Netflix's Outlook Improves After Friending Facebook

By Jake Lynch

BOSTON ( TheStreet) -- Perennial momentum stock Netflix ( NFLX) has gone from overvalued to illogically overvalued in recent weeks, though it's down about 3% from its recent 52-week high.

The fast-growth DVD-mailer and streaming video company, led by tech guru Reed Hastings, is scheduled to report its second-quarter results on Monday. Analysts forecast that Netflix increased quarterly adjusted earnings by 40% to $1.12 and sales by 52% to $790 million.

Expectations are lofty for the fast-growth firm, which beat earnings expectations by 3.7% last quarter, a solid outperformance, but suffered a stock price drop of more than 9%, in reaction. On the whole, analysts have tempered their view of Netflix's equity, which has advanced 55% in 2011, 163% in 12 months and 1,084% in the past five years.

Currently, 13, or 41%, of the researchers covering Netflix rank its stock "buy" while 12 rate it "hold" and seven rate it "sell." Interestingly, many of Wall Street's brand-name investment banks are still bullish.

JPMorgan, recently named the best overall equity researcher based on buy-side clients' perceptions, by surveyor Greenwich Associates, has an "overweight" ranking and lofty $340 target on Netflix. Goldman Sachs expects Netflix to hit $330 and Barclays predicts a rise to $315.

Earlier in the year, Netflix was sold short by vocal long-short hedge fund manager Whitney Tilson, who eventually sold out of his losing position. While Tilson conceded that Netflix has an outstanding business model, his thesis was predicated upon overvaluation, a relevant criticism of a stock that currently costs 44 times forward earnings and 48 times cash flow, enormous market premiums.

Tilson made other salient points about Netflix, especially its previously low-cost streaming contracts, which are unlikely to be renewed, as proven in contract renegotiations.

Goldman turned decidedly bullish on Netflix in April when it downgraded its view of the streaming competition posed by the likes of Google ( GOOG), Amazon ( AMZN) and Apple ( AAPL). JPMorgan is similarly unimpressed with competitive threats, especially now that Netflix has inked a partnership with privately-held Facebook. JPMorgan sees tremendous growth, domestically, still, given that Netflix's "current penetration is ~30% of broadband subscribers." That figure has plenty of upside.

Overseas growth is tepid, with an expansion into the U.K. under way. However, lower broadband penetration rates internationally, may, in fact, be a positive as Netflix does not yet have the capital, or cash flow, to launch any major overseas expansion. It held $343 million of cash and equivalents at first quarter's end and $236 million of long-term debt. Facebook may hold the key to another leg up in the stock as JPMorgan noted: "we are optimistic about how deep Facebook integration and personal accounts can further improve engagement and increase Netflix's addressable market." This partnership will strengthen Netflix's competitive position and deter new entrants.

Any company attempting to go head-to-head would need to incur significant up-front costs and, even then, would likely struggle with excessive marketing costs and discounting to steal market share. Put simply, when Netflix and Facebook became bosom buddies, the probability of a major push by a competing tech, like Google or Apple, decreased substantially since the cost to compete multiplied. One other advantage, stressed by JPMorgan, but underappreciated by many investors, is Netflix's proprietary rating algorithm, which may actually create demand for older recordings, allowing studios to monetize stagnant and cheap legacy content.

In JPMorgan's view, "this gives Netflix an additional point of leverage during negotiations with studios." Netflix's addressable market may be "the ~80 million homes that are connected with broadband" with the possibility for more than one subscription, or tiered and bundled subscriptions, for each household. As tablet computers and smart phones become the norm, Netflix's offerings may become even more relevant, though the strain on bandwidth may lead to higher costs for network operators like AT&T ( T) and Verizon ( VZ) and more technology input and maintenance costs for Netflix. Such costs will be offset by lower postage and infrastructure expenses.

DVD shipment declines will allow Netflix financial leverage to bolster its platform and video library. A recent Canadian launch has already attracted a million subscribers, or 8% of broadband users, and streaming services will be launched in 43 countries across Latin America and the Caribbean in 2011. JPMorgan projects 40 million broadband users in Latin America, presenting upside potential to analysts' subscriber growth targets.

While new competitive threats, such as HBO Go and Xfinity by Comcast ( CMCSA), are worth following, Netflix is still an attractive stock, though its valuation is meteoric. Along with Apple, it is a difficult-to-derail growth story.

-- Written by Jake Lynch in Boston.

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