A YTD chart of the FANG stocks shows one name sticking out like a sore thumb: Netflix, which at $99, is well below where it was trading at the start of the year, and substantially underperforming its FAG peers. Unfortunately for shareholders of the video streaming company, there is more pain in stock today because overnight Macquarie released a report titled “Crouching Tiger, Hidden Challenges“, in which it downgraded the stock to an Underperform with a $85 price target.
Here is the justification:
We are downgrading NFLX shares from Neutral to Underperform. We believe Netflix will succeed over time in its global expansion but the near-term may not be easy, with high content costs, increasing competition from Amazon in the US, and competitive markets in many countries that Netflix has launched into this year. Our views are shaped by contributions from Macquarie global TMT analysts that contributed to our accompanying report out today, “Global SVOD – Netflix, Amazon & the rise of the locals”.
International expansion isn’t easy. Many countries Netflix is expanding into have been growing pay TV markets with incumbent operators that have invested in VOD/SVOD offerings, often as add-ons to existing subscriptions. In addition, numerous SVOD services have gotten off the ground, often at cheaper prices and offering more local content. Many of Macquarie’s global TMT analysts are sceptical of Netflix’s initial launch efforts, citing price and lack of compelling content as risks. We have factored these views into our international subscriber model, where we estimate below-consensus 73m subs by 2019. We believe success will require partnering with local content providers and/or investing in more local content, or in content that will travel. This will be expensive – indeed, Netflix’s total content obligations have ballooned to $16-18bn including “unknown” off-balance sheet commitments, and could well rise further. We have developed a model that we’ve accurately employed before to forecast Netflix’s 3-year P&L content costs, which we work into our assumptions, leading us to cut EPS estimates in 2017, 2018 and 2019.
US growth could also be tougher in the near term, with more competition from Amazon, which is doubling its content spending this year, and a plethora of OTT options coming to market, from HBO Now to skinny bundles to virtual MVPDs like Hulu Plus. These will all compete for producers’ content and consumers’ time.
Longer term however we think SVOD is rising inexorably and there’s little doubt Netflix will do well, with deep pockets, top-notch data to inform on viewership, and a pricing lever, having now raised ASP and delivered good revenue improvement – up 28% in Q2.
Earnings and target price revision
We are reducing 2017E EPS from $0.85 to $0.74.
12-month price target: US$85.00 based on a DCF methodology.
Catalyst: Programming or subscriber updates, Q3 results in Oct.
Action and recommendation
Downgrade to Underperform. We expect investors will remain focused on raw sub numbers, which could disappoint near-term from both international sub adds and price elasticity on demand in the US. These effects could increasingly stand out in light of the high content costs.