Rule #1 Finance Blog

With Investor Phil Town


Here’s a great first homework assignment from Rachael, who chose Netflix (NFLX) after doing her 3 circles assignment (Passion, Talent, Money) to locate an Industry Sector. I think she did a terrific job. Keep reading.

Hi Phil!

I was reading your blog this morning about the Alex and 4Ms, so I did some research on one of the companies I have my eye on…Netflix (NFLX). Would you mind giving me a critique of my thinking?

Netflix is something that fits into my 3 columns so to speak, movies are a passion of mine, I spend a lot of time watching them (very good at this), and definitely a lot of money too, so this seemed like a good match for me in the "meaning" department. In addition, I admire the company’s revolutionary idea that has truly changed the way America watches movies.

Secondly, for the moat – I think it has a big one. It’s a pioneer
company, and the term "netflix" is basically THE household name for a
DVD mail service, despite a few competitors (Blockbuster and Walmart).
I read that the company also is working on some patents. They’ve
worked out the kinks where other companies are just starting. AND,
people will definitely be watching movies in the future, so there is a
predictable market for them.

read up on the CEO, and he definitely has BAG! He wants Netflix to be
"The world’s largest and leading Internet movie network." They have an
ultimate goal of sending movies via the internet where people can
download them (like a video on demand). He is also concerned with
customer service, and states that word of mouth is the best marketing.
It’s been rated #1 in customer satisfaction for online retailers. They have over a million subscribers, they must be doing something right!

Next, margin of safety-according to the tools (let me know if this
is wrong, I just plugged numbers into the valuation calculator) it’s
valued at $96 and selling for about $26…I think that’s quite a
margin. The big guys are moving in too (it’s green!).

So I guess my issue is…since it’s a fairly new company there isn’t
a lot of historical data. Am I right to be more hesistant in buying
something like this than something that’s been around for awhile? I
mean the phase 1/2 characteristics look good, but there are a few N/As
because the information is not available. Sorry for the novel! Any
help is appreciated!


My response:

Not bad for a first try, Rachael.  Very nice actually.  Let’s post this one okay?

Remember that the single most critical thing that we are seeking
is certainty about the future of this business.  Certainty comes from
having a moat and a very nice, predictable, consistent track record that
goes back 10 years or more.  Hugely important!
You did everything great with Netflix including recognizing
that they are an almost brand new public business with only two years
of profitability and equity growth.  That means that we can only invest
about 10% of our money in this one.  Too risky for the main portfolio
since we have nothing to base an opinion of value on except … well,
except just a good feeling and a guess.
Although they don’t have proof of moat because they are new, let’s
see how the MOS looks:  Estimated growth rate is 32% by the analysts,
which is high.  Equity is only growing at about 20%.  That puts the PE
at 40 instead of the historical 80 or so.  They have .28 TTM EPS.
So… I get a future value of $70 with a current value of $17 and an
MOS of $9.  And its selling for $26.  That makes it not buyable.
Of course if I use the higher growth number of 32% I’ll still only
get a PE of 64 but I NEVER use a PE higher than 50.  Over 50 is just
totally bull market land, and we’re not in one and won’t be.  So with
those two numbers, 32% growth and 50 PE, I get a future value of $225,
a sticker of $55 and a MOS of $28.  That makes it buyable.
So what to do?  If we want this in our Risky Biz portfolio we’re
going to have to get comfortable with that higher growth rate.  That
means really learning the biz.
You did such a good job, I want you to do that for us.  Learn the
biz.  Who is out there who can demolish Netflix?  Or is their moat so
big that nobody can touch them – are they are the Viagra of dvd’s, the Coke of movie rentals?  So, Google their website, find the annual
reports and tell us what you think.