Wednesday, March 03, 2010

Netflix (NASDAQ:NFLX): Downgraded at Merrill Lynch/BofA & Kaufman

Netflix (NASDAQ:NFLX) is going to be in the penalty box today as two firms are out downgrading the name this morning:

- Merrill Lynch is downgrading NFLX to Underperform from Buy while keeping their $70 price target noting the 26% rise YTD to near $70 is pricing in a very optimistic scenario with their DCF requiring a near tripling of subscribers by 2015 and a low 10% discount rate to justify the current share price.

Further, this optimistic scenario ignores the increased competitive risk as consumers begin consuming more and more video content online, likely reducing the value of Netflix’s unique DVD distribution capabilities over the long term. Therefore they are downgrading the stock from Buy to Underperform and maintaining our $70 price objective which has high short interest (19% as of the end of January) and near-term momentum (1Q10 is likely in-line or better) supporting a premium valuation given the long-term cash generation capabilities of the business.

Low 4Q churn may not be sustainable
Netflix’s impressive 30bps y/y decline in churn in 4Q and the high subscriber growth guidance based on extrapolating this low churn forward was the primary driver of the stock’s upward move this year. If this churn can remain low, Netflix should benefit from both better subscriber growth (fewer new subscribers to find to replace smaller subscriber losses) and higher profitability (marketing goes down as a percentage of revenue because the company does not need to buy as many new customers to support growth). But it is reasonable to question whether this low churn rate can be continued longer term.

Competitive risks increasing
The most significant new threat is HBO GO which leverages HBO’s undisputed subscription content lead (roughly 65% of movies for 5 out of their first 6 years) and much larger subscriber base (~29mn headline subs). HBO GO is still developing its model and has not solved the “last ten feet problem” (i.e. getting onto the TV) but could be a real threat longer term. Wal-mart’s Vudu acquisition shows increased interest in the space, though is likely not directly competitive

Not a Q1 call – expect in-line or better
Q1 is seasonally Netflix’s most front-end loaded quarter as gift cards and holiday sales of Blu-ray/DVD players drive gross sub adds in Jan. Netflix’s guidance for the first quarter of 32% y/y growth in ending subscribers is high, but likely achievable given the visibility they had when they gave guidance on 1/27.

- Kaufman is downgrading NFLX to Hold from Buy while maintaining their $69 price target noting that while they maintain a positive bias on NFLX's fundamentals, they believe shares are fully valued at current levels with shares trading at 26x/21x our 2010/2011 PF EPS estimates vs. their 15%-20% LT growth estimate. Firm notes that NFLX is currently trading at the upper end of its forward GAAP P/E range over the last three years (28x forward GAAP EPS today vs. range of 16x-36x and a mean and median of 24x). They would look to get more constructive on shares in the low $60s.

Search Data Analysis Indicates Continued Strong Sub Growth in 1Q. Based on their analysis of searches for the term "Netflix" on Google, Kaufman expects solid sub growth to continue in 1Q. Historically, there has been a 95% correlation between search volume growth for "Netflix" and gross sub growth. For 1Q (through 2/27), "Netflix" searches have showed an increase of 38% Y/Y (vs. Kaufman 36% estimate), which represents an increase from the 34% growth in searches in 4Q (34% Y/Y reported growth).

Stock Catalysts. Kaufman believes potential positive catalysts for Netflix shares include 1) successful rollout of Netflix for Wii in the spring and continued traction with PS3 launch, 2) additional studio deals that expands Netflix's digital catalog, and 3) continued trend of lower churn. Potential negative catalysts include 1) increased competition (i.e., Wal-Mart acquisition of Vudu), 2) postage rate increases, and 3) more limited margin upside.

Notablecalls: With two bullish firms throwing in the towel, NFLX is likely to get sold today. The stock acted somewhat weaker relative to the market yesterday which should give the bears some more confidence.

The main risk I see here is the general market as I think we're headed to new highs over the next weeks. Netflix will likely follow, destroying anyone short the name.

But I guess this is not something one should be concerned about today.

The stock is going to trade down by at least 4-5%, putting the $66 level in play, with $65 not out of the question if the bears have enough conviction today.

PS: I'm now hearing Susquehanna has also downgraded NFLX this morning. That makes 3 downgrades.

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