A Tale of Two Stocks

The equity market has had a great run, currently up around 24% for the year (S&P500). Tempting as it is to assess the risk of a reversal as high, we tend to avoid market calls like that. But two stocks that recently reported earnings provide an interesting contrast.

Netflix (NFLX) last night reported quarterly revenues of $1.1 Billion (up 22% year-on-year) and EPS of 52 cents (versus 13 cents a year ago). At $360 a share it’s currently trading at 106X next year’s forecast EPS of $3.41, or 4X next year’s forecast revenues. CEO Reed Hastings was moved to comment on the “euphoria” surrounding the stock. We don’t own NFLX, sadly, since it has rallied around 275% so far this year. It obviously was very cheap a year ago, but doesn’t fit our investing model of companies with reasonable earnings visibility and a persistent competitive edge. They have a great product though.

IBM reported last week and disappointed analysts with revenues of $23.7 Billion, about $1 Billion less than expected. IBM will probably earn around $16 in EPS this year, close to $18 next year and remains on target for management’s goal of $20 in operating earnings in 2015. It currently trades for less than 10X 2014 EPS. IBM is down about 10% this year, around half of which came as a result of their disappointing 3Q13 earnings last week. IBM’s revenues have been flat for years. In 2008 they generated $103 Billion in sales. They’ll probably do $101 Billion this year and somewhere between 100 and 104 in 2014. IBM is not a company with revenue growth. However, their EPS in 2008 was $8.93 and their operating margin has improved from 15.2% to around 20%. Over six years they’ve doubled profits on flat sales by operating more efficiently and providing customers what they want. They’ve also reduced their sharecount by 18% through buybacks, further supporting the growth in EPS. They will keep doing all of these things.

We own IBM. The contrasting stock performance of IBM and NFLX don’t mean the market is expensive, but at current valuations we would only ever own the former and not the latter.