When it comes to crushing analyst expectations, very few technology firms can match what Netflix (NASDAQ:NFLX) just delivered. Shares of the streaming-video powerhouse are currently trading about 15% higher than Wall Street’s consensus price estimate for the stock's value for the next 12 months.
At $398 a share as of last night's close, Netflix is up more than 100% for just the first half of 2018. And that's after hitting a record high of $423 on June 21. Analysts are furiously playing catch-up, searching for a more accurate price target since their forecasts have been rendered meaningless.
Nevertheless, these eye-popping gains are starting to make some investors nervous. They're wondering, perhaps correctly, whether Netflix can continue to deliver market-beating earnings. Of course, that begs the larger question—has Netflix become a dangerous buy?
Here are the main two reasons Netflix bears cite as to why the company’s valuation has grown frothy, as well as our response to their anxiety.
1. Soaring Debt
While building content that’s unique, fresh and entertaining for its 125 million global subscribers, Netflix has amassed a hefty $8.5 billion worth of debt. That's a level of borrowing that's unlikely to shrink anytime soon. Indeed, according to Moody’s, Netflix is likely to add another $15 billion to its debt load in order to fund production of original content in the coming years.
To justify that elevated level of leverage, Netflix has to become net-cash-flow-positive in the next five years, says Moody's. That means the company must continue generating robust subscriber growth each year. As a benchmark, the streaming service added 26 million subscribers in the past 12 months to March 31.
If it can sustain that torrid pace, combined with increases to its subscription fee, Netflix should become cash flow positive when its number of subscribers jumps from the current 125 million to 200 million, something that's forecast to occur by the end of 2021.
If you’re planning to buy Netflix stock today, that’s the key number you should be watching. Any lapses on this metrics will trigger an immediate selloff, ending this remarkable rally. Thus far the market has been willing to ignore Netflix’s massive leverage and weighty cash burn, as long as the company continues to beat estimates each quarter while issuing bullish subscriber forecasts.
2. Competitive Threats
Since Netflix still has to borrow aggressively to power its growth, the next logical question would be: what would stop other deep-pocketed rivals, such as Amazon (NASDAQ:AMZN) and Apple (NASDAQ:AAPL), from entering this lucrative arena?
The only true barrier for competitors who want to enter the subscription-driven streaming video business is the need for intensive injections of capital. If you’re a long-term investor who's considering whether to buy and hold Netflix for the next five years, for instance, this is one of the most important metrics to consider before you put your investment dollars to work.
The most successful long-term investments are in companies which have a wide economic moat. This means they have enough financial power to thwart competition. Netflix certainly lacks the financial muscle to do that right now. But when you look at the competitive landscape at the moment, no other company can even come close to what Netflix is offering subscribers.
Amazon’s Prime Video, which is part of its $119-a-year Prime shipping subscription in the US, is mostly used as an add-on to Netflix. Hulu, a joint venture between Disney (DIS), Twenty-First Century Fox (NASDAQ:FOX), Comcast (NASDAQ:CMCSA) and AT&T (NYSE:T), ultimately poses a serious threat because of its Hulu Live offering. Perhaps of more concern is that Hulu is supported by all the major networks, each with a studio of its own. But it's not yet global though it is offered to users in Japan as well as the US.
Still, Hulu, or a similar enterprise, may prove to be the biggest competitive threat Netflix may face since it will come from legacy media companies, such as Walt Disney, which earn billions and have the muscle to try joining forces in order to put together a product that could give subscribers a true alternative to Netflix.
The Bottom Line
There are a plenty of reasons to doubt that Netflix will be able to continue its success story. If you’re willing to bet on Netflix going forward, you have to be a firm believer that one day the company’s accelerating subscriber growth will produce cash flows that will both pay for its content spending while also producing massive bottom-line profit.
We're believers. Netflix is perfectly positioned to make that happen. It has a first-mover advantage, ongoing global subscription expansion as well as gradual price increases. We think Netflix has built a dominant streaming and content franchise that’s going to be hard to match in the next five years.