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Is the Worst Over for Netflix?


The stock gets an analyst upgrade, but long-term prospects remain gray.

MINYANVILLE ORIGINAL After hitting a two-year low at the start of the month, shares of Netflix (NFLX) have since inched their way back over the $60 mark.

Boosting the DVD rental and Internet streaming company was an upgrade from Below Average to Average by Caris & Co analyst David Miller, who noted that Netflix will get a boost from the likely renegotiation of a deal with pay-TV channel Epix.

Netflix had signed a five-year contract with Epix back in August 2010, in which the former would obtain the exclusive online streaming rights – 90 days after the pay TV window – to movies produced by Paramount (VIA), Lions Gate (LGF) and MGM, the three co-owners of Epix for at least two years. For the remaining three years of the contract, a provision in the deal allows Epix to license the rights to other competitors.

Two years have since elapsed, and Epix is now able to license streaming rights to its content to other companies should it choose to. Miller believes that if Epix does so, Netflix will be able to negotiate a substantially lower fee for the final three years of the contract, which would reduce the company's content costs for 2013.

Searching Second Quarter Results for Clues

There has not been an official announcement of a renegotiation of terms between Netflix and Epix, but Netflix's second quarter results report released in July noted that the company would hold non-exclusive rights to Epix movies up till mid-August 2013.

After its poor second quarter results came out, Netflix stock was hammered, falling 27.1% in a single day. The consensus earnings per share for 2013 also plunged from $2.20 to $0.95 a share, with the range spanning a high of $3.56 to a low of -$0.05.

"We believe that consensus figure is simply too draconian, and is the result of estimate revisions based on emotion rather than analysis," Miller writes. He forecasts fiscal 2013 earnings of $1.88 per share, and has a price target of $59 for the company.

Preempting Miller's note was Capital Research Global Investors, who displayed its own confidence in Netflix after disclosing on Friday that it had bought a 10.5% stake of the company during the second quarter.

But, as the Wall Street Journal calculates, Capital Research must have paid around $463.7 million for the shares based on the average second quarter price of $79.43. Since Netflix's share price is now around $65, Capital Research's 5.84 million shares are now worth some $379 million.

Not Everyone Is Optimistic

Not everyone is as optimistic about Netflix as Miller and Capital Research are, however. Both Forbes and Seeking Alpha note, for example, that the company is bleeding money as it continues to focus on its costly streaming business over its much more profitable DVD rental business.

How profitable is the DVD rental business for Netflix? In the second quarter, DVD rentals accounted for $291 million of Netflix's revenue, but its profit margin was a stunning 46%, or $14 million. In contrast, Netflix's streaming operations worldwide brought in $598 million, but contributed a net loss of $6 million ultimately.

The problem for Netflix's streaming services is twofold. Firstly, the company's plan of expanding globally has been costly. Currently, Netflix is available in United Kingdom, Ireland, Canada, and Latin America, and it has ambitions of entering four Nordic countries later this year. Its overseas streaming business contributed a significant $89 million loss in the second quarter.

"We expect Netflix's 'growth at all costs' business model to negatively impact its shares," wrote Wedbush analyst Michael Pachter in a January research note, Forbes points out.

Secondly, just as cable operators such as Comcast (CMCSA) and Time Warner Cable (TWC) are subject to the pricing whims of content providers, Netflix has no choice but to cough up large sums of cash to license content from the likes of News Corp. (NWS), CBS Corporation (CBS) and Dreamworks Animation (DWA).

By paying big, Netflix might be able to weaken competitors such as Amazon (AMZN), and later, Redbox Instant by Coinstar (CSTR) & Verizon (VZ), but ultimately it's the studios that win, as the average bidding price for their content goes up. Judging by its losses thus far, international streaming revenue is not going to make up for high prices Netflix has to pay for licensing rights.

The loser of Netflix's strategy, as Seeking Alpha points out, is the Netflix investor, because "whatever happens here, with Netflix spending profligately on content deals, the end result will be thin margins and/or further dilution."

There is one solution to the problem of rising content costs: raising prices, of course. But that brings along its own set of issues. Don Reisinger at Fortune notes:
The last time Netflix raised its prices, the company was met with a deafening outcry. And that only affected those who had both its streaming and DVD plans. If Netflix follows up with a hike on its 24 million domestic streaming users and nearly 4 million international users, who knows what could result?

Despite the strength of its DVD rental business and worries over rising content licensing costs, Netflix seems to be all in on Internet streaming. Investors will have to weigh whether or not they think Netflix's global expansion will become a success and whether the company will become the dominant player in the video-on-demand business.

Twitter: @sterlingwong
No positions in stocks mentioned.
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