Netflix: Are High Price Multiples Justified?

Dec.17.12 | About: Netflix, Inc. (NFLX)

Unfortunately, Netflix's (NASDAQ:NFLX) recent deals with companies like Disney and NBC are not lowering the company's high price multiples. Even though Netflix now has seen overall improvements that makes it unique among service providers like HBO and Amazon (AMZN), the growth stories surrounding these new deals do not justify Netflix's high price multiples.

With earnings per share of 0.29, compared with Amazon's 0.24, Comcast's (NASDAQ:CMCSA) 2.19, and Verizon's 1.08, and price-to-earnings ratio of 111.61, compared with Verizon's 41.40, Intel's 9.01, and 17.08 for Comcast, Netflix is behind its rivals. To make matters worse, Netflix's competitors are making things alot tougher. Amazon now markets its Prime service for $7.99 per month, matching the monthly subscription fee Netflix charges for its collection of movies and TV shows. Verizon and Coinstar's Redbox unit have formed a joint venture to sell video services aimed at competing against Netflix.

Netflix faces at least three new deep-pocketed competitors in the streaming business. They are Verizon (VZ), Comcast, and now Intel (NASDAQ:INTC). Verizon, Comcast, and Intel have began bidding for content licenses and driving-up the prices Netflix must pay, thereby squeezing the company's already paper-thin streaming margins. An added concern is that the company is forced to pay new licensing fees to studios in order to get clearance to stream the content directly to consumers' televisions.

In its 2012 first quarter report, Netflix added nearly 3 million streaming members to its network, bringing its total to over 26 million global streaming members. Domestically, the service delivered $67 million of contribution profit, equivalent to a 13% contribution margin. However, it had a net loss of $5 million or .08 cents a share, disappointing many shareholders.

In September, Netflix and NBC announced an expanded license agreement through which Netflix members could instantly watch a selection of broadcast series from the NBC television network and content from some NBC Universal's popular cable channels. The Hollywood Reporter said the deal could be worth as much as $300 million per year, up from just $25 million. With the price of content skyrocketing for the DVD rental and video streaming service, it's not surprising that Netflix is jacking up its prices. Netflix has split up its video streaming and DVD plans, making each worth $7.99. To have access to both plans, users will have to pay $15.98 per month, a 60% rate hike over the previous $9.99 combined plan. The result has been a revolt by its customers. The announcement of the expanded NBC deal generated more than 45,000 mostly negative comments on Netflix's Facebook page. The company's blog has also received thousands of negative comments. Many vowed to ditch Netflix.

Despite this, Netflix's subscriber base increased from 25.3 million subscribers in the year-ago period to 31.8 million in the third quarter of 2012. However, the company earned a net income of $8 million, but it off-set a $3 million decline in DVD contribution profit, a $3 million increase in international losses, a $2 million increase in global operating expenses, and higher license fees. Third quarter gross profit declined to 26.8% from 27.6% in the second quarter and 34.7% in the third quarter of 2011. Total cash declined by $32 million. Free cash flow was -$20 million, despite positive "net income".

It is understandable that the recent deals increased Netflix subscribers, but it is noticeable that the company's net income is off-set by declines in DVD contribution profit, increase in international losses, and increase in global operating expenses. The company continues to experience cost escalation due to higher license and renewal fees. For instance, Netflix needs to pay $5 billion for streaming content obligations, out of which $2.1 billion is to be paid within the next 12 months. It is therefore clear that with the deals, Netflix is not experiencing improvement in comparison to the previous year. Looking at the successive deals and the decreasing margins, we can say Netflix is good to hold but not to buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.