Sunday, April 23, 2006

Earnings Preview: Netflix

Online movie rental provider Netflix (NFLX) reports tomorrow after the close. Analysts expect EPS of 6 cents vs. a loss of 9 cents same period year ago. Our bullish sentiment on Netflix remains intact. Below are some reasons we think shares of Netflix could reward the more patient breed of investor.

1. Netflix has less than 5 million subscribers, so we think the room for growth is enormous.

2. NFLX's customer base is remarkably loyal and the more users it books, the higher the switching costs for Netflix users. Studies show that it's harder to drop a service when all your friends are also users. Like begets like.

3. Netflix grew its subscriber base over 60% last year, amidst a less than favorable milieu. Netflix's rivals have ramped up promotional efforts in order to steal Netflix's customers, who haven't fallen for lower price points. That attests to Netflix's brand power.

4. Netflix's business model (no late fees, no standing in line, and no walking out of the store with a film you don't really want to see) creates what we think is a compelling value proposition. Furthermore, Netflix specializes in catering to minority tastes and leverages its capacity to operate shelf-free. Because specialized markets are more predictable, the risk of failure is much lower, and so small-to-mid-budget movies can be very profitable. Taking all this into account, we foresee accelerated subscriber growth for Netflix in F2006 & F2007.

5. Over 30% of the stock is held by insiders and the company is debt free. With the founder still on board, we believe it is in the best interest of CEO Reed Hastings to see the firm prosper and ultimately hit critical mass.

6. Competitor Blockbuster Video (BBI) is begging for life: It can barely eke out operating cash flow (CFO) from its $6B in annual sales and it's drowning under a pile of debt. Unsurprisingly, the stock is at an ugly 52 week low and most likely on its way to $3.

Valuation Based on what we estimate could be a 50% jump in 2006 to 2007 earnings, we think shares of Netflix could technically trade up to $50-55 dollars. Our boldest assumption pegs NFLX earning roughly $1 in earnings in 07 -- at a 50x forward multiple, that'd put shares at $50. Note that we find it incredibly difficult to "value" NFLX because the competitive landscape is literally up for grabs. Because NFLX is still a young company, we think most of the Street decided long ago that Netflix had lost the war. We are a bit more sanguine -- Netflix has faltered before, and management quickly brought the firm back to its feet. Investors who are buying Netflix at today's price are essentially betting on Reed Hasting's vision and execution history. Our 2006 price target is $40. On a risk basis, we rate Netflix "speculative, " especially now that shares have already tripled over the last year. Netflix's beta (a measure of volatility vis-a-vis the broad market) is 2.5, whereas AMZN and BBI hold a beta of 1.7 and .5, respectively.

Risks After years of shrugging these threats, Blockbuster has launched a series of programs to try to counteract Netflix's strategy. Last August the company began promoting an online program similar to Netflix's—but offering lower prices, as well as two coupons each month for free in-store rentals. And for movie buffs who like Netflix's pricing concept (in which customers pay a flat monthly fee for unlimited rentals) but prefer renting from a brick-and-mortar store, Blockbuster now runs a flat-price Movie Pass program. In addition, Netflix has come under fire lately for discriminating against current customers (so it can get movies out faster to new users), as well for keeping subscribers on its books even when those subscribers have put their accounts on hold. Further allegations/investigations could adversely impact NFLX's stock price, which is currently flirting with a new 52 week high. Note that Blockbuster (BBI) is also receiving a slap on the wrist, this time for misleading customers with its "no late fee" policy (keep the video for more than a week, Blockbuster will automatically assume you're buying it). Lastly, we'd be amiss not to tell you that insiders exercised plenty of stock options throughout April -- in fact, Netflix's CFO pocketed close to $2M. Yummy.

Summary With the Walmart/Amazon threat waning (Walmart will likely stick to selling DVDs while Amazon would be foolish to penetrate a price sensitive domain that their distribution network isn't necessarily prepared for), Netflix could see more upside. We suggest investors wait for a pullback before picking up shares. There's no question that Netflix's top line story looks attractive -- now let's wait and see if the company can deliver a decent margin outlook (operating margins are currently under 2%). After the close tomorrow, investors will have a better feel for how the firm is doing on this front. We're barely in the third inning, here -- as to what Netflix will look like 5 years from now, that's anybody's guess.

For a PDF version of this report, please point your browser here. Monday update: Our bull call was dead-on: late Monday, NFLX shares popped 6% after smashing earnings, raising guidance, and reporting lower subscriber churn from a year ago period.

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