Tech

Netflix sky-high valuation leaves no room for error

The Globe and Mail

(Adrien Veczan)

Shares of Netflix broke through the $200 (U.S.) barrier on Tuesday, giving the online and DVD film rental service a valuation of $10.5-billion, more than four times its market worth at the start of the year.

The runup is raising questions about whether the stock of the Los Gatos, Calif., company is vulnerable to a selloff.

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Even with its robust financial performance - annual profit is forecast to grow 33 per cent this year - the company faces significantly higher market expectations than Apple Inc. and Google Inc., both of which are building online entertainment delivery services themselves.

On a price-to-earnings basis, Netflix shares trade at a multiple of 78, compared with Apple's 21 and Google's 23.

"There is no denying that Netflix is on a roll, with accelerating subscriber growth coupled with declining cost of customer acquisition. We are hard pressed to find anything to complain about in the quarter or the forward guidance, leaving valuation as the only issue holding us back from a more positive stance on the stock," notes Steve Frankel, an analyst with Dougherty & Co. in Minneapolis.

Management has built an "amazing company," he acknowledges, but the sky-high valuation leaves no room for error.

Challenges include maintaining gross margins, digesting acquisitions and managing expansion outside the United States. He has a $142 price target on the stock and recommends buying if the shares sink to the $130 range - 35 per cent lower than they are now.

The two largest investors in the company have recently opted to take some of their profits off the table. Fidelity Management, which owns 8.9 per cent, and Technology Crossover Ventures, which owns 3.5 per cent, have both sold significant portions of their stakes, according to filings in September and October. Netflix chief executive officer Reed Hastings owns about 2.5 per cent of the outstanding stock.

Last week, Netflix introduced an online subscription service in the U.S. that gives customers unlimited access to the firm's library of films and TV programming for $7.99 a month. The debut followed a similar launch in Canada in September for $7.99 (Canadian). U.S. customers can still tap the mail order service for DVDs, which costs an extra $2 a month.

Increasing Competition

But Netflix faces increasing competition, both at home and in new markets as it expands outside the United States. In Canada, Netflix's first international foray, Momentous Corp.'s Zip.ca remains the dominant force in the mail-order DVD business with a library of some 80,000 titles. Zip, whose monthly mail-order plans start at $10.95, says it is in "the late stages" of negotiating with all the major Hollywood studios and others to bring streaming service to its customers.

Netflix has been expanding at a rapid rate, increasing its customer base by about 50 per cent over the last year to 15.9 million paying customers at the end of September. Analysts generally like the company's shift to a streaming service because it carries lower costs than the mail-order business. Netflix is spending more than $500-million (U.S.) a year on postage fees alone.

But some analysts like Daniel Ernst, of Hudson Square Research Inc. in New York, question whether the new model will really bring significant savings. "While the absence of mail costs materially reduces [costs]for Netflix, we believe that rising content costs could supersede the mail cost saving," he wrote in a recent report. Netflix's agreement to pay major U.S. content providers almost $1-billion over five years will significantly cut into the average revenue per customer, which has been decreasing due to lower price plans.

"Given that major studios are very likely to expect increasing rates to obtain streaming-only rights, we fully expect Netflix's content costs to rise further," says Mr. Ernst, who rates the stock a "sell."

This week a new threat has emerged for Netflix and other firms trying to leapfrog the cable companies in delivering content. Comcast Corp., the largest U.S. cable TV company, levied a charge on Level 3 Communications Inc. for content it delivers across Comcast's network. Level 3 is a key partner that helps Netflix stream programming.

Level 3 said it will complain to U.S. regulators on the grounds the fee violates net-neutrality rules, but some analysts have warned that if the fees do stand, Netflix could be forced to pass them on to customers.

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Companies & investments Mentioned In This Article (1)

Company Price Change Volume
Netflix Inc.
NFLX-Q
350.99 0.573 % 429,203