Netflix (Nasdaq: NFLX)Why I like it:1. This is a revolutionary innovator, it has changed the way we rent movies.2. Larger companies with a ton of capital resources have tried to enter this market and have failed. 3. Decentralized distribution, most of the time these centers are near post offices.4. Preparing to deliver completely online. IE watch it now feature, while entering into strategic agreements (LG, Xbox 360), to bring movies more efficiently to TV.5. I believe that the emergence and subsequent IPO of Red Box will speed up the demise of Blockbuster. When that happens there will be $5 – 5.5B dollars available for the taking. I am confident NFLX can capture the majority of those dollars.6. The proprietary recommendation service, (based on algorithms and approx 2B movie ratings), is phenomenal data. I think at some point, NFLX will figure out a way to leverage this information into other revenue streams. Business:Netflix is the largest online movie rental subscription service in the U.S., providing 8.4M subscribers access to 90K DVD’s. It also allows access to 6k movies through watch it now. Netflix has partnerships with major studios to distribute their film content 3-6 months after release. FYI, VOD is about a month behind this schedule. The Netflix growth strategy is predicated on 3 dynamics.1. Continue to provide value, by providing service features that enable social networking.2. Continue to use technology to enhance the subscriber experience and operate efficiently.3. Continue to build mutually beneficial relationships with studios.Key metrics include: Churn, this is customer cancellation divided by the sum of beginning subscribers and gross subscriber additions. As of Q2 08, Churn stood at 4.2%. Subscriber Acquisition Costs, are total marketing expenses divided by total gross subscriber additions. Currently SAC, is the lowest it’s ever been at $28.95 per subscriber or 4.2%. Risks:1. Currently, the business model is at the mercy of the post office and the studios. In particular, the post office has proven to be most inconsiderate as it raises its rates constantly. When the company is able to completely cut out this middle man, profitability will definitely increase. 2. Competition, - there’s lots of it and that leads to market saturation. Fortunately, consumers use a combination of services to satisfy their needs. Still the tree can only grow so high.3. The resistance from Apple to partner up. Apple is a dominant force who always tries to do its own thing IE Apple TV. Thus far, ITV this has been a failed exercise. But there are a ton of Mac users out there that are not able to enjoy Netflix. Management:Using MDP principles I assess mgmt as the following-Ownership – Insiders own 5.2% of the company. In particular Ceo Reed Hastings owns $76M of the stock. Allocation – To demonstrate the quality of the business ROE is currently 17.2% while ROI is around 13%. For comparison Blockbuster is returning 1.7% on equity and 6.5% on capital.Tenure – No problem here, Mr Hastings has been on the board since inception and has been the CEO for 10 years.Stewardship – Over the last 3 yrs the company has diluted themselves at .26% annually. Stock based compensation came in at $12M, the lowest it’s been over that time. This $12M represents 1% of sales but 18% of net income. Valuation:Netflix is currently trading at P/S multiple and P/E multiples near its 5 yr averages but below its 10 yr averages. Using a DCF with a 15% growth rate then 7.5% with a 3% terminal, I value Netflix at around $37 per share. Considering today’s prices this is a 15% safety net. Longer term, I am so confident in this business that I am not too concerned about getting it at an absolutely great price. I’m comfortable here and adding shares at different valuation points.
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