slow.

Let the wild ride continue.

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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.