Don’t Fall Into This Value Trap
Rahul is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Netflix (NASDAQ: NFLX) has had a huge down slide till now as the stock has dropped ~70% from its peak in July 2011. In the wake of this slide, some investors are getting increasingly bullish as they believe that the stock has hit rock bottom. Recently, the analysts at Bank of America have also upgraded Netflix citing that the “bull case is more convincing than the bear case” after the price correction. While the investors may find this “value trap” stock attractive, we still remain bearish on Netflix given its slowing user growth in the US, increasing competition and international profitability concerns. We believe that Netflix prices have not been fully corrected and expect to see further downside going forward.
We believe that Netflix’s Subscriptions are closing in on their saturation levels in the US. This is evident by the slow sub growth in Q2 as total Subs grew to 23.9 million from 23.4 million in 1Q12. To continue its status as a growth company Netflix has tried to expand internationally but it has brought more woes than relief for investors. Netflix management plans to use up the profits generated in the US markets for growth in the international markets. While expanding in international markets is a good long term opportunity, we believe that Netflix is likely to incur losses for an indefinite period as a result. The US competitive landscape might also change as investors wait for profitability making it a high risk and low reward venture.
With contrast to management's belief, the international markets may not provide high revenue generating opportunities given the low density and inept penetration of Netflix streaming devices in the International markets. The company is already facing troubles with its Latin America expansion as it is facing challenges including low device penetration, weak Internet infrastructure, substantial investment in subtitling content and difficulties in payments. While Netflix may not face such challenges in the Nordic countries with a high education rate and higher per capita income, we believe that it will take a long time before the company eventually manages to reap profits. If we assume the same penetration in Scandinavia as in the US, we estimate incremental subs of around 2 million at the peak of saturation levels. We believe that it is a much lower figure considering the high investment and the many years it will take Netflix to reach saturation levels.
While we believe that Netflix will be able to maintain its leadership position in US markets, we believe that Netflix is likely to face increasing competitive pressures as Verizon (NYSE: VZ) and Coinstar (NASDAQ: CSTR) JV launch their Redbox Instant product portfolio in 2H12 in which coinstar is believed to hold a 35% share. In a recent patent Litigation case settled between verizon and TiVo, their appears to be an indication that TiVo might infact support Redbox Instant. Another daunting challenger for Netflix could be Amazon (NASDAQ: AMZN) which currently offers streaming as a value added benefit with its Amazon Prime offering. Amazon has already launched its service “Lovefilm” among the Scandinavian users, which might further add to the international expansion woes as Netflix continuously loses its first mover advantage.
Considering that content is the main driver of subscriptions for Netflix, rising content costs present a major problem for Netflix. As the rise in the subscription adds has trended lower than the increase in the content costs, Netflix is facing increasing pressure on operating margins. Netflix still needs to pay $1.2 billion to content providers Disney, CBS Corporation and Time Warner which signifies the need for Netflix to better manage its content costs. Netflix remains between a rock and a hard place as it cannot risk increasing the prices to pass the content costs to subscribers considering that the price hike had driven customers away in 2011.
While Netflix' decision to expand its operations internationally is a necessity, we believe that it is bound to post losses for a long period as a result. We believe that Netflix can continue the downslide with its lofty Forward PE valuation of 67 considering the high competitive pressure and stagnation in the domestic business and therefore we rate this stock as a sell.
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