NEW YORK (TheStreet) -- Seemingly forever, Netflix (NFLX) has been portrayed as the overvalued, underprofitable poster child for that darn nutty Internet sector. So could the movies-on-demand giant really be about to earn $35 a share within a couple of years?
RBC Capital analyst Mark Mahaney thinks so. And that view is not as crazy as you might think.
Netflix shares are down nearly 6%, or almost $27, to about $425.20 as of 1 p.m. Tuesday. The drop follows a report of second-quarter earnings that slightly topped most estimates for both profit and subscriber growth. Net income more than doubled to $71 million, or $1.15 a share, from $29 million, or 49 cents a share, in last year's second quarter. But Netflix said third-quarter earnings would be lower than expected because it's planning to take a bigger loss in Europe to expand faster.
"Red is the new black," said long-time Netflix bear Michael Pachter this morning on CNBC, riffing on the title of Netflix's hit show Orange is the New Black.
But of all the discredited reasons to sell Netflix, the most discredited of all is fear of short-term losses driven by CEO Reed Hastings' decisions to put more metal on the pedal. Bears have been fooled so often by Hastings' moves that Netflix's stock chart has long resembled an inverted W -- selloffs like today's followed by booms. (Some of those "booms" look like little bumps now that the stock is above $420, but looked pretty darn big at the time.)
We have seen this movie before.
The best thing about this company has always been its ability to balance aggressiveness with building a solid foundation for profitability. This year, consensus estimates say Netflix will earn $4.12 a share, more than double last year's profit, as revenue jumps 25% to $5.5 billion. And that's with international operations that are still in startup mode on track to lose $200 million or more this year.
The question is, what does Netflix look like when its European business grows up?
Mahaney says it looks like 100 million subscribers, paying $10 a month vs. $8 and change now, with 30% operating-profit margins (meaning, 30 cents of every dollar it collects becomes pretax profit). The math says that generates $3.6 billion in operating income, or just under $35 a share. At that rate, Netflix's valuation today is about seven times those operating earnings.
The next question, is how long will it take and how realistic are the assumptions?
The answer is, it looks like this vision is three years away.
Netflix has about 50 million subscribers now, and is coming off 12 months that saw its customer count jump more than a third. At that rate, getting to 100 million would happen by early 2017. With some natural slowing, maybe it takes another six to 12 months.
As for margins, Mahaney points to Time Warner's (TWX) HBO business, a more-mature competitor that makes nearly 40% profit before interest, taxes and non-cash charges. HBO is the jewel in Time Warner's crown, and it's the reason Rupert Murdoch's 21st Century Fox (FOXA) wants to pay $80 billion to buy Time Warner, even if my colleague jokingly says Murdoch really just wants to buy Batman's Wayne Enterprises instead.
"With Netflix currently at 50 million global streaming [subscribers] and only available to less than 30% of global broadband households, and given what we see as the universal appeal of video streaming, we see the potential for its global [customer] base to at least double," Mahaney says. "With evidence of pricing power, we believe that Netflix's average revenue per user can rise nicely from current levels."
Getting to get 30% profit margins means the domestic business needs to build up from 27% profit on each dollar of sales now (though Pachter says this number excludes technology spending and some overhead). It also means the much newer international business must reverse its 2014 losses of $200 million to $250 million a year, Mahaney said in an interview.
A price increase, more customers, and some cost controls can get the U.S. business to the target, with the international unit following as it matures.
"We think margins can get close to the HBO level,'' Mahaney said. "We're making a bet that the international business can scale the way the U.S. did. There isn't any structural difference between the markets.''
It's a surprisingly un-radical scenario for such growth -- and one reason Netflix has always scared the tar out of old-media barons like Time Warner CEO Jeff Bewkes.
And it's why Mike Pachter looms as the new Rick Santelli, forever wrong on CNBC.
Mullaney writes on the economy, health care and technology. Contact him at firstname.lastname@example.org and follow him on Twitter @timmullaney.
At the time of publication, the author held no positions in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.
TheStreet Ratings team rates NETFLIX INC as a Hold with a ratings score of C+. TheStreet Ratings Team has this to say about their recommendation:
"We rate NETFLIX INC (NFLX) a HOLD. The primary factors that have impacted our rating are mixed ? some indicating strength, some showing weaknesses, with little evidence to justify the expectation of either a positive or negative performance for this stock relative to most other stocks. The company's strengths can be seen in multiple areas, such as its robust revenue growth, solid stock price performance and impressive record of earnings per share growth. However, as a counter to these strengths, we find that the company has favored debt over equity in the management of its balance sheet."
Highlights from the analysis by TheStreet Ratings Team goes as follows:
- The revenue growth came in higher than the industry average of 4.8%. Since the same quarter one year prior, revenues rose by 24.0%. Growth in the company's revenue appears to have helped boost the earnings per share.
- Powered by its strong earnings growth of 1620.00% and other important driving factors, this stock has surged by 63.98% over the past year, outperforming the rise in the S&P 500 Index during the same period. Although NFLX had significant growth over the past year, our hold rating indicates that we do not recommend additional investment in this stock at the current time.
- NFLX's debt-to-equity ratio of 0.61 is somewhat low overall, but it is high when compared to the industry average, implying that the management of the debt levels should be evaluated further. Regardless of the somewhat mixed results with the debt-to-equity ratio, the company's quick ratio of 0.74 is weak.
- Current return on equity exceeded its ROE from the same quarter one year prior. This is a clear sign of strength within the company. When compared to other companies in the Internet & Catalog Retail industry and the overall market, NETFLIX INC's return on equity is below that of both the industry average and the S&P 500.
- You can view the full analysis from the report here: NFLX Ratings Report