In this segment of the Motley Fool Money podcast, host Chris Hill, Million Dollar Portfolio's Jason Moser and Matt Argersinger, and Total Income's Ron Gross discuss how high the expectations are for Netflix (NASDAQ: NFLX) in the wake of its third-quarter report.
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Investors have pushed the price to a remarkable P/E ratio. The growth in subscribers seems to justify the move. But its content cost per user is outstripping revenue per user, and that could be a big problem.
A full transcript follows the video.
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This video was recorded on Oct. 20, 2017.
Chris Hill: Shares of Netflix down slightly this week after a third-quarter report, Matty, that is strong by any objective measure. They brought in 5.3 million new subscribers. Once again, that was higher than expected. Is it just because the stock is so insanely high right now?
Matt Argersinger: And it's had such a tremendous run this year. So the fact that it's given a few percentage points after what otherwise were great earnings, I'm not surprised. But you said it -- subscriber numbers are really the story. The international subscriber numbers of 44% year over year, that just blows away anything that investors, including me, were thinking they could do this year. And that's really been the story.
I thought there was an interesting quote by CEO Reed Hastings on the conference call. We talked about Netflix's market opportunity as "How many broadband users are there in the world, how is that growing, and what kind of share of that can Netflix get?" On the conference call, he said, "Well, I tend to think of it as people. All the people in the planet will get the benefit of the internet over the next 20 years, and we hope that all of them will get to enjoy Netflix also."
Hill: [laughs] His addressable market is the entire planet?
Ron Gross: That's a business plan.
Argersinger: So maybe a new benchmark there for market opportunity. I think that's important for a number of reasons. I think if you buy Netflix right now at today's price, at an $85 billion market cap, at a valuation that a lot of investors would call insane, I think you have to believe that this is a company that can achieve, within a reasonable amount of time, something like over 500 million subscribers. Because the content cost for this business is going the wrong way. They're going to spend between $7 [billion] and $8 billion on content next year, some think $17 billion over the next few years. I think that number gets revised up. The content cost per subscriber is growing faster than the revenue per subscriber. That's unsustainable. Can they get to a point where that number plateaus and the subscriber number continues to grow? That's where they need to get.
Hill: Jason, when you think about how Netflix recently announced they were raising prices, to a person, we all agreed, of course they have that pricing power. But as Matty indicated, if the costs are going up higher than their ability to raise prices, maybe not in the next year or two, but starting in 2020 and beyond, this becomes a serious problem.
Jason Moser: And I'm glad you brought that up, because it's sort of what sticks on my mind in regard to Netflix. What we track quarter in and quarter out is the growth in that obligation, that content obligation, versus the growth in revenue. Revenue, at some point or another, they're going to have a saturated user base. So the growth in revenue is going to have to come from price increases, to some extent. And I just wonder how far they can go with that. I mean, I think it's fair to expect that they will raise prices every year to two years.
Now, as long as they can keep a core, simple, low-cost option for all viewers out there, that will probably behoove them, and then offer sorts of step plans from there for different sorts of definition or how many viewers, or what have you. But that's the question that I keep on coming back to. How far can they really take that pricing? I think in the near term, it's a pretty easy no-brainer that they can keep on escalating prices. But 10 years down the road, I'm not sure. They're going to be beholden to those content costs, I think, in perpetuity.
Gross: Call me a dumb value investor, but all those great things we said could happen -- content costs mitigating and growth going up and prices rising -- that's got to be baked into the current stock price to support this kind of a market cap. So they would have to exceed all those amazing things we just said for the stock to continue to be a good investment. Why would I put my money into a bet like that?
Argersinger: I think what's probably not priced in is Netflix, in 10 years, is the dominant internet TV platform. In other words, it reaches what Reed Hastings says, which is, most people in the world having a Netflix account. I think that's going to be hard to achieve. When Amazon is spending billions, Apple says they're going to spend over a billion, I think YouTube is ramping up their spending on content, Hulu, the list goes on. Can they maintain a brand that people recognize, that people want to subscribe to, that's a familiar app for most people in the world? That is a heck of a goal to shoot for.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Chris Hill owns shares of Amazon. Jason Moser owns shares of Apple. Matthew Argersinger owns shares of Amazon, Apple, and Netflix and has the following options: short December 2017 $900 puts on Amazon. Ron Gross owns shares of Amazon and Apple. The Motley Fool owns shares of and recommends Amazon, Apple, and Netflix. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.