Outlook: Is Netflix Delaying Inevitable Higher Content Costs?

Source: Thinkstock

Source: Thinkstock

Netflix (NASDAQ:NFLX) shares have declined recently from net neutrality and competition concerns. After hitting its all time high share price of $458 earlier this month, the stock has since pulled back just under 20 percent to its Tuesday closing price of $370.84. We believe that the recent share price decline is largely attributable to concerns over the impacts of net neutrality, which we believe are warranted, and concerns that the Apple-Comcast deal means that Apple will launch a competitive product, which we believe are unwarranted.

Regarding net neutrality, we think that charges by internet service providers (ISPs) have the potential to meaningfully impact Netflix’s domestic streaming profits. As a result, we think that a price increase for Netflix’s streaming service is inevitable. Although content costs are clearly on the rise, we believe Netflix has done a masterful job of balancing quality against quantity, cutting out large portions of its streaming content in favor of a much smaller portfolio of higher priced content. The looming off-balance sheet streaming content obligations of roughly $7.3 billion (and growing) suggest to us that Netflix is delaying the impact of higher content costs on its income statement by pushing the costs into future periods.

We are confident that this will catch up with Netflix eventually, and that it will see its content costs increase significantly in the next two or three years. So far, however, strong streaming subscriber growth has continued, and Netflix has managed to offset large increases in spending by generating even larger increases in revenue.

We think that Netflix’s domestic subscriber growth has largely come from lower income users over the past two years. Netflix has added almost 12 million net domestic streaming subscribers over the last two years, and we believe that its recent success comes primarily from people re-entering the workforce or from people getting back on their feet as the country emerges from the recession. While this growth could continue in upcoming quarters as more lower-income members join, we think it shifts Netflix’s customer base from a price insensitive one to one that may consider switching should a lower priced competitor emerge.

We believe that Amazon is that competitor, and believe that Amazon’s (NASDAQ:AMZN) recent price hike for Prime from $79 to $99 (effective for annual membership renewals occurring after April 17) potentially sets the company up to announce a standalone streaming video service on its earnings call, which we expect to occur in late April. We think Amazon has an incentive to offer streaming for half the Netflix price ($3.99 monthly), and could use a standalone streaming offering to justify the price increase for Prime simply by saying that the $99 price includes a $47.88 streaming subscription. Amazon could also cross-sell Prime to streaming customers, offering an upgrade to Prime and free shipping for a year for an additional $51.12. If this happens, we think that Netflix shares will be under continuing pressure for the foreseeable future.

We would be long Netflix shares into Q1 results, and would be long Netflix puts immediately after with a short expiration. We believe season two of House of Cards will allow it to meet or exceed its domestic streaming subscriber net additions guidance of 2.25 million. In addition, we believe it can meet or exceed its EPS guidance of $0.78 from domestic streaming strength and cost control. We have modeled domestic streaming subscriber net additions of 2.33 million and EPS of $0.79, versus current consensus of $0.82.

In regards to the puts, we think investors have a call option on whether Amazon will introduce a standalone streaming service when it reports, likely a week after Netflix. If Amazon does introduce such a service, Netflix shares will get hit. The announcement of an Amazon standalone streaming service may happen this quarter, or next quarter, or never. It seems to us that Amazon has several incentives to offer standalone streaming (such as higher revenues that can lead to increased content purchases and up sell of Prime), and believe the company must at least be considering it.

Long-term, although it is far from certain that Amazon will offer a standalone streaming service, we believe it is far more likely that content costs will continue to rise with the expiration of every deal, and that ISPs will impose ever-increasing fees for access to the last mile.

We are maintaining our UNDERPERFORM rating and 12-month price target of $175. Our price target reflects a sum-of-the-parts that values domestic streaming at $140, international streaming at $17 per share, and domestic DVD at $18 per share. We continue to believe that Netflix’s high aluation is somewhat unwarranted given the potential for slowing domestic growth as competition ramps up, coupled with increasing content and broadband access costs.

Michael Pachter is an analyst at Wedbush Securities. 

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