Netflix Reports Stellar Numbers, But Here’s Why You Shouldn’t Buy

Source: Netflix

Netflix (NASDAQ:NFLX) is a favorite among growth stock investors, and the company’s second-quarter earnings figures show us why. The company generated 37 percent revenue growth and 135 percent earnings per share growth year over year. These are stellar numbers, and they sent shares higher in after-hours trading even after the stock’s impressive run for the year.

Netflix is a leading content provider. It has a rapidly growing customer base as Netflix streaming becomes a staple of many consumers’ entertainment budgets while costing them just a few dollars per month. With a shift toward international markets and toward its higher-margin streaming business in lieu of its DVD rental business, investors are enthusiastic that the company has a bright future of solid growth ahead of it.

That’s the good news. The bad news is that this story is well known, and as a result, the stock trades at well over 100 times earnings. Bulls might argue that on a PEG basis the stock isn’t so expensive, meaning that the company is growing so quickly that it is worth this earnings multiple. But there are issues with this argument.

First, most of the company’s earnings growth comes from margin expansion. The company is growing margins from a very low base, meaning that even slight improvements in efficiency will lead to substantial improvements in margins. But as margins rise, it becomes more difficult for the company to grow them at the same rate. So I think that over time, the company’s earnings growth will converge with its sales growth, and its sales growth — while impressive at 37 percent – is too slow to support such a high price-to-earnings multiple.

Second, while Netflix is well established and while it has a powerful brand, it is competing with many other companies that have deep pockets and that can compete on price while offering unique content. I think this is more of a threat as the company winds down its DVD business, because the DVD business requires an extensive distribution network that provides a wide economic moat. Streaming is becoming ubiquitous, and ubiquity leads to commodification. While Netflix will have an advantage given that it has a pre-existing user base, it is inevitable that some competition will enter the market.

This is inevitable in virtually every new business. The problem for Netflix is that this competition isn’t priced into the stock, and as it becomes more apparent to investors, they will begin to sell their shares and revalue the company downward.

For now, however, I think the stock can remain elevated. There are a lot of short sellers in the market who at some point need to buy back their positions. Furthermore, investors seem to be attracted to stocks of companies that have high growth rates that are not contingent upon economic growth, and Netflix has the advantage of being largely recession-resistant.

Yet despite these advantages, the stock is simply too expensive for conservative investors looking for long-term cash flow streams. The company is growing, but this growth is priced in, and I think there are risks that are not priced in, such as competition and slowing margin growth.

With these points in mind I wouldn’t short the stock, but I would not be a buyer up here, either.

Disclosure: Ben Kramer-Miller has no position in Netflix.

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