Netflix shares jump on analyst upgrade

One investment bank thinks there may be close to a 30% upside.

By TheStreet Staff Oct 8, 2012 10:53AM

TheStreet.com logoNicholas Monu, iStock Exclusive, Getty ImagesBy Chris Ciaccia  

 

One investment bank thinks Netflix (NFLX) bears have had their fun and there may be close to 30% upside. Shares were up nearly 10% Monday.

 

Morgan Stanley analyst Scott Devitt upgraded the Internet video provider to "overweight" with an $85 price target, noting that Amazon (AMZN) is not a direct threat to Netflix's U.S. business. "We believe the primary driver of content revaluation was Netflix's own success," he wrote. "Netflix is poised to leverage its domestic cost structure and potentially become the global video platform."

 

Devitt does not believe Amazon will unbundle Prime Instant Video from Prime anytime soon and continue to use the "freemium model," with Prime users getting free content, then renting movies from Amazon to enhance their experience.

 

TheStreet Ratings has a "hold" rating on Netflix, in part because of very low net profit margins (0.70%) and declining net operating cash flow (down 77.2% to $19.69 million).

 

Netflix's business model has come under attack in recent weeks as companies like Toys R Us launch their own video-on-demand services. Other competitors such as Barnes & Noble (BKS) and Best Buy (BBY) continue to beef up offerings as well.

 

Should Amazon offer a standalone product, the Seattle online retailer will face issues that have plagued Netflix, rising content costs, adding perhaps as much as $1 billion to $1.2 billion in incremental costs.

 

Though Netflix shares are pricey, trading at 73 times 2013 estimated earnings, Devitt said the domestic business alone should support the current share price, not taking into account the international opportunities and costs Netflix faces.

 

If churn (industry terminology for customer loss) goes down, Netflix should see lower flux in revenue, and an increase in margins, as customers keep their subscriptions longer. "Any reacceleration (of subscribers) would be a material positive for the stock," Devitt said.

 

Bears have often wondered about rising content costs, and the company has given them ammunition to do so, given its recent outlook. In its most recent results, Netflix forecast third-quarter earnings that range from a loss of 10 cents a share to a profit of 14 cents a share. On the top line, the company expects revenue ranging from $890 million to $911 million. Netflix struck a positive tone in its commentary.

 

"Q3 has begun strongly for us, and we expect to be profitable again in Q3. In Q4, we will launch our next international market, which will drive us temporarily back into the red," wrote CEO Reed Hastings and CFO David Wells.

 

If Netflix is able to negotiate global content deals instead of localized ones, and the company's original programming causes lower churn, these are incremental positives for Netflix. Netflix's first major original programming, "House of Cards," will premiere on February 1, 2013.

 

While DVD disc sales are declining, Devitt noted that disc rentals have shown to be more resilient, which should help Netflix going forward. Even though disc rentals offer higher margins for Netflix as opposed to streaming, customers with multi-disc rental subscriptions will stay with Netflix, as "they cannot get their fix from Redbox." Redbox is owned by Coinstar (CSTR).

 

That's not to say there isn't an abundance of questions for shareholders, namely profitability in a maturing domestic market, and a global market which should see a prolonged investment cycle. There's also the risk that Amazon's LOVEFiLM will continue to grow at the same rate as Netflix's international business.

 

Shares of Netflix have had a very bumpy ride in 2012, although they are down only 3.89% year to date. Shares reached nearly $130 in early February, when it looked like fears were overblown. Since then, the company has lowered guidance, and concerns over profitability have continued to hit the stock.

 

It may be that Netflix is not going to be a major cash cow for investors, but Devitt believes the US business alone is enough to "queue up" support for the stock. We'll see if he's right.

 

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