Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Michael Corty. He is a senior equity analyst at Morningstar. We're going to look closer at Netflix and see what's driving the stock higher.
Michael, thanks for joining me today.
Michael Corty: Great to be with you, Jeremy.
Glaser: Why have investors been so excited about Netflix stock recently?
Corty: Netflix has become a momentum stock. Even CEO Reed Hastings in his recent quarterly letter referred to being concerned about investor euphoria in the shares.
Now, setting aside the lofty valuation for a second, Netflix is doing several things right as a business. They've built a compelling streaming video-on-demand service in the United States. They are on pace to add 6 million subscribers by the end of the year, which would put them at around 33 million.
In our view, the cable and satellite companies have done a poor job of offering a streaming service, and Netflix has really stepped right in. They've focused on three key areas in our view: first, kids programming; second, prior seasons of popular cable series that are still running on TV, like Breaking Bad; and third, Netflix getting into first-run programming on its service--a series like House of Cards, which is a series that they don't own, but they have the licensing rights to for the first few years.
Glaser: It sounds like they've recovered from kind of that Qwikster debacle that seems like it has really gone out of investors' memories.
Corty: Yes. The stock has been a rocket ship over the past 12 months.
Glaser: When we see a stock increasing this quickly, even when fundamentals are doing well, it raises the question of valuation. Where is the valuation level right now? Is it completely unmoored from reality?
Corty: We think Netflix is extremely overvalued at this point. With the stock trading at around $320, that's over 80 times our 2014 earnings-per-share estimate. Now, we think Netflix shares are worth $180, and the assumptions we use to get to that value are optimistic in our opinion. By 2017, we assume Netflix gets to almost 50 million subscribers and increases their earnings per share from around $2 today to near the $10 level in 2017.
Now there are a lot of hurdles between today and 2017 in getting that EPS growth. But even if you did assume that they did get $10 a share in EPS in 2017, at today's price you're still paying 32 times 2017 earnings per share, and we think that's rather lofty.
Glaser: When they add all of these new subscribers, isn't that going to just drop to the bottom line? Could profitability expand more than maybe you are expecting?
Corty: Sure. That's a fair question. We see domestic profitability improving, but we think there are limits to that margin expansion. In our view, adding each incremental subscriber is essentially harder for Netflix to do. The way Netflix is going to try to achieve this goal is by investing more in higher-quality content, and we think that's going to limit the margin expansion.
Glaser: You mentioned that the performance has been pretty good and you think it's going to continue to do well. Does that mean that Netflix has an economic moat? Is this competitive advantage sustainable in anyway?
Corty: That's a fair question, and one we debate often internally. A valid argument can be made on both ends, Netflix having a moat or not having a moat. We've come down on the side of Netflix not having a moat.
One of our concerns about Netflix is whether the current competitive advantage it enjoys today is going to last for another 10 years, with 10 years being a key hurdle for Morningstar assigning an economic moat.
Netflix doesn't have a lot of control of its costs. Most of its key programming is secured under short-term licensing deals, and we expect a lot of competition on the horizon over the next decade.
Another point about Netflix’s moat is that the international expansion is a poor use of capital in our view. They are essentially taking the profits from the U.S. and trying to grow in overseas business, and we think they have little to no competitive edge in most of their international markets.
Glaser: If you don't think Netflix has a moat, we did recently raise the Morningstar Economic Moat Rating on several content producers to wide. Can you talk a little bit about why those companies do have sustainable competitive advantages?
Corty: Sure. We recently raised three media companies’ moat ratings to wide from narrow. Those companies are Time Warner, 21st Century Fox, and Discovery. And debating the moat ratings on those companies, obviously, how content gets sold and consumed over the next few decades is up for debate. But we think having a vertically integrated business--which means in this case they own not only the channels, but the content on those channels--is going to position these companies well, no matter how all this content conception and changes in technology shake out over the next few decades.
For example, companies like Fox and Time Warner are still getting advertising dollars and affiliate fees from traditional television distribution, and now they are incrementally getting more money from licensing data content to the likes of Amazon and Netflix.
Glaser: Are there any investment ideas there. Do any of those companies look attractively valued?
Corty: I wish there were. Unfortunately, the stocks like Disney, Time Warner, and 21st Century Fox are all trading near my fair value estimates. However, these are wide-moat companies that I'd encourage investors to put on their radar list and wait for a better margin of safety before looking to invest new money.
Glaser: Overall, it seems like you are optimistic that Netflix can continue doing well, but that the valuation just isn't supported.
Corty: Yes, the risk/reward ratio there is just very slanted on the side of risk and not on reward. We just don't see how you can look at the stock at $320 and see a lot of upside. We see downside, just based on the valuation. We like the service; we don't like the stock.
Glaser: Michael, thanks for your thoughts today.
Glaser: From Morningstar, I'm Jeremy Glaser.