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Published: July 22, 2010
Success brings its own pitfalls. The better
a company does, the more investors love it. And they keep on
showing their love by pushing up shares until the
price-to-earnings ratio (P/E) moves into nosebleed
territory. One false move and the richly-valued stock can take a
beating.
No stock better highlights this notion than Netflix (Nasdaq:
NFLX). The DVD rental firm has had an historic run. Its
sales rose more than +1000% from 2002 to 2009, while earnings
per share have risen at least +37% every year in that stretch
(with the exception of 2006, when profits rose only +10%).
For a number of years, Netflix had as many detractors as
supporters. Short sellers piled in to the stock, assuming that
the company would eventually be the victim of technological
obsolescence, as cable companies boosted video-on-demand
services. As recently as 2007, shares still sold for less than
$20. Since then, Netflix has maintained its white hot growth,
leading shares to rise more than +500% in the last three years.
And that gain meant that shares were now worth 60 times trailing
earnings and 45 times projected 2010 earnings. Priced to
perfection, as they say. Priced to perfection also means any
misstep will be trouble.
Well, on Wednesday evening, Netflix finally
stumbled. That's when the company announced that second-quarter
sales were at the low end of expectations, and that it is now
spending more money to harvest new subscribers.
Subscriber acquisition costs (SAC) were $24.37 per subscriber in
the most recent quarter, up from $21.54 in the first quarter of
2010. We saw the same problem emerge with wireless service
providers and satellite TV companies. They started to spend more
on subscriber acquisition costs just as sales started to
flatten.
Is this scenario replaying at Netflix? Well, signs are emerging
that the days of heady growth will soon be over. For example, an
increasing number of new customers are signing up for the
one-rental-at-a-time $8.99 service, but a rising number of
existing customers are also downgrading to that plan from
higher-priced plans. The average revenue per user (ARPU) dropped
-7.8% from a year ago to $12.29.
But it's too soon to write off the company. After all, more so
than any of its peers, Netflix has aggressively prepared for the
day when all movies are downloaded. To its credit, the company
has said for quite some time that DVD-by-mail is only an interim
step. The company even likes it when customers stream movies
form a Netflix server rather than get them in the mail, as it
saves postage and handling costs. Moreover, Netflix has done an
outstanding job of locking up major movie studios to long-term
deals. And thanks to continued robust subscriber gains, Netflix
now has 15 million fairly loyal customers. A just-announced move
into Canada could eventually add up to two million more users.
So Netflix isn't going away. It's just morphing. But investors
need to keep an eye out for any new competitors. The movie
studios would love to see other options emerge so they can gain
better negotiating
leverage against Netflix. More than likely, Netflix's costs
will rise as it has to cut more studio-friendly deals, and as it
pays more in marketing to acquire those last holdouts that don't
yet get DVD rentals.
Action to Take --> But back
to that pesky high
P/E ratio. Netflix now looks on track to earn roughly $2.85
a share this year, and $3.50 to $3.75 a share next year. Even
with Thursday's -10% selloff, shares still trade for 38 times
projected 2010 profits, and about 30 times next year's profits.
But looking beyond 2011, growth looks set to sharply slow,
putting that P/E ratio out of whack. Shares look like they'll
keep falling as investors slowly adjust to the reality that
Netflix is nearing the end of a stunning growth phase.
-- David Sterman
Staff Writer
StreetAuthority |
