Netflix (NFLX): A Short Sellers Dream... Or Nightmare

December 13, 2012 5:59 PM EST
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Price: $138.60 +0.14%

Rating Summary:
    33 Buy, 23 Hold, 9 Sell

Rating Trend: Up Up

Today's Overall Ratings:
    Up: 30 | Down: 30 | New: 23
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Bears love to hate Netflix (Nasdaq: NFLX). The 26.7 percent short interest in the stock is a perfect illustration of the hate-level. Even the recent Disney (NYSE: DIS) deal was no reason for the most hardened of the bears to step away. In fact it made some double down.


First, they don't believe that the deal validate Netflix's longer-term viability, analyst. Bears would argue that Disney now just has a free option on Netflix's future success. If all goes to plan, Disney earns a premium above what Starz was willing to pay; if not, Disney turns around and rebids to the next highest bidder. The second debate centers around if the company can afford the Disney content. Bears would argue that Netflix cannot afford this content and will have to raise capital again.

In a note to clients Wednesday, Morgan Stanley Scott Devitt dispelled these Disney concerns. The analyst said the Disney deal does in fact validate Netflix's longer-term viability. "Hollywood is a small world, and no one wants 'egg on their face,' he said. "We believe Disney structured a deal that was economically beneficial for the company that was based on the assumption that Netflix will be able to pay." Commenting on if the company can afford the Disney content, he said they can. "We believe Netflix can afford it based on its current content obligation schedule, however, Netflix has two additional options: 1) rationalize its content portfolio and cut underperforming content or 2) raise prices. A third outcome of the Disney content is that the catalog titles and direct to movie content will lower churn of existing and new subs."

Devitt reiterated his Overweight rating and raised his price target to $105. He said the Disney deal makes Netflix's content portfolio unique among other competing platforms. "We believe it's not about having everything, it’s about having the best, and right now, Netflix clearly has the best content portfolio, domestically. Amazon Prime Instant Video remains highly commoditized with no exclusive content, currently."

The $105 price target is the "base case." Under a "bull case" the stock could be worth $150 per share, he said. This could happen if in addition to disciplined content acquisition, Netflix is able to reduce churn and drive incremental sub growth by delivering strong original programming. Additionally, international shows promising sub growth but still runs breakeven 2013E EPS of $1.12.

Commenting on the sensitive topic of raising prices, the analyst said the Disney content and future content deals may be enough incremental value to justify modest price increases. He notes Redbox increased its cost to rent DVDs from $1.00 per day to $1.20, which is effectively a 20% price increase. A 20% price increase for Netflix would bring the company's Domestic Streaming ARPPU to $9.59. A $9.99 price point would be a 25% price increase. "As long as Netflix continues to develop a differentiated content portfolio, we believe the company has the ability to exercise modest pricing power down the road.

Devitt also believes the original programming and Disney content could reduce churn, which is positive for profitability. "Netflix has invested in growing its content portfolio for kids," he comments. "We believe this strategy is sound as kids generally have more uniform viewing tastes. Adults, on the other hand, have very specific viewing tastes and are therefore a much more difficult demographic to buy content for, universally. Because Netflix already has some Disney catalog titles available and will be adding direct-to-DVD films in 2013, we expect that churn will subside, incrementally. We also believe that Netflix will experience some degree of churn benefit by offering its original programming, scheduled to be released in Spring of 2013."

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