Don't Buy Netflix: The Stock Is Too Expensive With No Turnaround

| About: Netflix, Inc. (NFLX)
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In an earlier article on Netflix (NASDAQ:NFLX), we were bearish on the company due to competitive and financial reasons. The stock price has declined 23% since then, due to a disappointing outlook given in the Q2 2012 earnings release regarding the difficulty in attaining the subscriber target, and expectations of a Q42012 loss caused by expansion. This article is an update on the drivers behind Netflix's stock and provides an analysis of the recent news (content cost, content deals, competitor's moves) surrounding Netflix.

The company returned to profitability in the second quarter (EPS of $0.11/share), but this was less than last year's result of $1.26/share. A revenue increase of 13% over Q2 2011 was almost offset by rising costs. Free cash flows, which have almost mirrored net income in the past, are expected to trail income in Q3 2012 because of content payments for original and licensed content. The operating cash flow was $153 million in the trailing 12 months, while cash in hand was $813 million by last quarter's end. Below is an update of the circumstances that Netflix faces.

Subscription growth is required to meet content acquisition cost, which is not happening as fast as required. Netflix has to pay $1.2 billion to content providers like Disney (NYSE:DIS), CBS Corp (NYSE:CBS) and Warner Bros. (NYSE:TWX). Increased churn is also a possibility if the content is outdated or continuous investment for licensing content is not made. Renegotiating the upcoming fees might be a catalyst for share price appreciation, but there is no such news so far.

Total subscriptions from the streaming business increased to 27.56 million in 2Q 2012 from 26.48mn in 1Q2012. The company had set a target of 7 million domestic subscriptions additions for the streaming business this year. In Q1 2012, it was able to add 1.74 million, while it only added 0.53 million in Q2 2012 due to seasonality. In these circumstances, the company expects to add 1-1.8 million domestic streaming subscriptions in the third quarter. This seems far-fetched since in 2010 the company had added 1.8 million on the back of a strong response from Netflix for the iPhone. The company needs 1.8 million additions to achieve the 7 million full-year target if it follows the 2010 additions trend.

Competition is another front that is important from a subscription growth point of view. Netflix faces significant competition in the U.S. and abroad from Amazon (NASDAQ:AMZN) Prime and LoveFilm. In our last article, we received comments about the viewing experience on Amazon's competing Prime instant video service. According to one comment, Netflix seems to have an edge over Amazon considering viewing experience on PCs and the iPhone, while according to another comment, Amazon is "every bit as good as Netflix" for platforms where it has an app like the PS3 and Xbox 360. We think the competition is not just limited to viewing experiences. Amazon's service is much cheaper at $79/year, and this price includes services like free two-day shipping of millions of items along with access to Kindle books. Apart from Amazon, there is competition from BSkyB (10.6 million pay-TV U.K. subs), Sky's Now TV cable companies, and HBO GO, in terms of content and pricing.

Amazon, in particular, has already signed and continues to sign new content deals. Among them is the latest NBC Universal Cable and New Media distribution (which is responsible for the sale of content like "Parks & Recreation" and "Saturday Night Live," to non-theatrical markets) deal, which follows deals with Viacom (NYSE:VIA), Paramount Studios and MGM. This narrows the content gap between Netflix and Amazon.

The company announced expansion into the Nordic regions (Norway, Sweden, Denmark and Finland) in Q4. Growth in the EU might not be ideal considering the economic turmoil in the region. The company already expects expansion to drive bottom line into the red zone in Q4. Moreover, international streaming business losses have continued despite an increase in subscriptions. This eats up the contribution of domestic streaming. Moreover, Amazon's LoveFilm is already present in the Nordic region (2 million subs including those from the U.K.). The return from this expansion is questionable at the moment and the company will do better off if it first concentrates on the U.S. till it gets saturated.

According to CEO Reed Hastings and a study by Procera Networks, the Olympics hurt NFLX's viewership. Traffic dropped 25% as compared to normal. This might have a small effect on subscription additions for Q3.

Among the news that goes in favor of Netflix are the company's announcements regarding the launch of its 'Just for Kids' service on the Xbox 360, as well as a multi-year deal with distributor Radius-TWC for films starting in 2013.

Caris & Co recently upgraded the stock citing an older 5-year deal with Epix, a pay-TV channel, which will benefit the company now after two years. According to the agreement, Epix can also sell rights to films from Paramount, Lionsgate and MGM to other services in the last three years. Netflix will have to pay less to Epix in 2013, as it is no longer getting exclusive online rights. However, we view this is as a loss of competitive advantage. Competitors can now supply this content to consumers on cheaper prices than Netflix.

Similarly, Netflix was upgraded to buy from outperform by the Bank of America, citing domestic profit growth, better content spending, international expansion and a drop in stock.

Valuation and Recommendation:

JPMorgan has a price target of $63 for Netflix based on its sum of parts analysis, with the U.S. business funding international expansion.

Netflix is trading at an EV/EBITDA multiple of 13x as compared to Comcast (NASDAQ:CMCSA)'s 6x, Time Warner Cable's 7x, Dish Network (NASDAQ:DISH)'s 6x and Amazon's 54x.

Its P/E multiple is pretty high too. Even using 2013/14 EPS estimates, the stock is trading at a P/E of 50x and 40x respectively.

We will also not recommend a long position since Netflix's woes are far from over. We remain skeptical regarding the company's claims that international subscription growth can justify huge spending in international content amidst strong competition. We will be closely following any content fee renegotiation (e.g. Epix) and new content deals, along with subscriber growth. Another thing to Netflix's disadvantage is its non-diversified source of revenue in a very competitive industry, as compared to peers like Amazon and other media companies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The article has been written by Qineqt's Retail Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.