Netflix Still Too Expensive

We were not surprised by  Netflix's (NFLX) impressive first-quarter results, given the company's recent momentum and its substantial head start in attracting new customers for its streaming video service. However, we continue to believe that the market is projecting current growth too far into the future, without considering the impact of accelerating programming costs and looming competition from larger, well-capitalized competitors. We're sticking with our fair value estimate.

It is hard to call the results anything less than impressive, with 3.6 million net subscriber additions, which lifted the quarter-end count to 23.6 million. Sales improved 46% to $719 million, driven by a 61% increase in paid subscribers offset by a 7% decline in average revenuer per sub to $12 per month. The lower ARPU is the result of more new customers taking the $8 streaming-only service.

We are not surprised that the quarterly operating margin improved to 16% from 12% as management hinted at higher near-term margins in the February earnings call, given the lack of large content deals in the period. However, we still expect margin pressure in the long run, as our view is that the company does not have a sustainable competitive advantage in procuring quality content. Therefore, to satisfy its current customers and attract each incremental customer, Netflix will have to spend more on both current and higher-quality content. While financial terms for its licensed content are not publicly disclosed, some of the reported costs for the older library content lead us to believe that Netflix will have to pay substantially more in the future.

Netflix shares have had a great run, but with the stock currently trading at more than 50 times our estimate of 2011 earnings per share, we think the market is overlooking some of the long-term challenges facing the firm.

Premium Members can see our full  Netflix Analyst Report, including fair value estimate, consider buy/sell prices, bull and bear breakdown, and risk analysis. If you're not a Premium Member, you can take a free, 14-day Morningstar.com Premium trial.