We reiterate our long-term Neutral rating on Netflix Inc. (NFLX) with a target price of $121.00. Netflix reported better-than-expected fourth quarter results, boosted by a higher subscriber base. On a sequential basis, Netflix added 600,000 subscribers in the fourth quarter of 2011, largely offsetting the loss of 800,000 subscribers in the third quarter.
Netflix ended 2011 with 26.3 million subscribers (Domestic and International), which was 31.5% higher than the number of subscribers at the end of 2010. In the upcoming quarters, we expect continued growth in the subscriber base, especially in the international markets.
Moreover, to retain domestic as well as international viewers and add new subscribers, Netflix has been entering into licensing agreements with several big Hollywood production houses to bolster its content library. Moreover, to make its streaming services distinguishable from the other service providers, the company has bought the exclusive rights to stream some original series such as “House of Cards” and “Arrested Development“.
More recently, the company has picked the exclusive distribution rights to third party productions, such as E Street Band guitarist Steven Van Zandt starred “Lilyhammer.” Netflix is also in talks to secure the rights to the horror drama “Hemlock Grove,” a series produced by Gaumont International Television and another original series called “Orange Is the New Black” from Jenji Leslie Kohan, creator of the Showtime comedy “Weeds.”
Additionally, Netflix’s international expansion is a solid strategy, as the company would be able to enjoy a first-mover advantage in many nascent markets. It would also be able to offset market share losses and price competition in the domestic market with revenues from abroad.
However, the international expansion that the company has undertaken is escalating costs in the form of technology investments (58.6% increase year over year) and marketing expenses (37.0% increase year over year). Moreover, general and administrative expenses increased 82.8% when compared with the year-ago period. The majority of these costs were incurred to support the international expansion.
Another major near-term challenge for the company is cost escalation in the form of license and renewal fees. Netflix said in a regulatory filing that it has impending payments of more than $3.5 billion over the next few years for the content under contract.
Despite the higher costs, we believe that Netflix will probably see sales strengthening, as subscribers take note of the improving portfolio. This would ultimately enable the company to build a position for itself over the long term.
However, we believe that increasing costs related to licensing and renewal fees and higher capital expenditure due to international expansion can hurt earnings in the near term. Moreover, increasing competition from Amazon.com Inc. (AMZN) and Verizon Communications Inc. (VZ) will remain an overhang on the stock going forward.
Currently, Netflix has a Zacks #3 Rank, which implies a Hold rating in the short term.
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