Analyst: Investors Bid Netflix Shares Above Fair Value

Source: Thinkstock

Source: Thinkstock

Netflix (NASDAQ:NFLX) delivered a solid quarter, with most metrics at or above the high end of its guidance. Subscribers, revenues, EPS, and contribution profit all came in at the high end of guidance, in-line with consensus expectations.

The company accelerated the roll-out of its international expansion, with a launch in several European countries in September, rather than in “late 2014.” As a result, contribution profit from international operations will continue to be negative for at least the balance of the year.

We believe “contribution profit” substantially overstates actual profitability, as it ignores over $400 million of annual technology spending necessary to deliver streaming video. In our view, management is disingenuous by ignoring tech spending, and investors have irrationally bid shares above fair value.

We think the biggest issue that investors have overlooked is the gap between free cash-flow and net income, which totals a cumulative $277 million ($2.72 per share) for the last nine quarters. This gap must ultimately be amortized through Netflix’s income statement, pressuring future earnings. Given that the bulk of the spending is on content with an average life of three years or less, we expect earnings pressure to begin as soon as next year.

We also expect continued pressure on profitability from DVD subscriber defections. When technology spending is factored in, DVD subscribers generate approximately half of all operating profit for the company, and we think that the continued high defection rate will pressure earnings going forward.

We think direct competition from Amazon is imminent. Amazon recently paid an estimated $350 million annually for exclusive rights to stream HBO content. The exclusive nature of the deal suggests a standalone subscription plan is coming.

We are maintaining our UNDERPERFORM rating but raising our 12-month price target to $245 from $215 to reflect better-than-expected subs growth and improving domestic streaming profitability. Our PT reflects a sum-of-the-parts analysis that values domestic streaming at $180/share (up from $150), international at $50/share (unchanged), and domestic DVD at $15/share (unchanged.) We believe Netflix’s high valuation is unwarranted given the potential for slowing domestic growth as competition ramps up, coupled with increasing content costs.

Michael Pachter is an analyst at Wedbush Securities. 

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