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Netflix Shares Still Not Attractive

Tue, 25 Oct 2011

Despite the big drop in price, Netflix's lack of competitive advantages makes it hard to justify the current valuation, says Morningstar's Michael Corty.

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Video Transcript

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Netflix had a wild ride over the last couple of months that has been worthy of a Hollywood blockbuster.

I'm here today with Michael Corty--he is Morningstar's senior equity analyst who covers Netflix--to take a look at the stock and see what the future might hold for it.

Michael, thanks for joining me.

Michael Corty: Thanks for having me, Jeremy.

Glaser: So, for people who may not have been following Netflix that closely over the last couple of months, can you walk us through some of the recent missteps the company has taken and why the stock is off just so much right now?

Corty: Sure. I'll try to keep the timeline as brief as possible. There's been a lot of moving parts in the last three months.

Essentially, Netflix reported earnings at the end of July when the stock was trading around $260 a share, and during that earnings call they talked about a price increase, which caused a lot of controversy, and the main point of the price increase, the main takeaway, was that for someone that was getting one DVD at a time plus streaming used to pay $10, and with the price increase, if you wanted both, they'd be paying $16, a 60% increase. So that was kind of the first step.

And then, in early September, Starz, one of their key content partners, announced that they would not renew their deal with Netflix for Sony and Disney movies, and at that point the stock was still over $200.

And then, in middle of September, they announced they were going to miss their third-quarter guidance, and then they also announced that they were going to launch Qwikster, which essentially was breaking off the DVD and the streaming business. That got a lot of negative attention, as it should have--it was a decision that totally didn't make sense. And then, several days later, management wrote a letter saying that they had reversed their decision on Qwikster.

And then, yesterday, the company reported a bleak fourth-quarter outlook and projected an operating loss in the first two quarters of 2012. It blamed the loss next year on international expansion, but we think there's some decline in domestic profitability that's in there as well. So, I know that's a mouthful, but that's a lot of news flow that's happened within the last three months.

Glaser: So, we had this big string of bad news and bad story after bad story. Was this surprising to you? Did you think that Netflix was going to continue to be such a highflying company?

Corty: No, we've had a 1-star call on the stock for some time, and for a few years now, that call didn't look correct, as Netflix stock reached a high of even $300 this summer. Our concern was just based on the fact that company doesn't have an economic moat, and the streaming business that they're aggressively launching, they really don't have any competitive advantage in that business, because essentially they have to license content and then sell it to their consumers or their customers, and the content owners really have the advantage there for a few reasons. One, the quality content, we believe, will be kind of kept in the pay-TV ecosystem, which is so valuable for content owners. And then the content that does get made available to Netflix, if it happens to be a hit or successful, the content owners always have the chance to come back and reprice that content. So Netflix's competitive advantage is minimal to none in the streaming business, in our view.

What surprised us is the rapid rate of the decline. It seems like we had a longer-term view that Netflix stock was vastly overvalued, but we think some of the recent decisions by management have pulled the story forward. We thought it was going to take a few years for it to play out, and a lot of this has happened in the last three months.

Glaser: When a lot of investors see a stock down 30%-40% in one day, they might view that as a buying opportunity. So looking forward, does Netflix now all of a sudden look inexpensive or look like it has good growth prospects, or do you think it can continue to struggle from here?

Corty: That's a great question, and our inclination as a value investor is to like a stock the cheaper it gets. But in this case, we'd caution investors from looking at the stock on a relative basis, especially since that all-time high, close to $300, was a bubble-like price, in our view. The fact that the company lacks an economic moat; they face significant competition that's on the horizon from well-capitalized possible competitors like Amazon, Apple; and the fact that they have to deal with these content owners that can constantly reprice their content--we think there are a lot of long-term headwinds for Netflix. So at this point, our fair value is $80, and we'd want a good margin of safety before recommending the shares.

Glaser: So when Netflix is talking about some of their growth initiatives like expanding streaming overseas, are those things that you don't think are really going to be able to power the kind of valuation that the shares even have at today's levels?

Corty: That's a good question. We're skeptical of the international expansion story. The U.S. is a great country for content consumption, and the average American consumes a lot of content, and having an incremental streaming service kind of fits in to the American lifestyle.

When you go overseas, Netflix has even less of a competitive advantage, in our view, because in the U.S. they started with the DVDs and then kind of rolled into streaming. In the international markets, they even admit that they have no idea what the profitability is going to look like a few years out, and they don't have the DVD business to fall back on. So we actually think that this international expansion is a bad idea for Netflix shareholders.

Glaser: Michael, thanks so much for your thoughts, and we'll be catching up with you later as the story continues to unfold.

Corty: I am sure. Thanks Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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