Netflix: Good Things Ahead But Serious Questions Remain

Sep.13.11 | About: Netflix, Inc. (NFLX)

With Netflix (NASDAQ:NFLX) hovering around that $200 level again, an important question seems to creep back in: Which will we see next - $100 or $300? You can easily make arguments for both. The longs will tell you that the growth story has just started, and shorts will tell you the accounting's bad and the P/E is too high. With just 3 weeks left in the quarter, let's take a look at both sides of the argument. Last quarter's investor letter provides some good information for this discussion.

We'll start with the bad. Netflix's new price plans went into effect this month. DVD and streaming plans are now separate. You can still get them both, but it's going to cost you a bit more. The troubling part is a line that says "we hate making our subscribers upset with us". Well, you could have left that part out. I think it's rather obvious. They expect that some customers will cancel their plans or just downgrade which service they choose. But the company still believes its plans are an incredible value. That remains to be seen. At the end of last quarter, Netflix had 10 million streaming only and 3 million DVD only. It's likely that many of the 12 million that have the streaming and DVD option will simply navigate to the streaming only, which would be positive for the company's margins.

The second problem is the Starz deal. Morningstar has a good note out on this issue. The current deal runs for another 6 months, so Netflix still has some time to work things out. But as this article points out, at what price? $300 million a year or more for exclusivity will take a chunk out of their margins. One might wonder if it would be better not to pay, as the loss of customer revenue might be less than the increased expenses. But you'll never convince a company of this idea. In the end, I think they will reach a deal, but it better be for an extended period of time, because with content prices on the rise, you don't want to have to come back to the negotiating table again anytime soon.

With 24.59 million domestic subscribers at the end of last quarter, you begin to wonder how much more that number can grow. Netflix said in its report that they expect about 25 million by the end of Q3, which would be the lowest quarterly subscriber addition in the past 2 years. To be fair, some of this could be due to the pricing change, and the company does expect to return to a more normal pattern in Q4.

Now let's look at the positives. Netflix added more than 5 million new subscribers in the first half of 2011, and they should add a few million more in the second half. The company is projected for 48% revenue growth y/o/y in this quarter, and almost 63% growth in the next quarter. The company believes that with a good Q4 it could see its first billion dollar revenue quarter. With expectations currently at $969 million, I don't think it will, but I think it will be close. It will certainly get to that next year though. 52% revenue growth this year and 38% next year are no small feat in this economy, even for a company in this phase of its growth stage. If the company can make the 57% projected earnings growth for this year, investors will be happy. Projections are for 47% EPS growth next year, but that will remain to be seen if and when they come to an agreement with Starz.

There will come a time when Netflix will not see any more quarters where they add 2 or 3 million domestic subscribers. And that is when they will need to turn to their international business to continue their growth. Last quarter, international revenue accounted for less than 2% of revenue, and international subscribers make up less than 4% of the its global total. This segment is currently losing money, but this current quarter is only the 5th overall for the international business. With only 1 million international subscribers, there is plenty of room to grow.

The valuation argument for Netflix can be extremely complicated. With a current P/E of 51.5, you may think it's rather expensive, but the forward P/E is slightly under 30. That's not terrible when you take a look at this company's growth prospects. Netflix has the cash flow currently to buy back shares, and it has reduced its overall share count by 10% in the last 9 quarters. Continued buybacks will certainly help the case for the longs, even only if all it does is scare away some of the shorts.

Netflix has a great story, and the next few chapters will be extremely important. It will take a quarter or two to sort out the pricing changes and subscriber plan counts. The company also needs to get the Starz deal renewed, but only at a price that makes sense. Content prices are constantly on the rise, so for this company to hit its targets going forward, it will need to continue its subscriber growth, with the international segment being key to this all. I see good things ahead for this company, but serious questions do remain. The company will need to be flawless, or the stock will take a beating.

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