Pando

Netflix is one of the most successful companies in the tech sector, and the most absurdly valued

By Kevin Kelleher , written on July 20, 2015

From The Earnings Desk

Netflix continues to roll out its new original programming but, in some ways, the company itself has become a compelling spectacle of its own.

Not only is Netflix one of the most successful companies to come out of Silicon Valley in the past 20 years, its stock is maybe the strongest case the tech market has that even the most successful companies can be dangerously overvalued.

For most of its history, Netflix has drawn the attention of bearish naysayers and bullish speculators alike. It has defied all predictions of its downfall, shifting away from the dying DVD and emerging as the most influential streaming video company. And that has only left speculators that much more confident.

In the past few years, the costs of negotiating costly content licenses, creating its own programs, and expanding into several overseas markets at was seen by bears as too ambitious, burning through cash with no guarantee of success. But recent quarters show that the spending is paying off in terms of new subscribers in the US and abroad.

On the other hand, as good as that news is, it never seems to justify the fact that Netflix shares regularly rallies 10 percent or 20 percent every time it does what everyone expects – namely, deliver strong earnings – so that $10,000 invested in its 2002 IPO would be worth more than $1 million today. Only part of that has to do with the success story that Netflix is. The rest is something no company really wants, which is speculative and irrational investing that almost never ends well.

Last week, Netflix reported earning that, looking at the headline numbers, were nothing special. Revenue came in line with Wall Street's expectation of $1.65 billion and net income came in at 6 cents a share, two cents above the forecast. The stock surged 18 percent on that report, mostly because investors were looking at other metrics to see if the sizable investments are bringing in new customers.

They are. Netflix also said that it added 900,000 net new subscribers in the US, 50 percent above the 600,000 net adds it had estimated. Net new subscriptions in international markets, where the company has been spending heavily in anticipation of growth, were even stronger: 2.4 million against the 1.9 million Netflix had forecast.

Currently, Netflix has 65.6 million members around the world. The company said that new series in its original programming slate such as Marvel's Daredevil, Sense8 and the animation series Dragons: Race to the Edge helped drive the stronger-than-expected increase in subscriptions.

At the same time, an international expansion is burning through cash at an increasing rate. Free cash flow was negative $229 million, well above the negative $59 million figure that analysts had expected and also larger than the negative $163 million in free cash flow last quarter. And the spending isn't slowing down: the company expects to spend more than $6 billion in cash on global content in 2016.

So Netflix isn't rising on expectations of growth in profits this quarter - or even in the coming few quarters. The global audience is steadily growing but that is coming at a huge cost, thanks to aggressive spending in multiple markets. And while it's easy to imagine that this approach will keep Netflix's revenue expanding, it's a stretch of any fundamental analysis to expect material profits from the company anytime soon.

This has never been an issue for Netflix investors, who have long accorded the stock a PE ratio above 100 and sometimes – like right now – above 500. Netflix ended last week trading at 522 times its expected earnings this year. Even for those banking on a strong year in 2016, the stock is still trading at 370 times the profit that analysts are expecting 18 months from now.

Nobody is more perplexed by this than Netflix CEO Reed Hastings. Two years ago, he suggested that investors were getting a little ahead of themselves in terms of valuing the stock. Asked about his thoughts now that Netflix has more than doubled so far this year, he said,

“...it probably shows why at least I should keep my day job and not try to be a stock picker, because when the stock was half this price I described it as euphoric. So it's a mystery to me. And what we focus on is how to get incredible content, stream it beautifully, market it in every country, grow the member base; and I think I'm out of the stock commentary business.”

In theory, an elevated stock price is good for a technology company that lures and retains talented employees with stock options. A collective sigh ran through the Googleplex last week when the company reported strong earnings that boosted its market cap by $6.4 billion billion in a day. For more than a year, a stagnant stock price had been hanging over Google as it seeks to hold on to employees in a competitive job market.

This kind of benefit, though, only goes so far. A stock like Netflix that surges wildly every time it reports earnings may just as easily plummet wildly on any hint of disappointment. Hastings learned this lesson during the backlash to the ill-fated Qwikster announcement four years ago.

So Netflix is not only one of the most successful companies in the tech sector, it is almost certainly the most absurdly valued and speculative tech stock that has a brand name recognition among consumers. The volatile stock is making the company look even more successful than it is. The reverse of that situation is one no company wants – a tumbling stock that conceals just how well Netflix is being managed.