Netflix's (NASDAQ:NFLX) shares had plummeted around 16% due to cutting down of the challenging domestic subscription target, from 7 million to 5.4 million for the year. The decline has been offset by unconfirmed rumors of Microsoft (NASDAQ:MSFT) looking to buy the company. The current price of $69 is above the consensus mean price target of $65. As the volatility in the stock price continues, we reiterate our earlier recommendation of avoiding NFLX.
In the 10% session after the Q3 earnings release, CEO Reed Hastings said that the company is on track to full brand recovery within a three year period, helped by spending on originals. Free cash flow is expected to be negative for several coming quarters due to funding of originals. It is of importance to know that according to the earnings call transcript, the company does not have rights for syndication, DVD and licensing of original content. Moreover, the CFO David Wells said in the earnings call that original content would be less than 10% of the hours viewed, or maybe less than 5% for next year. This gives rise to the debate of how many subscriptions can be gained through offering the expensive original content.
Content, if not original, remains an issue for the company. When asked about how the company will handle new content deals and the ones that come for renegotiation, the CEO replied by saying that it is an "auction market". This will continue to be a challenge for the company as more and more deep pocketed companies enter the market to benefit from the internet video trend. Content (especially exclusive) is the main driver of customer loyalty in this industry.
Withdrawal from loss making markets is also difficult because the content agreements are usually long term. Further expansion also relies on the company returning to profitability in its existing operations. Any attempt to raise prices (though the management plans none at present) can result in a backlash like the one seen in 2011, from which the company has not recovered yet. The company also recognizes Amazon (NASDAQ:AMZN) as a significant competitor at similar price points, though it has a subset of NFLX's content in the US. Amazon too is engaging in efforts to provide original content.
The CEO attributed the subscription guidance miss to a forecasting error and looks forward to reach 60-90 million as more and more households get used to online video streaming.
As the company continues to work through a decline in its DVD business, losses from international expansion and content payments amidst tough competition, we think that the forward P/E of 158x and EV/EBITDA of 23x show that it is not a good investment opportunity. Hurricane Sandy might help increase viewership for Netflix and word of mouth advertisement might be faster, but the volatility in the stock does not make it attractive. The rumor about Microsoft's interest in NFLX is not substantiated, and any further rumors might lead to covering of short positions by bearish investors. Currently, almost 30% of the float is short.