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Buy, Sell or Hold: Why Investors Need to Tune in to Netflix

In the new age of media all roads lead to streaming content. Whether it's music, movies or TV Shows, how entertainment gets delivered is never going to be the same.

As this secular change takes place, traditional media companies are now scrambling to get their piece of action.

Where this "movie" really gets interesting for investors is the path they are going take to claim their share of the streaming pie – especially if you own Netflix, Inc. (NASDAQ: NFLX)

That because Netflix has laid the groundwork to be the leader in the new world of streaming media. And on Jan, 23, the plot thickened even more when the company reported its Q4/2012 earnings and blew away everyone's expectations.

Netflix posted earnings per share of 13 cents on revenues of $945 million. Both handily beat consensus estimates, which called for a loss off 13 cents per share and revenues of only $934 million.

But one of the most important items for investors to note from the earnings release was that Netflix added over 2 million new domestic subscribers (at $7.99 per month) in the fourth quarter. In all, NFLX ended the year with 25.47 million paid subscribers – well ahead of expectations.

As a result, the company's is up 66% in eight trading days. The rocketing share price has pushed its trailing 12-month P/E up to 578 and the forward P/E to 60.

Now ordinarily gaudy numbers like these would make me pass on a company like this as an investment – but "hold" on while I make a case for Netflix.

Netflix (Nasdaq: NFLX): The Sequel

Gone are the days when Netflix was primarily a provider of DVDs through the mail.

Granted the DVD business still adds 50% to the margin, but the business is slowly dying off as subscribers for this service dropped another 380,000 during the fourth quarter.
The thing is Netflix is not particularly worried about the slowing of the DVD business since it is now transitioning itself into the streaming media market through heavy expenditures designed to build content.

Netflix has made strategic moves with major media partners in order to have exclusive content as part of its service. For instance, Netflix entered into a licensing agreement with Walt Disney with exclusive rights to new movies beginning in 2016.

But partnering with content providers is not as sexy as creating your own exclusive content.

Much like HBO has done with tremendous success, Netflix is creating its own programming. On Feb. 1, Netflix will premiere the series "House of Cards" starring Kevin Spacey as it debuts its first of five original programs.

However, programming isn't cheap. The Disney deal alone is estimated to cost $300 million per year, and two seasons of House of Cards will cost approximately $100 million.

In fact, many will argue that Netflix's quarterly numbers aren't all they are cracked up to be and point to two consecutive quarters of negative free cash flow – $51 million in the current quarter – as proof.

This is a valid concern that shouldn't be overlooked but the primary contributor to this unattractive trend has been the startup costs of creating new original programming. Investors have been warned that this trend will continue into Q1 of 2013 before reversing.

The game plan seems to be to finance these billion-dollar licensing agreements and provide Netflix original programming through expansion of subscribers.

In fact, CEO Reed Hastings even said as much during the earnings conference call: "The virtuous cycle for us is to gain more subscribers, get more content, gain more subscribers, get more content."

So the question now is – how many more subscribers can Netflix hope to add in the months and years ahead?

The Netflix Audience

Domestically, Netflix has 27.15 million subscribers, which accounts for nearly 9% of the total population. This is an increase of 25%, or 5.5 million subscribers, from the previous year.

How many more customers can the company hope to add before it reaches saturation levels? Estimates vary. However, it is believed that even though the rate of increase will slow down, there is still plenty of room for Netflix to grow.

Much has been said and written about who will come out on top of this race into streaming video content. But there are people who subscribe to Netflix and a secondary service such as Amazon's Prime. I thought this was odd at first, then figured why not?

In the past, people often chose to subscribe to both HBO and Showtime. Why wouldn't they subscribe to numerous streaming content providers?

The issue then becomes not so much of what old movies or TV shows are available but rather what differentiates one from another in programming. It is no wonder that Mr. Hastings views HBO as his prime competitor rather than Amazon. (To get my take on Amazon click here.)

So the race for content is on while the landscape transitions from cable television and DVD rentals to streaming content.

Smarter cable networks, like HBO, will move away from cable and shift toward streaming. Smarter DVD providers, like Coinstar/Redbox, are looking to transition to streaming with new content deals. There is room for all as this shift happens in the months and years ahead.

Netflix does have the advantage of being the first mover, and having the content and subscribers to really make a success out of it – a success that will be passed on to shareholders.

The Current Netflix Ticket Price

Even though I like the idea of what Netflix has lined up and its future looks bright, I do realize there are enough variables in its future to keep me pondering.

Will its new self-developed shows be hits? Will it be able to afford new licensing agreements? What are the saturation levels for the streaming media business?

Much of the story I have laid out is a guessing game into the future outcome of an entire industry – an industry as fickle as the media industry.

After the huge surge in Netflix's share price over the past two weeks, the stock is currently priced to perfection and there is no justifiable way I can recommend a "buy" on Netflix no matter how much I like the story.

Perhaps with a significant pullback, it may be a "buy" but, for now, if you are a current shareholder and are willing to accept further volatility, Netflix is a "hold".

About the Author: David Mamos brings nearly 15 years of analytical experience to the table with a background ranging from big-picture fundamental analysis to highly technical trading decisions. He began his career working as a financial advisor with Royal Alliance in 2001 and helped clients with portfolio management as well as buy-sell decisions before transitioning to the development, implementation and execution of trading strategies for aggressive investors.

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