Did Netflix Deserve to Lose $345 Million in Market Value Today?

Netflix reported earnings after the close yesterday (Monday July 24) and proceeded to get hammered in after hours trading for what seem to me insufficent reasons.  The stock was down about $5 today, about 21% of it’s market capitalization, to close at $18.78 on extremely heavy volume – 15.23 million of the 54.88 million outstanding shares, about 28% of the company, traded hands today.  The company’s market cap got knocked down from $1.644 billion to $1.299 billion.  In other words, Wall Street decided the company is worth about $345 million less than it thought it was worth 24 hours ago!

Why?  Rick Munarriz over at Motley Fool, a long time supporter of the stock, give these reasons:

Despite a 62% surge in subscriber growth, revenue rose just 46% to $239.4 million as new customers took to lower priced plans…….


Also problematic is that it costs more for Netflix to land new patrons, who in are turn are paying less.  The company is now paying an average of $43.95 per gross subscriber addition.  That is substantially more than the $38.13 tab it was running a year ago or even the $38.47 it reported in the seasonally challenging March quarter. 

He also mentions the persistent worry about video on demand destroying Netflix’s business. 

Now these worries ring true to me because I am a part of the problem.  I became a Netflix subscriber in the 2nd quarter.  I started with a 2 week free trial offer that I got through the mail and then switched over to the $9.95/month, 1 movie at a time, plan. 

But 46% revenue growth is damn good!  Not only was revenue growth 46% for the 1st quarter but it was also 46% for the 1st half of the year – from $316.5 million to $463.5 million.  If they can continue that through the second half of the year that would mean close to $1 billion in revenues for 2006.  The market is valuing the company at $1.299 billion but it also has $342 million in cash on it’s balance sheet and no debt for a $957 million enterprise value.  So Netflix is trading for about 1 times this year’s (2006) sales. 

2005 operating cash flow was $163 million for a 5.9 trailing enterprise value to operating cash flow ratio.  First half operating cash flow grew by almost 58% to $104 million.  If they can keep that up through the end of the year that would mean $257 million in operating cash flow for full year 2006, for an enterprise value to operating cash flow ratio of 3.7.  That is extremely cheap!

My sense is that this isn’t really reflective of cash generated by operating the business because much of the “Acquisitions of DVD Library” that they list in the investing section of their cash flow statement is really to service their growing customer base and is therefore an operating, not investing, expense.  In fact, the SEC recently required Blockbuster to move it’s “Rental Library Purchases” from the investing to operating section of it’s cash flow statement.  In the 1st quarter, this reduced Blockbuster’s operating cash flow by $168 million to $41 million.  It makes no sense that they require Blockbuster to do this but not Netflix.  The only reason I can think of is that Netflix is growing so fast, while Blockbuster is actually shrinking, that much of Netflix’s DVD acquisitions are truly “investment” in expanding the business. 

Therefore we need to look at free cash flow.  Free cash flow in the first half of 2006 was $18 million – compared to the $104 million in operating cash flow – due mainly to $82 million spent on acquistions for the DVD Library.  That compares to -$6 million for the 1st half of 2005 and $24 million for all of 2005.  Since they grew revenues at 46% in the first half and operating cash at 58% let’s assume that they will be able to grow free cash flow by 40% for all of 2006 to $34 million.  That gives the company a 28.3 ($957/$34) enterprise value to free cash flow ratio for 2006.

For a company growing the top line at 46% and operating cash at 58% that is a pretty reasonable price.  True cash generated by operations is somewhere between 3.7 and 28.3 (we again run into the problem of distinguishing between capital expenditures that are to be considered “replacements” of the wear and tear from operating the business and those that should be considered “investments” to grow the business in the future).

Netflix hasn’t been this cheap in nearly a year and it’s sucessfully executed on its growth trajectory since then making it a more valuable business now compared with then.  I think it’s a buy here.  

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