Netflix's Growth Prospects Over-Optimistic?

NEW YORK (TheStreet) -Whitney Tilson, the founder and managing partner of T2 Partners LLC and the Tilson Mutual Funds, recently wrote a detailed thesis on Seeking Alpha that Netflix's (NFLX) (NADAQ:NFLX) stock presents an exceptional short opportunity.

In response to this, Netflix's CEO Reed Hastings countered with his own commentary dissecting Whitney's analysis and asserting a growth outlook for his company. While the discussion emphasized margins in the years ahead, we believe that the prospect of subscriber saturation represents a more substantial long-term risk to Netflix's growth.

As we examine Netflix's subscriber growth prospects in the face of market saturation, we pose the following hypothesis. Arguing for Netflix stock upside is equivalent to betting that Netflix (approaching 20 million subscribers) can close in on the number of subscribers that AT&T ( T) or Verizon ( VZ) garners in the mobile phone market (near 100 million subscribers).

Our current price estimate for Netflix's stock stands at $106, which is significantly below the current market price.

Netflix's subscriber has grown rapidly over the past few years, from a mere 4.2 million in 2005 to a robust 19 million (est.) at 2010 year-end.

We anticipate continued growth of Netflix's subscriber base driven by increased adoption of its by-mail DVD business model and video streaming offerings, and project that total users will breach 40 million by the end of our forecast period on the strength of international expansion. Thus, our analysis already incorporates an optimistic subscriber growth scenario.

If Whitney's thesis is indeed misguided, the counter argument implies that Netflix's stock price will continue to rise or, at the very least, sustain its current valuation. What does this mean in terms of subscribers?

To justify Netflix's current market price, Netflix would need to establish a whopping 80 million subscriber database by the end of our forecast period, and continue this growth in the long-term. While we do acknowledge that this calculation excludes supplementary factors that could lift the company's intrinsic value, the subscriber base remains the most important driver and the effective gatekeeper to Netflix's stock upside.

Besides subscriber base, the most critical variable is profit margin, a metric that will likely shrink as the market saturates. With less food to go around the content providers' table, players like Netflix could ultimately find themselves spending more to gain less. Adding further weight to margins is the expected rise in content acquisition costs in the years ahead.

In his reply to Whitney's article, Reed Hastings states: "While saturation will happen eventually, given the recent huge acceleration of our business specifically, and streaming generally, saturation seems unlikely to hit in the short term."

While it is true that streaming adoption is quickly gathering pace at the moment, we believe that the implied growth necessary to justify Netflix's current valuation is unobtainable. Where are 60 million new subscribers going to come from?

Clearly a large part of that will have to come from the U.S. where Netflix has been a pioneer in making movies conveniently available to the consumer. But that level of growth can not materialize until Netflix becomes the next AT&T or the next Verizon, which are among the largest subscription service providers in the U.S.

Netflix has already surpassed every major pay TV provider excluding Comcast and DirecTV in subscriber count, and would actually need to approach the level of subscribers that AT&T and Verizon only enjoy in the mobile phone business in order to substantiate its current market price. The idea itself is extreme.

Netflix has a good business model, but let's be rational. The barriers to entry are not high. Capital expenditure requirements are low and Netflix cannot sustain the quasi-monopolistic state that AT&T and Verizon enjoy in their business. Netflix's position in the streaming market is already being threatened by large established players like Apple ( AAPL)'s iTunes, Amazon ( AMZN) and Hulu.

Whitney Tilson argues that:

"We have analyzed the last decade of Netflix's quarterly statements, in which the company discloses customer additions and cancellations, and calculated that Netflix has had approximately 30 million customer cancellations. In other words, the company has had to add approximately 47 million customers - more than 40% of U.S. households - to be left with today's 16.9 million customers"

While Whitney's concerns are valid, we do believe that his claims may be exaggerated. The 30 million cancellations that he cites may not be representative of unique customers, as there are likely many subscribers that tried the service more than once in the hopes of a better experience.

Further, we contend that subscribers who might have canceled in the past cannot be excluded from the pool of future prospective customers. Netflix has been tirelessly working to improve the customer experience and many of these subscribers might opt to sign up again.

However, the increase in Netflix's potential pool of customers, when accounting for prior subscribers, is relatively minor compared to the growth necessary to justify the company's current stock price. The 80 million customers required to raise Netflix's intrinsic value to its current price amounts to roughly double our base case forecasts.

A lot of hype has surrounded Netflix's debut in Canada and its aspirations for further international expansion. Could this make up the balance in subscriber growth? Again, this is unlikely. We highlight several key reasons to be skeptical regarding the company's potential to generate sharp subscriber growth from international markets.

First, Netflix has only tested the waters in Canada, which represents a population of about 33 million, a small fraction of total U.S. population. The Canadian market, for reference, is about equivalent to the state of California.

Clearly Netflix could expand further into regions like Europe, but the company could hit face a headwind there from the incumbent video rental service provider Lovefilm. Although Lovefilm is smaller than Netflix, it offers a similar service and is likely to put up a fight.

Lovefilm is also strengthening its online delivery technology, just as Netflix has done in the U.S. Furthermore, the European market is a comparatively closed market, meaning that adoption of a foreign service like Netflix might face additional speed-bumps.

Expansion into emerging markets could be a bit optimistic given comparatively lower broadband penetration and data speeds in these markets. Added complications like high DVD piracy rates and the necessity to carry local content might further deter Netflix from seeking its pot of gold in emerging markets.

While Netflix remains an intriguing name to follow in the years ahead, we believe the company's true growth prospects fall well short of justifying the premium its stock commands in current markets.

You can see the complete $106 Trefis price estimate for Netflix's stock here .

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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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