Tuesday, October 09, 2012

Netflix (NASDAQ:NFLX): Taking the money and running; see risk to streaming adds - Merrill

Merrill Lynch/BofA is downgrading Netflix (NASDAQ:NFLX) to Underperform from Buy this morning.

- With the stock up 31% in past two weeks, risks outweigh reward heading into Q3.

Since their upgrade on August 14th, several things have changed that make the firm unwilling to chase this stock after a 31% upward move in the last two weeks, including: 1) Amazon has continued its aggressive content acquisition, buying the Epix content as soon as it came off exclusivity with Netflix thus taking away the most valuable differential for marketing purposes (Epix has the closest thing either company has to recent Hollywood blockbuster content); 2) less comfort in Netflix’s ability to meet even the Street’s relatively low expectations of 6mn net additions to it domestic streaming business; and 3) less acquisition value support at these levels – Amazon is likely content to wait until Netflix is ex-growth in the US and thus cheaper before it considers an acquisition at >$4.09bn (current market capitalization plus some acquisition premium). This quarter reminds them a lot of last quarter, with heavy short covering driving the stock up post quarter end on no or limited news; a set-up the firm doesn't like to see in any hyper-volatile stock like Netflix.

Will it be 7mn, 6mn or 5mn net US streaming ads?
Early this year, Netflix put out a “soft” guidance target of 7mn net sub additions to its domestic streaming business. From their conversations, as well as Street estimates, it is clear that few if any believed this number from the get go and fewer believe it now. Merrill doesn't think the company needs to guide to 7mn net adds for the year (3.5mn in Q4 assuming Q3 is at 1.4mn, the mid-point of guidance), but less than the ~6mn that the Street is modeling could hurt the stock. They see net additions significantly below estimates as the biggest risk to the stock due to: 1) signals Netflix has reached the second inflection point on its penetration curve and 2) domestic streaming subs will plateau sooner than expected, pressuring FY13 ests (they are currently modeling 33mn domestic streaming FY13 subs).

Notablecalls: NFLX is up 17 pts since last Wednesday after the wonderful positive call from Citi (see below) and the relatively ill-timed upgrade from Morgan Stanley yesterday. As Merrill notes, this does remind a lot of last quarter, which ended in a rather painful 20 pt drop in stock price.

In my humble opinion, yesterday's move can solely be attributed to short squeeze as fast money traders attempted to fade the MSCO upgrade. I also suspect many of them ended up covering their shorts by end of day as the stock failed to cave.

These trading dynamics leave NFLX vulnerable to the downside today on the Merrill downgrade.

I'm thinking below $70 level today.

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