After Netflix's (NASDAQ:NFLX) massive gains thus far in 2018, many bullish investors are wondering if the share price of this video-streaming service has sprinted way ahead of the stock's fundamentals. Is the timing right for booking some profits?
This thinking has some weight, too. Who could have predicted the size of the gains Netflix has delivered in just over the first two months of this year? Currently trading at $331.44, shares have surged 65%, leaving the other top technology companies in the FAANG group far behind.
Amazon (NASDAQ:AMZN), which is the second best-performing stock in the group, has produced less than half of what Netflix has delivered. And when you compare the Netflix gains to the broader market, it's a similar story. Netflix is the best performer on the S&P 500 year-to-date.
After this most recent eye-popping rally, many analysts are racing to upgrade their price targets for Netflix as they try to make sense of this dramatic move. According to a Reuters’ analysis, the jump in Netflix shares in 2018 has been so rapid that Wall Street analysts last week were as much as $60 behind. Netflix stock price remained well above analysts’ average 12-month target for much of this year, and the gap between the actual share price and the mean target hit a two-year high earlier last week.
Is Netflix Overvalued?
Is the stock in overbought territory? I believe two factors will determine if the market is correct in pushing Netflix stock this far this fast.
First, the excitement is all about subscriber growth. As long as Netflix continues to beat estimates and issue bullish subscriber forecasts, the stock will continue to advance. In the fourth-quarter, Netflix added 8.3 million new streaming subscribers — easily beating Wall Street estimates for the period.
By the end of 2017, Netflix had 117.6 million streaming members worldwide. Wall Street expects Netflix to end this year with 141.8 million streaming subscribers, an increase of 20% from last year.
The second factor to note is related to the first factor, but the market is not worried about that as yet. I’m talking about the company’s cash-burn, necessary to fuel more growth in content, and thus subscriptions.
The company’s aggressive spending on original content and marketing means it probably won’t generate free cash flow for the next few years. On average, analysts are predicting outflows of $2.85 billion this year, $1.92 billion in 2019 and $1.16 billion 2020, according to data compiled by Bloomberg.
As I wrote on January 25, the success of Netflix is very much linked to the company’s ability to produce original content and keep subscribers tuned in and glued to their screens. This is not an easy task and it requires considerable spending. But the news flow on this front suggests that the company has been making all the right moves.
According to a recent report in the New York Times, former President Barack Obama and First Lady Michelle Obama are in advanced talks with Netflix about a content deal. The New York Times said both Obamas are discussing several possibilities, including the former president moderating conversations on topics such as immigration, health care and climate change, and the First Lady producing shows on nutrition and fitness for children.
The news about the Obama deal follows the recent hiring of Ryan Murphy, an award-winning producer, director and writer, whom Netflix poached from 21st Century Fox (NASDAQ:FOX) for a contract valued at $300 million over five years, the biggest TV deal of this type ever. As well, after it took home its first Academy Award for the documentary "Icarus" last week, Netflix's stock surged nearly 5%.
My point: as long as Netflix can show investors that it’s doing the right things with the cash being spent, they won’t care about the burn rate.
The bottom line: it’s difficult to justify buying a company whose shares trade at 265 times trailing earnings. However that logic doesn’t work for Netflix and other FAANG players which remain in explosive growth mode.
I would continue to hold on to Netflix stock despite the temptation to book some profits at these levels. I don’t think the Netflix rally has run its course yet. Indeed, I see the next move—to $400 a share—well within reach.