Netflix is Fairly Valued

Price Target: $536

Netflix has long been a market darling and six months ago Pivotal Research set a new price target for the stock at $650. The stock currently trades at $520, so this represents about 25% upside to today’s price. Let’s dig into the details to determine what would need to be true for Pivotal’s price target to be justified.

There are two primary drivers of the value of Netflix – the number of subscribers (along with revenue per subscriber) and operating margins.

Subscribers and Revenue per Subscriber

Unsurprisingly, 2020 was a spectacular year for Netflix. The company added 37mm new subscribers crossing 200mm in total subscribers. As investors, the big question is how many subscribers can Netflix add over the next decade?

Netflix is kind enough to break down their subscriber numbers by geography – see 2nd tab of the model. In order to compute revenue going forward, I multiply the average number of subscribers per year by the average revenue per user (ARPU). Below I look at each geography in more detail.

USA and Canada (UCAN)

Subscriber growth has averaged 8% over the last two years, but this includes 2020 which was a blockbuster year. I forecast 5% grown in 2021 declining to 1% by 2025 (roughly population growth for the US and Canada) and staying at that level .

ARPU grew 6% in 2020. I expect the growth rate to remain in the low single digit area as the premium plan currently tops out at $16/month, but I expect Netflix will raise prices by about $1 every two years on average (assuming no dramatic changes to the content, like somehow getting the rights to live sports).

Europe, the Middle East and Africa (EMEA)

This is Netflix’s second biggest market after the US, and has grown an average of 39% per year during the last two years. I expect 13% growth in 2021 given a lot of growth was pulled forward to 2020. I forecast Netflix will still be able to add a massive number of new subscribers every year (~8mm), but this will represent 13% growth declining down to 7% by 2025 as the market gets more saturated.

ARPU increased by 2% in 2020, but was down by 1% in 2019. I model 1% growth going forward as Netflix experiments with different pricing models for EMEA. There is a good chance ARPU might actually fall over the next five years as Netflix expands in Africa, but this should be offset by stronger pricing in Europe.

Latin America (LATAM)

Netflix penetration in Latin America is already quite high with 16mm members in Brazil and 7mm members in Mexico. These numbers represent about 20% of households in each of these countries and may serve as a guide for penetration in Asia as Netflix expands. While subscribers have grown an average of 25% in the last two years, I expect this growth to slow dramatically in 2021 and beyond given the relatively high penetration and the already large subscriber base at the end of 2020 (~38mm). My forecast is that the number of subscribers in LATAM will essentially double in the next decade as more households get access to broadband and the population continues to grow.

ARPU declined 9% in 2020, but I expect this will stabilize going forward, given this is the lowest ARPU (average revenue per user) of all regions. I therefore model a drop of 5% in 2021, and 0% growth going forward. Currency risk is a very real issue for Netflix and the company took a $660mm hit in 2020. Expect to see similar large losses (or gains) as the company becomes more global.

Asia Pacific (APAC)

This region currently has the lowest penetration, with only 25mm subscribers at the end of 2020. I model subscribers growing by 7mm per year for the next decade (in line with the average of the last two years), with ARPU staying flat as Netflix will likely need to price competitively to gain share.

Margins

This is the other major driver of the company’s valuation. Netflix had an 18% operating margin in 2020 and is targeting 20% in 2021. How margins evolve beyond 2021 is anyone’s guess, but I assume they improve by about 2%/year until 2025 and then stay at 28% going forward. This seems reasonable given Netflix has stated they “intend to continue to grow [their] operating margin each year at an average rate of 3% per year over any few-year period”.

All else being equal, margins would need to improve by 3% /year for the next five years getting to 35% and stay at that level for the stock to be worth $650 today (the price target from Pivotal Research). While this is certainly possible, and in line with the guidance from Netflix, it seems like a stretch to me. Competition in the space is only going to get stronger, so I expect Netflix will have limited capacity to increase prices internationally.

Valuation

Based on my membership and margin assumptions, a discount rate of 3%, and a FCF multiplier of 20x for terminal value, I value Netflix at $536 today. As always the model is available here if you’d like to input your own assumptions.

Interestingly, while Netflix has massive content cap-ex costs (expected at ~$18B in 2020 pre-COVID), these do not meaningfully impact the valuation going forward because they are typically amortized in four years.

Given my calculation of intrinsic value is right on top of today’s share price, I’ll buy a small stake for the IF Fund and hope for a more attractive entry point going forward. It’s certainly possible I’m being overly conservative in my margin assumptions, so I’d love to hear if you have a strong view on margins going forward.