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At Netflix, the picture is darkening Add to ...

Netflix , with a series of deals to stream movies and television shows over the Internet, seems poised to make a technological transition that its floundering competitor Blockbuster Inc. failed to do.

Yet investor belief that Netflix will be one of the last content providers standing has created a stock that is, at a minimum, well valued, perhaps even overvalued. There are a number of potential short-term hiccups coming for both its top and bottom lines, and some serious long-term competition coming from names you know.

Netflix's current frothy value suggests investors are looking past those negatives. At the all-time high of $174.40 (U.S.) it set last week, it's up 2,225 per cent from its May, 2002, initial public offering. At Tuesday's trades in the $150 to $160 range, it has a market capitalization of $8-billion. The stock is trading at more than four times its last 12 months' revenue of $1.9-billion and roughly 60 times its $136.8-million in earnings, according to Standard & Poor's Capital IQ.

Netflix's market cap "is a pretty big number," Greg Maffei, chief executive officer of Liberty Media Corp., which owns the Starz movie cable channel, told CNBC last week. "I was having lunch with Charlie Ergen [CEO of satellite broadcast company DISH Network]recently, and he noted it was worth more than DISH. He thought that was a little odd." (DISH posted revenue of $12-billion and profit of nearly $750-million in the past 12 months.)

Netflix became an investor favourite by doing to Blockbuster and other video chains what Amazon.com has done to bookstores: It exploited the inefficiencies of the competitors' expensive brick-and-mortar retail network with a business model built on warehouses, the Internet, and the U.S. Postal Service.

Yet there are still costs to that model of buying, storing and shipping all those little plastic discs. Not as much with streaming movies over the Internet: Barclays analysts Douglas Anmuth and Ronald Josey estimate a user could stream about 16 two-hour movies for the same delivery cost to Netflix as one DVD. (Five cents per stream versus 81 cents per DVD, to be specific.)

And that is where the growth is: Standard & Poor's credit analyst Jayne Ross believes the broadband home-video market is expected to increase by more than 50 per cent annually over the next several years, even as the overall movie rental business will be flat to slightly up.

The good news is that a move to streaming distribution will boost Netflix's margins. Mr. Anmuth and Mr. Josey of Barclays estimate the streaming-only plans would increase gross margins by five to eight percentage points above the roughly 82-per-cent margin on its $8.99-per-month by-mail plans.

The downside, however, is that Netflix will likely cannibalize its own subscriber base as it gains in streaming. The company also has $13.99, $16.99 and $23.99-a-month plans in the United States that allow users an increasingly larger number of DVDs; by offering unlimited streaming as part of the $8.99 price point, Netflix will likely decrease its average revenue per user.

That, combined with unusually high adoption rates this year, worries Wedbush analyst Michael Pachter, one of the most bearish Netflix analysts with an "underperform" rating and a 12-month target price of just $78. Mr. Pachter notes that Netflix has rolled out its service to the iPad and the three major video-game systems - the Nintendo Wii, Xbox 360 and PS3 - in the past 12 months. "Once the installed console base is saturated, we expect to see new subscriber additions only from new console purchasers, slowing the rate of growth."

These are the short-term knowns. Less clear is the cost of acquiring all that studio content for its services, something that could roll back some of the gains from streaming.

The biggest unknown, however, is competition: Amazon and Google, which have made steps into the streaming business, dwarf Netflix in size and brand recognition; Hulu, the television-streaming site planning a premium offering, already has a more sizable library than Netflix.

At the same time, however, Netflix has a head start with its existing customer base. "There will be more competition for Netflix in digital streaming than there has been in DVD by mail, but the barriers to entry for a streaming subscription service are significant," say analysts Michael Olson and Andrew Murphy of Piper Jaffray & Co.

"It would be difficult for any of these companies to offer a strong title library, with no existing sub base to offset content expenses."


So what does Netflix's entry into Canada mean for the stock?

It's a positive, but not a huge one, argue analysts George Askew of Stifel Nicolaus and Michael Pachter of Wedbush Securities.

Both expect Netflix to achieve the same level of household penetration in Canada that the company enjoys in the United States. Mr. Pachter thinks that will happen in "the very long run," while Mr. Askew estimates it will take about three years.

If Netflix can duplicate its U.S. success in Canada, it will add between one million and 1.5 million subscribers. Canadian revenue could add up to about $140-million (U.S.), Mr. Pachter figures.

That would be a nice boost for Netflix, but not a bonanza.

David Milstead


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