Is Netflix a Poor Investment to Make?

Source: Netflix

Netflix (NASDAQ:NFLX) has been relatively strong this year, with shares rising more than 14 percent. This is despite the fact that the market has generally been punishing growth stocks, many of which have fallen despite the fact that the stock market is up slightly for the year. In particular, Netflix shares have been especially strong since bottoming out in April — the stock has gained over 30 percent since then.

Investors have several good reasons to bid up shares of Netflix. First, the company is growing its sales, and it is growing its profits even more. One of the problems that a lot of growth companies have had this year is that while their sales continued growing, their profits declined, or at the very least they failed to grow at an acceptable rate from the perspective of a growth investor. These companies have had trouble growing their margins due to commodification of the products they sell or rising input costs. This has hit growth companies like Whole Foods (NYSE:WFM) and Panera Bread (NASDAQ:PNRA)  hard.

Netflix has bucked this trend because its product cannot easily be replicated: that is, it is difficult for a new company to enter the market and offer content streaming to the extent that Netflix can. The company has reported profit growth that far outweighs its sales growth, with net profit margins growing from 2.6 percent to 4.2 percent year over year in the most recent quarter. This coupled with double-digit sales growth means that the company’s profits are soaring.

Not only are the company’s profits soaring, but it has a “subscription” business model, meaning that each of its customers pays for its streaming services regularly. Given that Netflix offers modest pricing, it is unlikely that subscribers will cancel their plans even if they are facing tight budgets. This not only improves growth but means that the company’s revenue is more reliable and therefore more valuable for long-term investors.

With all of these positives, why do I think investors should sell Netflix? It’s pretty simple: The valuation is extremely high. As great as the company is, it trades at over 150 times trailing earnings and at nearly 60 times 2015 earnings estimates. What this means is that investors are assuming that the incredible growth we are seeing today carries into the future.

Maybe it will, although in a minute I will explain why I don’t think this is the case. The problem is that even if the company can continue to grow at this astronomical rate the stock is fairly valued, meaning that in order to justify buying the stock today, you need to assume that the company can grow even faster! While the company is expanding into new markets and while it is expanding into original content, I think this is highly unlikely.

In fact, as I just suggested, I think growth is set to slow, at least modestly. The trouble is that the kind of margin growth that Netflix is showing can only continue up to a point. It is relatively easy to grow margins from 2.6 percent to 4.2 percent. But at this rate, margins reach double-digit levels very quickly. What happens in, say, five years? The company won’t be able to grow its margins as quickly.

With this in mind and with sales growth at about 20 percent, it makes more sense to assume that growth will trend toward this 20 percent level. Furthermore, as the company expands, it won’t be able to grow its sales as quickly. It follows that in a few years Netflix’s growth will be substantially slow unless it can find new markets or find new ways to cut expenses.

These feats are not unobtainable, but they are improbable. Nevertheless, the stock seems to be pricing them in.

With this being the case, Netflix is a poor investment at the current share price. But that doesn’t mean it is a poor investment at any share price. If you agree with the bullish features of the company’s business that I cite above, then wait for weakness. As those who follow the stock know, Netflix shares can be extremely volatile. Take advantage of that volatility to buy on weakness and to sell on strength, and you can make a lot of money. But don’t be suckered in at these nosebleed valuations.

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

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