2 Ways Bulls Are Wrong About Netflix

2 Ways Bulls Are Wrong About Netflix

Netflix is one of the most hotly contested stocks in the market today. Bulls like my colleague Anders Bylund think the sky is the limit and that Netflix stock could go to $600 within a few years. By contrast, prominent bears like TheStreet's Rocco Pendola believe it's only a matter of time before Netflix comes crashing back to earth.

Both sides have some good points to make. However, Netflix bulls and bears alike tend to overstate their cases with flawed or exaggerated arguments. With dubious cases being tossed around on both sides, it can be difficult for investors to sort out what's really happening. Today, I'll look at two flaws in bulls' arguments. Check back this weekend to see how the bears may also be pulling your leg!

What earnings growth?
Netflix stock is now trading for about 200 times projected 2013 earnings. That valuation implies investors consider Netflix a big-time growth company. Indeed, bulls (and the media) often get sucked into calculating Netflix's year-over-year earnings growth to justify the stock's high valuation. For example, in the first half of 2013, Netflix saw pre-tax income (excluding a debt refinancing charge) grow 20-fold year over year, from $3.6 million to more than $72 million!

However, while it's true Netflix is posting rapid year-over-year earnings growth, its earnings are still well below peak levels. In fact, Netflix's pre-tax income in the first half of 2013 was 65% below what it produced in the same period of 2011 ! Analysts don't expect Netflix to regain its 2011 profit level until at least 2015.

Bulls might point out that Netflix has greatly increased its investment in international markets in the past two years. Indeed, higher international losses do account for the majority of Netflix's decline in pre-tax profit.

Still, even if you exclude international losses from the calculation, Netflix's pre-tax income was about 7% below 2011 levels in the first half of 2013. Meanwhile, the share count has grown by more than 10%, so each shareholder is entitled to a smaller percentage of that profit.

Margins can go both ways
Netflix bulls are also very impressed by growth in the company's contribution margin for the domestic streaming segment. This statistic represents the percentage of streaming revenue that remains after Netflix pays for content acquisition and delivery costs and advertising expenses.

Domestic streaming contribution margin has jumped from 14.3% in the first quarter of 2012 to 22.5% last quarter. The midpoint of Netflix's guidance calls for an increase to 23.8% for the current quarter. Management's goal is to grow this contribution margin by 400 basis points per year.

Bulls therefore believe Netflix's domestic streaming contribution margin will continue growing at this rate for a long time. This is a dangerous assumption. To be clear, Netflix's "long term view" states, "As long as we continue to grow as we have been, we are likely to be able to continue this margin expansion." In other words, Netflix needs to continue adding about 6 million domestic streaming subscribers annually to maintain this contribution margin growth rate.

However, Netflix's domestic subscriber growth is likely to taper off beginning within the next few quarters. First, market saturation will become an increasingly important barrier to domestic growth. Netflix's U.S. streaming subscriber base already totals more than one-third of the 88 million U.S. households with high-speed Internet.

Since some people are not interested in Internet TV, and others are satisfied with competing services such as Hulu and Amazon.com's Prime Instant Video, the pool of potential new Netflix subscribers is shrinking.

Second, Netflix recently lost several high-profile series to Amazon, including Downton Abbey, SpongeBob SquarePants, and Dora the Explorer. This boosted margins in the near-term, since Netflix is no longer paying for that content. However, as subscribers begin to notice that this content is missing, some attrition is likely.

Netflix's foray into original content may offset these losses, but original content is very expensive. If Netflix has to step up original content investment to maintain its subscriber growth rate, that will just as surely put a damper on margin growth.

Bulls overlook trouble spots
Netflix bulls tend to exaggerate Netflix's earnings growth prospects for two reasons. First, they have focused on the company's year-over-year earnings growth, which is merely an artifact of the company's dreadful 2012 performance. A longer look backward reveals that Netflix's pre-tax income has dropped by 65% over the past two years.

Second, bulls expect significant long-term expansion in Netflix's domestic streaming contribution margin. However, even Netflix executives have carefully hedged their goal of achieving 400 basis points of improvement each year. There are good reasons to believe subscriber growth will slow soon, ending the period of rapid margin expansion.

Still, while there are some major gaps in the bull case, Netflix bears' arguments aren't always up to snuff either. Check back this weekend for the other side of this story!

The future of television
Americans reportedly spend nearly 34 hours a week watching television! With television viewing taking up almost as much time as the average work week, the potential for profits in the space is enormous. The Motley Fool's top experts have created a new free report titled "Will Netflix Own the Future of Television?" The report not only outlines where the future of television is heading, but offers top ideas for how to profit. To get your free report, just click here!

The article 2 Ways Bulls Are Wrong About Netflix originally appeared on Fool.com.

Fool contributor Adam Levine-Weinberg is short shares of Netflix and Amazon.com. Adam Levine-Weinberg is also long December 2013 $275 puts on Netflix. The Motley Fool recommends Amazon.com and Netflix. The Motley Fool owns shares of Amazon.com and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Originally published