DEEP STOCK ANALYSIS: Netflix New Expansion

The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.

Last night, Netflix (NASDAQ:NFLX) announced that it will launch in Norway, Denmark, Sweden, and Finland in late 2012.  Netflix previously announced in its Investor Letters that it would open an additional attractive European market in Q4. The Nordic streaming service will feature a low monthly price and an array of content (Hollywood, local, and global television shows and movies), with many titles available in high definition with Dolby Digital (NYSE:DLB) Plus surround sound. Netflix will announce details about content, pricing, and supported devices closer to the actual launch.

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We expect Netflix to penetrate the Nordic countries at a similar rate to its UK penetration. With a high education rate and high household incomes in the Nordic countries, Netflix should be able to avoid many of the challenges that it has experienced in Latin America, including low device  penetration, weak Internet infrastructure, and consumer payment challenges. In addition, Nordic viewers will likely have a higher level of proficiency in the English language, potentially limiting dependence on subtitles, and they endure long winters, increasing the need for in-home entertainment.

Nordic expansion is expected to lead to a loss in Q4. After earning $0.11 in Q2, and guiding to $(0.10) – 0.14 in Q3, Netflix expects a Q4 loss, likely due to the marketing expense and content costs associated with the Nordic launch. However, the Nordic launch will likely have a limited impact on top-line growth in the near term due to a stronger affinity for localized content, particularly movies, than in Canada (Netflix’s first international launch), and a smaller population (≈ 25 million) than Latin America and the British Isles (the second and third international launches).

Interestingly, the Netflix announcement mentioned “TV shows” before “movies”, and its domestic television advertising has adopted the same order.  We think that this is a subtle acknowledgment that Netflix will offer an increasing mix of lower-cost television programming, and will continue to play hardball with movie studios on constantly increasing rights fees for Hollywood movie content.

Maintaining our FY:12 estimates, which already reflect the Q4 European launch. We expect revenue of $3.65 billion and EPS of $0.03, compared to consensus for revenue of $3.61 billion and EPS of $0.01. There is no detailed financial guidance.

In our view, FY:13 consensus EPS of $0.95 remains too high. The company has clearly articulated its strategy of alternating periods of expansion (losses) with periods of profitability, making sustained profitability elusive. We expect Netflix to operate at roughly break-even until it has completed its international land grab later this decade. At our FY:13 EPS estimate of $0.50, the stock closed yesterday at roughly 120x earnings, and should consensus estimates drop closer to our estimate, we think that shares could trade closer to our $45 price target.

We continue to view full-year domestic streaming net adds guidance as unrealistic. Netflix expects 2012 domestic streaming net additions of ≈ 7 million. With 1.74 million domestic streaming net adds in Q1 and 0.53 million more in Q2, Netflix must add approximately 4.73 million over the second half of the year to hit its target. This implies a 32/68 split between 1H and 2H, even more aggressive than its historical 41/59 split.

Maintaining our UNDERPERFORM rating and 12-month price target of $45. Our price target is 15x our sustainable EPS estimate of $3, which we believe is attainable (albeit aggressive) only if Netflix forsakes growth at all costs and raises prices. Our multiple is in line with the company’s long-term growth rate.

Risks to the attainment of our share price target include: a sudden increase in subscriber growth, declining competition from other movie rental competitors, lower than expected costs for content, technology development and deployment, and improving macroeconomic factors.

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Michael Pachter is an analyst at Wedbush Securities.