Netflix Deserves Some Respect

By Ben McClure | July 20, 2009 AAA

Netflix (Nasdaq:NFLX), the mail-order and streaming video rental company, delivered solid second-quarter numbers on Thursday, matching Wall Street analysts' sales expectations and topping earnings forecasts.
Still, the market - skittish about the cloudy outlook for the economy in general and Netflix's streaming video business - knocked the stock down about 10%.

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Room to Rise
I'd say the stock is still an investment story that merits consideration. Netflix, unlike a lot of other media and entertainment stocks out there, is debt free, remains a prodigious free cash flow producer, and has an appealing valuation when you consider its rapid growth rate.

Now priced at about $42, the stock has room to go higher. Netflix trades on a forward price-to-earnings multiple of about 20, while its earnings are expected to see growth as high as 30% this year. I think that this is an attractive valuation. (For further reading, check out Making A Winning Long-Term Stock Pick)

Benefiting from Downturn
If anything, the tough economic environment will continue to benefit Netflix. Cost-conscious consumers, forgoing trips to the cinema and pricey cable TV packages, are taking advantage of Netflix's cheaper offerings. For less than the price of a pair of movie tickets, consumers can choose from thousands of movies delivered to them through rental or web-based streaming. Comcast (NYSE:CMCSA), for instance, has a promotional price of $39.99 per month for digital cable, while the average Netflix subscriber forks out less than $14.00 per month. Not surprisngly, Netflix ended the second quarter with more than 10.6 million subscribers, up 289,000 from the first quarter.

Still, Wall Street is awfully nervous about the prospects of Netflix streaming video service. After all, while Netflix offers unlimited videos to its streaming subscribers, it still must pay rights fees on that stream to the studios. Longer term, that could prove costly.

All the same, costs for Netflix just keep falling. Indeed, Netflix is spending less money to bring in each additional dollar of revenue. While its technology and marketing costs grew in the last quarter, the total cost of adding a new subscriber fell to $23.88 in the second quarter from $28.89 for the same period in 2008, and $25.79 for the first quarter of 2009. (For more, see Equity Valuation In Good Times And Bad)

Costs per subscriber fall as more customers stream content to their personal computers and set-top boxes rather than having DVDs shipped to their homes. As streaming gains momentum, it will translate into even lower costs and higher profits.

Here's some early proof: Free cash flow for the second quarter was $26.3 million compared to $12.7 million in the second quarter of 2008 and $15.1 million for the first quarter of 2009.

Competition
DVD kiosks from privately-owned Redbox pose a challenge to Netflix, although RedBox is limited to new releases, and is more likely to hurt Blockbuster (NYSE:BBI). More worrying is competition from online video services such as Amazon (NYSE:AMZN), Apple (Nasdaq:AAPL) and Hulu, a joint venture from General Electric Co. (NYSE:GE), Walt Disney & Co. (NYSE:DIS) and New Corp. (NYSE:NWS).

Bottom Line
But looking at Netflix's performance so far, it's hard to find the competition having much of an impact right now. If anything, competition in the space could prove to be a positive for Netflix's valuation as big media groups see acquisitions as a faster, more reliable approach to expand their video market presence.

Despite the market's pessimism, Netflix could be a stock worth owning through 2009.

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