Netflix (NFLX) is up 19% since the start of October based on a buy recommendation from Citigroup's analyst Mark Mahanay, based on improving customer satisfaction, and due to Whitney Tilson reversing his stance on NFLX to a buy. We still do not recommend buying NFLX as it is still expensive at current multiples and has a lot of challenges to face including tough competition in the US and abroad.
The shares had been under pressure because of concerns over content costs, subscriber growth target being too challenging to meet and the tough competition it faces from Amazon's (AMZN) streaming service. At the end of 2011, there was a huge decline in subscriptions and customer satisfaction due to price hikes by Netflix.
The reiteration of the buy rating by Citi's (C) analyst is based on valuation being highly reasonable and improvement in customer satisfaction. His target price is $120, which is almost twice the current price of $62. He does admit that the company faces strong competition, uncertainty regarding international profitability and content acquisition requirements. According to the Citigroup group survey (involving 3800 internet users of which 1200 plus are current NFLX customers and 700 are past subscribers), the customer satisfaction has improved 3-4% for the first time since the pricing crisis last year. Moreover, 37% say that the content library has improved while 16% say that it has worsened. Netflix's online video destination has also improved 5% from Q1 level of 30%.
We think that this is not a significant jump in consumer satisfaction given the fact that the customer satisfaction is directly linked with the content NFLX provides. As long as NFLX keeps spending heavily on content and provides exclusive content, customers will subscribe to it. Amazon is gaining fast in terms of amount of content with its latest deals with content providers like Epix. When AMZN starts providing as much value through content as NFLX, subscribers would have little reason to subscribe to NFLX. Let's not forget that AMZN is providing free shipping incentives in its streaming offering as a part of Amazon Prime which is priced at $79/year compared to NFLX offering at $7.99/month.
There is also the question of whether Netflix can grow subscribers fast enough to spend continuously on content acquisition as well as compensate for the declining DVD business and international expansion costs. NFLX is also likely going to be a price taker because there is a lot of demand for the content that the likes of CBS Corp (CBS) and Time Warner (TWX) have to offer.
Whitney Tilson, a prominent hedge fund manager reversed his position on Netflix from a sell to a buy citing global prospects. Tilson compared the company to Amazon's condition in 2001 - when Amazon was able to pull through challenges - and said that both companies were giving up short-term profitability for international presence. Tilson said, "There is a lot of talk about competitors but I don't see any detectable competition showing up". According to a Value walk article, Tilson's hedge fund has been almost stagnant this year and had dipped below breakeven partly due to the wrong stance on NFLX.
We think that international profitability is still uncertain as the company has yet to see profits from its present international operations. The company has also guided to losses in Q4 from Nordic expansion. International arena is not devoid of competition either. Amazon is present in UK as well as in Nordic regions. For more details on competition for NFLX abroad, read our previous article.
We reiterate our previous thesis that the outlook for NFLX remains challenging. We do not recommend investors buying NFLX even though it is trading 50% below its 52-week highs. A forward P/E of 72x is not exactly a tempting investing opportunity. Its peer, Amazon, which is trading at a forward P/E multiple of 111x is also overvalued compared to its earnings.