Tickers in this Article: NFLX, AMZN, AAPL, GOOG
Subscription video service Netflix (Nasdaq:NFLX) posted good results relative to Wall Street expectations, but once again it's the company's view of the future that matters more than the trailing results. To that end, there's likely to be at least some negative fussing tied to a view of third quarter subscription growth that was a few percentage points below the average expectation. While I like the business that Netflix has, and I believe management has wisely carved out some points of distinction from the competition, it's tough to see how these shares are cheap.

Streaming More Growth In Q2
Netflix reported that revenue rose 20% for the second quarter, in line with the average of sell-side estimates. The company reported over 600,000 net subscription adds, with domestic streaming subs up almost 25% (to just under 30 million), domestic DVD subs down 19% (to 7.5M), and international streaming subs up about 114% (to 7.7M). Overall pricing growth is still restrained, as average revenue per member declined 2% from the year-ago period and rose 2% sequentially.

SEE: Netflix Thriving On Partnerships

Despite concerns tied to marketing costs and content development/acquisition, margins continue to improve. Gross margin rose almost two points from the year-ago period, while operating income rose over 250%. While the operating margin improved three and a half points from the year-ago level, at just over 5% it's still fairly low on an absolute basis.

The Battle Goes On
I'm not sure how many readers remember the roll out of cell phone service and cable TV in the 1980's and 1990's, but Netflix's experience is going to be quite a bit different. Netflix doesn't require the same enormous amounts of debt-funded capital spending, but there is no respite from competition. Hulu is already a formidable rival, and one that is supported by several of the content providers that Netflix has to deal with, but so too is Amazon (Nasdaq:AMZN).

SEE: Hulu Sale Called Off

Add in the venture between Outerwall's (Nasdaq: OUTR) Redbox and Verizon Wireless, and the potential of greater future competition from Apple's (Nasdaq:AAPL) iTune service and Google's (Nasdaq:GOOG) YouTube, and the field gets crowded. And don't forget the traditional cable companies as well – should any of these providers wake up and realize that some of their customers want more of an a la carte service, they would immediately become a significant rival as well.

What it all means for Netflix is that there's always a spear at management's back. The company doesn't have that much flexibility on pricing, there's always the threat of rival content deals (like the recent deal between Amazon and Viacom (NYSE: VIA)), and original content is likely to be increasingly important. With the cost of live programming now often exceeding $2 million an episode, though, that's not a risk-free opportunity.

The Bottom Line
I think Netflix has built a good business, and I think a lot of the bearish arguments that Netflix is easily replaceable run counter to the fact that Netflix apparently accounts for about one-third of all downstream internet traffic today. Should Netflix continue to develop original and proprietary programming that viewers want to watch, the wall around the franchise just gets that much higher. If nothing else, I would argue that channels like HBO and Showtime have demonstrated that desirable original programming does add some stickiness to subscribers.

The problem with Netflix stock is the valuation. I'm comfortable with a 10-year 10% revenue CAGR, as well as a free cash flow margin in the low teens. That only works out to a fair value of about $142, though. Bumping the long-term margin into the high teens lifts the target to about $175, but you need revenue growth in the high teens and a high teens free cash flow margin to get close to $250, and that seems too aggressive to me. With competitors like Hulu and Amazon out there, and potentially more activity from Apple, Google, and cable companies in the future, I just think it will be hard to carve out that much profitability.

Accordingly, I won't be betting against the success of the company, but neither will I be buying the stock.

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