Are Netflix Shares Worth $300?

Includes: AMZN, NFLX
by: TMT Analyst

Netflix's (NASDAQ:NFLX) shares have outperformed every major TMT stock over the past two years except Liberty Capital (LCAPA) and Sirius XM (NASDAQ:SIRI). The shares are riding a secular wave of viewership shifting to digital, physical DVD rental store closings, a high penetration of its service on devices such as Xbox, PlayStation, and the Wii, and availability of its streaming service on new digital devices like the iPad. Further, competition for its "subscription-based' service has been non-existent to date, and management has been remarkably successful at entering into content deals with studios looking for additional ways to monetize their content.

Traffic trends to the site remain strong according to most of the Internet tracking services, and the streaming service continues to resonate well with consumers. The company is now expanding overseas, likely in Europe, where the field continues to be wide open, even with Amazon's (NASDAQ:AMZN) presence.

The cost structure is increasing due to the content deals and international expansion, but that has been baked into Street models. Plus, Netflix is partially offsetting those increasing costs with savings from fewer DVD mailings. In fact, DVD mailings declined 23% in 2010 and are likely to decline by half in 2011. That's a $600 million annual cost that is likely to decline into perpetuity (not one-for-one), allowing for greater spend on content that is unlikely to hack away at profit margins.

As for competition, the only serious threat, it appears, is's entry into the market. When Amazon will do that is anyone's guess, but the launch is sure to whack the stock. Investors who have been on the fence as the share price has massively appreciated can use that as an opportunity to get into the stock. We think Amazon's entry into the market should prove to be less of a threat to Netflix's business model than most think. We think the market is big enough for Netflix, a serious service offering from Amazon, Hulu, despite its troubles, and the authentification services being developed by the cable companies.

Netflix currently trades at 51x 2011 EPS, a multiple that on the surface looks egregious. However, when adjusting for growth (our preferred method of valuing high growth Internet stocks), the shares trade at a PEG of just 1.1x. Street estimates have Netflix growing its EPS at a 45% CAGR over the next three years. Historically, Internet stocks have reached their full valuations at PEGs between 1.5x and 2.0x. At a PEG of 1.5x, Netflix's shares should trade at $300, up 35% from the current share price.

Shorts, be concerned.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.