How Risky Is Netflix?

By Andrew Tonner Markets Fool.com

On the face of it, shares of video-streaming pioneer Netflix (NASDAQ: NFLX) might seem unduly risky. The company's stock has marched steadily upward over the years, rallying 37% during the past year alone. Its 323 price-to-earnings ratio certainly does little to ease any concerns investors might have.

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However, the fact remains that Netflix stock is significantly less risky than it appears at first glance due in large part to the powerful underlying economics of its subscription-based streaming business model.

Netflix's profitability: Hiding in plain sight

For those completely unfamiliar with the company, Netflix organizes its business into a U.S. streaming and international streaming reporting divisions. A look at the two segments suggests that Netflix's U.S. segment is approaching maturity, but its international business remains in high-growth mode, which helps mask the impressive underlying profitability inherent in the business model. Here's a quick snapshot of Netflix's U.S. segment's financial performance last year.

Metric Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Forecast
U.S. revenue (in billions) $1,161 $1,208 $1,304 $1,403 $1,471
U.S. paying memberships (in millions) 45.71 46.00 46.48 47.91 49.86
U.S. contribution margin 35.5% 34.3% 36.4% 38.2% 41.3%

Data source: Netflix investor relations; forecast is issued by Netflix management.

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You can see that, though not in perfect lockstep, Netflix's profitability, as defined by contribution margin, tends to expand as the number of paying members increases. For context, contribution margin is a rough proxy for operating margin, though some differences exist. In any case, the gradual increases in profitability should excite investors, especially as the same dynamic begins to unfold in the company's international business.

Metric Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Forecast
International revenue (in billions) $652 $758 $853 $948 $1,045
International paying members (in millions) 31.99 33.89 36.80 41.19 45.48
International contribution margin -16% -9.1% -8% -7% 1.5%

Data source: Netflix investor relations; forecast is issued by Netflix management.

Again, we see the same relationship between profitability and total paying users steadily pushing Netflix's international profits toward profitability. Netflix expects international contribution margins to vary from country to country, and some countries have already reached levels of profitability comparableto those of its U.S. operations. What's more, the company has said it believes it can actually improve its U.S. contribution margin even in periods during which its domestic subscriber count declines, due to the inherent flexibility of its strategy for content creation and marketing spending. All of this is to say that it doesn't seem unreasonable that Netflix could eventually achieve companywide contribution margins in the 30%-40% range over the long term.

Better still, the truly global nature of its service gives Netflix the ability to serve a far larger addressable market -- 6 billion people worldwide, after subtracting China -- than most traditional media companies. Netflix is shrewdly investing in localized original content in order to maximize its appeal and value proposition across its many geographic markets. However, there are indeed some potential risk factors that anyone considering Netflix shares will need to monitor.

Image source: Netflix.

Some issues remain

At one level, Netflix's decision to move into original-content production speaks to the visionary nature of its management team. Unfortunately, other streaming services including Amazon.com, Hulu, Alphabet's YouTube, and many others are now mimicking this strategy in a bid to differentiate themselves from one another.

Netflix has done an admirable job attracting leading talent, but it has had to spend lavishly in recent years to acquire both original and third-party content. And the company says it will continue to do so. Netflix has primarily done this in recent years by tapping debt markets to fund its content obligations. The company presently carries $3.3 billion in debt, versus cash and equivalents of $1.7 billion, as of its most recent regulatory filing. Moreover, its content spending spree has forced Netflix to produce negative operating cash flows in its last two fiscal years. This should abate over time as its international business expands, but it is indeed worth noting.

Valuation remains an important issue. Hopefully, we can all agree that Netflix's spending to fund its international expansion has artificially depressed its earnings, thereby overinflating its P/E ratio. However, the company's forward P/E ratio still remains a lofty 69. Considering the S&P 500 trades at 26 times earnings, Netflix is still expensive, even with our more complete understanding of the long-run margin profile of the business. However, given the size of the company's opportunity and its above-average economics, Netflix stock isn't nearly as risky as its current valuation might suggest.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Andrew Tonner has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, and Netflix. The Motley Fool has a disclosure policy.