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Should you buy shares in Netflix?

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In its latest quarterly results, Netflix saw the fastest-ever year-on -year growth in the streaming services history. But can this breakneck expansion continue?

Streaming service Netflix added a further 7.41 million new subscribers worldwide in the first three months of 2018, more than Wall Street had expected. This means its global subscriber base has now hit a staggering 125 million. Quarterly profits grew 63% year-on-year to $290m, with revenues up 43% to $3.7bn.

The forecast-beating jump in subscriber numbers is important because Netflix announced a series of price rises in October 2017 – the first for a number of years. The numbers show it is possible that the group can raise prices without losing subscribers, which is a reflection of the current quality of its offer.

Ad-free model

It is also important to note that revenues are generated by subscriptions – not by adverts. This is a vital part of its business model, as it means it is not dependent on the wider advertising market, which remains in flux as spending moves online. This remains an issue for companies such as broadcaster ITV and ad giant WPP, but Netflixs model means it is immune.

With a 2018 forward price-earnings ratio of 110, Netflix is certainly priced as a growth stock – and its earnings per share figure is expected to jump 122% in the current year based on earnings forecasts compiled by Reuters. However, it is estimated that the group provide its services to 50% of internet households in US, which implies that growth has to ease on this front as the business is getting quite mature. However, it is the strength of its international business that should take up the slack, as the service is only has a penetration of 12% globally excluding the US and China. This means there is still plenty of scope to boost subscriber numbers as management focuses on international growth.

Currently, profitability in the rest of the world is below that of the US. It needs to build up critical mass and there are costs associated with marketing and the provision of local content. Over the next few years, this content and marketing spend should be leveraged to help boost margins and therefore profits overall.

The company is investing significantly in its content. This year management plans to spend up to $8bn on new TV series, films, documentaries and other programmes in several languages. Its production pipeline now rivals the worlds biggest media companies. Netflix will release around 700 original pieces of programming this year, plus more than one stand-up special a week. The schedule also includes the production of about 80 movies, which is more than any Hollywood studio will produce.

The downside?

All of this seems very positive, but what are the risks to this view for shareholders? Firstly, the shares are very highly rated from an earnings point of view which means should something prove a disappointment it is likely the share will be hit substantially. The company has proved its ability to continue to expand its customer base while increasing prices, which is positive, but what will subscribers do in a recession? Is the service a “luxury good” or not. If the service is regarded as a luxury and the economy take a sharp shift downturn, customers could cancel their subscriptions in large numbers to save money.

There are also relatively few barriers to entry for a competitor to set up a similar service. Video streaming is not an inherently difficult business to enter and should a number of competitors emerge it will drive down prices, reducing long term profitability. This would lead to a derating in the shares. Netflix already has long-term competition from rival service Amazon Prime Video.

Another threat could be Donald Trumps controversial pledge to end net neutrality, which has been a fundamental principle of how the internet works. Net neutrality is the idea that all internet traffic is treated the same. But the new ruling will allow internet service providers to block or slow access to specific websites, and allow them to charge for those limits. This means that the value for video streaming could be grabbed by the internet service provider and not Netflix itself.

Netflix shares fell sharply in the tech sell-off in March but have since recovered a significant amount of that fall. If the company can continue to post solid quarters of growth such then this should justify its high valuation. It needs to keep subscriber growth buoyant and start to deliver on profits and margins. And mis-steps are likely to be punished hard.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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