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Analysts Cautious on Netflix as Stock Falls

22 Jul, 2010 By: Erik Gruenwedel

Analysts say Netflix’s burgeoning stock valuation has peaked in the near term, despite the company reporting another banner quarter with strong profits and a subscriber base topping 15 million members.

Michael Pachter, with Wedbush Morgan Securities in Los Angeles, maintained an “underperform” rating on the Los Gatos, Calif.-based online DVD rental pioneer’s stock, citing a “staggering” drop in average revenue per user (ARPU) as new and current subscribers opt for the lower priced $8.99 monthly plan for one DVD rental at a time and unlimited streaming.

Specifically, Pachter said Netflix’s ARPU drop of 58 cents undermined a projected ARPU increase of 40 cents.

“We saw a greater than expected drop, which suggests that an incremental million subscribers shifted from higher priced plans,” Pachter wrote in a note.

Indeed, Netflix subscriber base increased 42% year-over-year, while revenue rose just 27% by comparison.

Netflix management said it is focusing on gross profit per subscriber, which is increasing as shifts toward streaming reduce physical media distribution costs (i.e. shipping and handling).

“We think investors will continue to focus on ARPU as a predictor of earnings growth,” Pachter wrote, adding that Netflix would be “challenged” to grow at its current pace for more than another year.

“We expect its premium valuation to collapse,” he said.

Indeed, Pachter said Netflix shares are trading at 36 times forward earning per share (EPS) multiple compared to historic 20 to 25-times forward EPS multiple.

Earnings multiple is typically calculated from the previous two quarters combined with estimates on the next two quarters.

Pachter lowered his fiscal-year revenue guidance for Netflix to $2.17 billion from $2.19 billion. 

Separately, analyst Eric Wold with Merriman Curhan Ford in New York, maintained a “neutral” rating on Netflix shares, saying that despite the company’s “near monopolistic” control of the by-mail DVD/Blu-ray Disc rental market and increasing shift toward more profitable subscribers (via streaming), the stock has little room to grow.

“We continue to believe any potential [earnings per share] upside in the next few years is priced into [Netflix] shares at current levels — and recommend investors wait for a better entry point to accumulate further positions,” Wold wrote in a note prior to Netflix reporting fiscal results.

Analyst Ralph Schackart with William Blair & Co. in Chicago, said the downturn in Netflix’s share price reflected the exaggerated expectations Wall Street has come to anticipate in recent years.

“Shares were priced for perfection and light revenues, lower-than-expected ARPU, higher-than-expected churn and [subscriber acquisition costs] did not meet ‘perfection’ expectations,” wrote Schackart in a note.

Then again, analyst Rick Munarriz with TheMotelyFool.com countered that previous negative outlook on Netflix by arguing that CEO Reed Hastings and Netflix’s brass were actually prescient in ignoring top-line growth and focusing instead on margins.

“As long as the subscribers keep coming and margins keep holding up their end of the bargain, investors shouldn't care,” Munarriz wrote in a post.

Specifically, the analyst applauded Netflix’s migration toward more profitable subscribers who he said are supplanting costlier DVD rentals with streaming.

“Any shrewd investor would follow the margins before following the top line, and Netflix's performance in recent quarters shows it can make more money with people paying less as long as it makes it up in volume,” Munarriz wrote.

Regardless, Netflix shares July 22 fell more than $16 (13.5%) to $103 per share in heavy mid-day trading.

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