Is Netflix Fairly Valued?

| About: Netflix, Inc. (NFLX)

J.P. Morgan analysts Barton Crockett and Robert Milacci upgraded Netflix Inc. (NASDAQ:NFLX) on Wednesday, sending the shares, which had dropped substantially since the beginning of the year, up 5.7 percent during trading. Their essential point was that video downloads are unlikely to challenge the online DVD rental service for three to four years, and that the market had overreacted to the competitive threat. Our analysis shows the shares are about fairly valued, but with a caveat.

We hasten to add that the Morgan analysts are probably right about the competitive threat: Netflix is investing in online downloadable distribution - its R&D line was 5.3 percent of revenues in its June quarter - so movie downloads aren't just a threat, they're an opportunity: Even if Netflix isn't going to be the preeminent downloadable juggernaut in the future, at least it's in the game.

Many analyst reports are almost apologetic about hating Netflix. The truth is that everyone with a Netflix queue enjoys it a lot, but analytically, the company had a 7.0 percent net profit margin in its June quarter and spent 19.7 percent of its revenues on marketing. Acquisition cost per subscriber was $43.95 per gross addition in the latest quarter and $38.13 in the year-ago period. In this respect, the market, it appears to us, was primarily reacting to Netflix's high, and accelerating, customer acquisition costs and not the bugaboo of downloadable content when it drove the share price down 25.2 percent year-to-date through Tuesday's close.

Crockett and Milacci's best case is that Netflix will continue at a high rate of subscriber growth going forward, yet below management's projections. Their worst case scenario is that Netflix will reduce marketing spending and instead rely on its current customer base, reducing customer churn and acquisition costs alike. That throws the focus on customer cancellations, and that refocuses the spotlight on future competitive pressure.

This uncertainty is reflected in the disparity of long-term analyst projections. Crockett and Milacci don't present a long-term growth rate as such, but their model, which features a per-share estimate in 2010 of $1.85, implies a 37.3 percent annualized earnings growth rate in the next four years. Interestingly, this places them below the analyst mean long-term earnings growth projection of 42.8 percent, based on eight analyst projections. Many of them, though, are five-year projections.

Given Netflix's beta of 1.96 and its recent price-to-earnings-to-growth ratio of 0.80, a new investment in the company's shares today would require an annualized per-share earnings growth rate of 44.9 percent in the next five years in order to break even using today's share price. Even using the simple analyst mean projection, the shares seem to be fairly valued.

There's one final rub, though: The high long-term earnings growth rate projection that Reuters Estimates reports is 68 percent, while the low is 20 percent. The standard deviation is 14.6 percent. There is, therefore, a case to be made both to buy these shares, as a risky bet at a reasonable price, or avoid them due to high risk that's not reflected in a share-price discount. Only you know what kind of investor you are.

NFLX 1-yr Chart

At the time of publication, Paul DeMartino did not directly own puts or calls or shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.

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