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By Jeremy Glaser and Michael Corty, CFA | 10-28-2013 10:00 AM

Netflix: Great Service, Unattractive Stock

Netflix should keep its subscriber momentum going, but content providers remain in the driver's seat for the long term, says Morningstar's Michael Corty.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Michael Corty. He is a senior equity analyst at Morningstar. We're going to look closer at Netflix and see what's driving the stock higher.

Michael, thanks for joining me today.

Michael Corty: Great to be with you, Jeremy.

Glaser: Why have investors been so excited about Netflix stock recently?

Corty: Netflix has become a momentum stock. Even CEO Reed Hastings in his recent quarterly letter referred to being concerned about investor euphoria in the shares.

Now, setting aside the lofty valuation for a second, Netflix is doing several things right as a business. They've built a compelling streaming video-on-demand service in the United States. They are on pace to add 6 million subscribers by the end of the year, which would put them at around 33 million.

In our view, the cable and satellite companies have done a poor job of offering a streaming service, and Netflix has really stepped right in. They've focused on three key areas in our view: first, kids programming; second, prior seasons of popular cable series that are still running on TV, like Breaking Bad; and third, Netflix getting into first-run programming on its service--a series like House of Cards, which is a series that they don't own, but they have the licensing rights to for the first few years.

Glaser: It sounds like they've recovered from kind of that Qwikster debacle that seems like it has really gone out of investors' memories.

Corty: Yes. The stock has been a rocket ship over the past 12 months.

Glaser: When we see a stock increasing this quickly, even when fundamentals are doing well, it raises the question of valuation. Where is the valuation level right now? Is it completely unmoored from reality?

Corty: We think Netflix is extremely overvalued at this point. With the stock trading at around $320, that's over 80 times our 2014 earnings-per-share estimate. Now, we think Netflix shares are worth $180, and the assumptions we use to get to that value are optimistic in our opinion. By 2017, we assume Netflix gets to almost 50 million subscribers and increases their earnings per share from around $2 today to near the $10 level in 2017.

Now there are a lot of hurdles between today and 2017 in getting that EPS growth. But even if you did assume that they did get $10 a share in EPS in 2017, at today's price you're still paying 32 times 2017 earnings per share, and we think that's rather lofty.

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