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Recommendation: Sell
Price Target: $135

At $227, Netflix (NASDAQ:NFLX) is a now an overvalued disruptor in the TV & Film broadcast business. It is not the Amazon of content delivery; Amazon (NASDAQ:AMZN) is the Amazon of content delivery. Netflix has become an internet broadcast "network" and should be appraised like its peers: Time Warner (NYSE:TWX) parent of HBO, Starz (NASDAQ:STRZA), and AMC(NASDAQ:AMCX).

Stripping down Netflix to its core operations, this company is an online VOD TV & Film "network". Aside from not being broadcasted by cable & satellite TV, NFLX's operations look almost identical of a Starz, HBO, and AMC.

These operations include:

  1. Licensing and broadcasting of TV shows & Movies
  2. Producing original content for broadcast

In fact, the decline of the DVDs-by-mail operation forced Netflix to evolve and adapt in this way. I give kudos to their ability to evolve and adapt, Blockbuster (former bankrupt competitor of Netflix) would have keeled over a second time by now.

This innovator and disruptor of the TV & Film DVD rental business transformed itself into the largest streaming subscription business. Currently they have a competitive edge because they were first to market with a large device foot print and successfully converted their mailer business subscribers.

The business is extremely competitive with traditional premium cable providers like HBO & Starz on one end of the spectrum and new comers such as HULU, Redbox Instant, and Amazon Prime on the other. These are only a few names that will be competing in the VOD, original content, and streaming business. The field may get even more crowded as it evolves.

Four headwinds for margin compression and slower growth:

  1. Competitive Advantages Deteriorating & Innovation, Commoditized
    The network, broadcasting, and TV & Film business is evolving. Netflix now looks like a network, the broadcast networks are looking more like Netflix. HBO, Showtime, Starz, and AMC have developed VOD & streaming capabilities on large assortment of mobile devices and electronics. Competitors such as Hulu Plus, Redbox Instant, Amazon, and new disruptor, Aereo, will further expand the internet VOD/streaming footprint and weaken Netflix's moat.
  2. Content is King - Higher Content Costs
    Content producers are the winners; they now have a countless number of outlets to sell their TV shows and movies. The network or streamer who is willing to pay the most will have the rights. Also, content production has become more proprietary in its distribution. HBO and Showtime are no longer licensing their original content to Netflix; instead they have created a "value-added" streaming service for their premium subscribers and VOD with cable/satellite companies. To combat this loss of valuable content, Netflix has started producing its own original series, a very capital intensive operation.

    The core four broadcasters (ABC, CBS, FOX, & NBC) all have developed VOD streaming apps for iPad & Android devices. This has created more competition for Netflix viewership and decreased its value.

  3. Paying a Toll for Bandwidth

    Netflix has an incredible competitive advantage here. Currently premium cable networks must share subscriber revenue with TV service providers such as DirectTV (NASDAQ:DTV), Verizon FIOS, and Comcast (NASDAQ:CMCSA). Streaming is quickly gobbling market share of viewership. This paradigm shift of content distribution must eventually be monetized by the gatekeepers. The biggest and best wireless networks such as Verizon Wireless and AT&T have already started by capping bandwidth and paying for consumption.

2 & 3 can be terribly harmful to margins. Netflix content delivery is subsidized by unlimited internet access. I believe content providers take advantage of this by charging a premium to Netflix versus traditional outlets AND/OR Netflix has to license much more content to be competitive. These factors may be the lead contributors to much lower operating margins at Netflix compared to its peers. See FIGURE 2

4. Change in Netflix Capitalization - More debt to be issued

Like Netflix's biggest competitors, in order to develop and produce more original content they will need to issue more debt. Additional capital will be necessary to penetrate more markets as well. Their meager Operating Cash Flow (look at Fig. 1) will not support these growth and content initiatives. I suspect long term debt will double (from $500 mil to $1 bil) in the near future.

2012

2011

2010

Operating Cash Flow

$ 22.8

$ 317.7

$ 276.4

Acquisition of DVD Content Library*

($ 48.3)

($ 81.2)

($ 124)

Adjusted Operating Cash Flow

($ 25.5)

$ 236.5

$ 152.4

*Acquisition of DVD Content Library is stated on NFLX's 10K as a Cash flow from investing when clearly this is a purchase of inventory for operations.

Valuation: Quantify the opportunity for investors

The market has Netflix as the Amazon of content delivery. Meanwhile, all of these of these networks including Amazon are fighting for viewership and subscriber dollars.

As of FY 2012

NETFLIX
Domestic

Time Warner Network Segment

STARZ (STRZA)

AMC

Revenue

$ 3.3 Bil1

$ 14.2 Bil2

$ 1.3 Bil

$ 1.3 Bil

Subscribers

25 mil

~100 mil

56 mil

~98 mil

P/EBIT

26x3

9x

6x

13x

Operating Margin %

15%4

33%

36%

27%

  1. Revenue of $2.2 Billion is only Netflix's Domestic Streaming Revenue
  2. Time Warner Network segment Revenue (USA & Int'l), includes HBO/Cinemax Premium Subscriptions and TV channels such as CNN, TNT, TBS, and Cartoon Network etc.
  3. Netflix adjusted P/EBIT= Stock Price of $230 divided by $9.00 EBIT per share.
  4. An Operating Margin of 15% was used. One could make both cases of an extremely conservative or aggressive adjustment. Based on their historical record, Netflix has never had Operating margin higher than 13%. A operating margin of 15% could be considered "aggressive".

The chart above illustrates a peer-to-peer comparison of P/EBIT and Netflix looks extremely overvalued. Pricing the stock at a less aggressive P/EBIT of 15x would bring the stock down to a $135 price value which is a 40% discount to today's price. This would conceivably produce an adjusted 2012 P/E of 30.

Bullish investors are betting on 2 major catalysts for further price appreciation (1) Operating margin expansion closely matching its peers of 20% to 30%. (2) The continued growth of subscriptions globally. Some have forecasted 5 million additional subscribers per year for the next 3-5 years.

Bulls also believe the Netflix "brand" has penetrated the minds of the masses and has given them a competitive advantage. Consumers will go to Netflix first instead of the competition.

Source: Netflix: Extremely Overvalued Compared To Competitors