Why JP Morgan is Wrong on Netflix (NFLX)


I should probably correct the title- I’ll be the first to admit that I have no insight whatsoever about this quarter theyre going to report this month. However, I believe that the fundamental Netflix bull story is great and see the recent drop in price as an oppurtunity to buy Netflix.

The Business

Netflix sells movie rental plans from its website, netflix.com. Prices range from $6 – $48 per month depending on the number of movies you want out at a time. Under these plans, consumers choose the movies they want and they are sent out when previous movies are returned. Currently there are 5.7 million subscribers and a collection of 70,000 different DVD’s. The only direct competitor is Blockbuster, and also compete with Apple’s iTunes download-to-own movie platform.

The Numbers

Sales have grown from ~$150 million in 2002 to a projected $1 billion in 2006, a compound annual growth rate of 46%. Management projected in their latest conferance call that EPS will grown at a 50% annual clip over the next “few” years. Analysts are more pessimistic, however, and only project a 32.5% annual growth rate. Return on equity, assets, and capital have increased from barely 3% a few years ago to 26% for ROE and ROC and 18% for ROA.

The bull case

The bull case for Netflix is simple: Netflix has a great brand and a great product, so with broadband penetration increasing and HDTV’s getting cheaper, their service will become more popular. In addition, Netflix is building a downloadable movie platform that they will unveil later this month. Netflix built a great website and I see no reason why they couldn’t do it with downloading as well. Churn was only 4.2% which means that a very high percentage of customers stay on-board and use Netflix every month.

The bear case

The reason why Netflix has grown subscribers so rapidly is because of much higher marketing (and as a result,subscriber acquisition costs) costs. In addition, there is a clear shift going on from the higher priced plans to the lower priced ones, which is hurting margins. Blockbuster is returning from the dead and have stolen market share as well. iPod users are choosing to download movies from iTunes instead of Netflix.

My take

Both sides of the argument really make a lot of sense. High marketing costs have hurt margins but have also lured in subscribers. It’s the same problem that Costco faced: members or margins? Netflix chose the former while Costco chose the latter. There is so much pessism around Netflix, and I think that if it can grow anywhere near their own projects, and with $6 per share in cash to use to build out the online platform, the Company is well positioned for the future.


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