Investors are paying 144 times earnings for a piece of Netflix

The online video streaming company Netflix’s fourth quarter earnings were released yesterday. They should scare the hell out of the TV industry.

The online video streaming company Netflix’s fourth quarter earnings were released yesterday. They should scare the hell out of the TV industry.

The company announced that it’s bringing in far more international subscribers, and much more profit, than the market had been expecting. It’s investing in more in international growth than any other TV network.

A couple of years ago it’s fair to say TV execs weren’t taking Netflix seriously. In 2010 Jeff Bewkes, the CEO of Time Warner, said “It’s a little bit like, is the Albanian Army going to take over the world? I don’t think so.”

Mr Bewkes almost certainly wishes he could take that comment back. Netflix now has 75 million subscribers worldwide and it’s growing fast. Earlier this month, Netflix “flicked the switch” and instantaneously opened up its service to customers in 170 new countries. That’s the Netflix strategy right there – it’s aiming for nothing less than total worldwide domination of the TV industry.

And the scary thing for Mr Bewkes and his fellow TV execs it that the market seems to think Netflix can pull it off. Investors are willing to pay 144 times earnings for Netflix shares (compared to an average of 17.2 for the S&P 500), making it worth $42 billion dollars. In other words, they think Netflix will grow its profits hugely in the next couple of years.

So, can Netflix do it? It’s a great case study for anyone interested in business strategy (see yesterday’s email for more on that), or investing in growth companies. Today I want to explain the story so far. And tomorrow I’ll talk about the investment case for Netflix.

The three steps to world domination

Netflix didn’t look like a world dominating business a few years ago. It started out in 1997 as a small company with a weird business model – sending physical DVDs to movie fans via the post. The model worked well though. Netflix had a bigger range of movies than its competitors such as Blockbusters, and no late fees. It built up a big subscriber base.

Then in 2007 Netflix made an audacious bet. It abandoned the old DVDs-by-post model and transformed itself into an online-only video streaming service. In other words, it went from competing with Blockbuster video to competing with the entire TV industry. This was around the time that Mr Bewkes made his unfortunate Albanian army comment.

The move into online streaming was a big success, which allowed Netflix to grow its subscriber base and its revenue. At this point Netflix was picking up a head of steam.

Netflix had a problem though. It was relying on the TV networks and film studies to sell it content. And as it got bigger, the content owners started to notice how much money Netflix was making by distributing their content. The studios and networks started to realise they could build their own online streaming networks. In other words, whoever owned the content had all the power.

So Netflix made its next audacious bet. It started to sink billions and billions of dollars into original TV series and movies. In 2013 its CEO Reed Hastings said Netflix’s goal is to “become HBO [an American TV network] faster than HBO can become us”. If you’ve noticed the buzz about Netflix’s newest series like House of Cards and Making a Murderer, you’ll know it’s getting there.

Tomorrow: the giant alliances that are forming to stop Netflix. And what the company will need to do to justify its sky-high valuation.

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