Marcial: Why Pros Are Watching Netflix

While the stock market was crumbling last year, shares of Netflix (NFLX), the largest U.S. online movie-rental subscription service company, were on fire. The stock blasted from a 52-week low of 17.90 a share on Oct. 27 to a high of 50.24 by Apr. 13, 2009. Since then, however, Netflix has flickered, falling to just under 42 by June 19.

Was Netflix just a shooting star destined to plummet?

Not to worry, say some bulls, who see the decline as another opportunity for investors to ride the stock once more to higher levels. "Netflix should advance from currently depressed levels as the fundamentals of its business are intact, with several options for further growth ahead," says analyst Christa Quarles of investment firm Thomas Weisel Partners (TWPG), who rates the stock outperform.

One explanation for the stock's recent decline: Netflix is one of those counter-cyclical stocks that investors adore during an economic downturn, but when signs of a recovery show up, they bail out to go after economic recovery plays. Indeed, Netflix performed admirably as a counter-cyclical stock, notes Quarles.

Blockbuster, Redbox threats?There are other concerns. One is competition that may cut into Netflix's leading market share. There is worry not only about rival Blockbuster (BBI) but also over a company called Redbox, a large provider of DVD rentals through its 15,000 kiosks around the country, that offers a $1 fee overnight per DVD. Blockbuster operates about 10,000 full-service stores. Redbox is a unit of Coinstar (CSTR), which operates a network of self-service coin-counting machines in the U.S. The machines, located at supermarket chains where Redbox movie-rental kiosks are also installed, offer consumers a means of converting accumulated change into bills.

But Quarles and other analysts aren't too worried about Redbox. "Concerns about competition from Redbox are overblown," says Eric Wold, director of research at investment firm Merriman Curhan Ford (MERR), who rates Netflix a buy. Although there might be some pressure on its subscriber base if consumers do opt for a lower price-plan that Redbox offers, "we don't see a complete abandonment of Netflix's subscriptions", mainly because of the kiosks' inability to satisfy demand for movie titles adequately, says Wold.

Compared with Redbox's movie library, Netflix's collection is vast, including more than 100,000 films on DVD and an array of over 12,000 Blu-ray titles. At the end of 2009's first quarter, Netflix had 10.3 million subscribers. Analysts forecast its subscribers will increase by 20% a year in 2009 and 2010.

True, Redbox's number of kiosks is growing rapidly. The company's revenues jumped 179% in 2008, and it expects to expand growth by 80% this year, notes analyst Douglas Anmuth of Barclays Capital (BCS), who is nonetheless bullish on Netflix, which he rates overweight, with a 12-month price target of 50. (Barclays owns shares and has done banking for Netflix.) The analyst believes Redbox competes more directly with Blockbuster and local video stores than with Netflix.

Moreover, "the degree of long-term threat to Netflix from kiosks is limited in a digital world," asserts Anmuth. He says Netflix is well-positioned to be a "leader in the digital content space through its subscription model across both physical DVDs and streaming."

The Xbox factorNetflix has teamed up with consumer electronic companies to provide a range of devices that can instantly stream films, including television shows, to Netflix members' TVs and other devices. In the case of actual DVDs, Netflix offers one-day delivery to most subscribers from about 60 distribution centers in the country.

"We expect additional consumer electronics manufacturers to embed the Netflix streaming software," says Martin Pyykkonen , an analyst at Wunderlich Securities, who rates the stock a buy. So far, the streaming software is embedded in LG and Samsung flat-panel TVs, Roku and TiVo players, Apple Macs and Apple TV, and the Microsoft Xbox 360 video game console.

Redbox could become a "meaningful competitor," concedes Quarles of Thomas Weisel, but Netflix has strong options and is well-prepared to fight back, including expanding its arrangement with Microsoft (MSFT), which has added Netflix to its list of content providers in the Windows Media Center. Since November, Netflix has been on Microsoft's Xbox, which generated a huge number of subscribers to Netflix.

"We believe Xbox's contribution to Netflix's fourth-quarter results is substantial," says Quarles; Microsoft and Netflix are very happy with the arrangement, she adds. "Our checks indicate the service has been an important factor in driving up Xbox gold subscriptions." So she expects that when Microsoft and Netflix renegotiate an extension of the agreement, which lapses in the second half of 2009, they are apt to agree on a more expanded business arrangement.

Microsoft's inclusion of Netflix in its media center and Xbox allows consumers to more easily sign up for the service, stream movies to their personal computers, and catalog the list of movies in their Netflix queue.

Quarles' 12-month price target for Netflix's stock of 51 is based on her 2009 earnings forecast of $1.70 a share on revenues of $1.6 billion, and $2.05 a share in 2010 on revenues of $1.9 billion. up from 2008's $1.32 a share on $1.3 billion.

Without doubt, Americans' undiminished romance with Hollywood and movies is driving Netflix's robust earnings and sales growth. And investors are counting on Netflix to benefit significantly from the continuing trend away from brick-and-mortar video rental stores to online subscription services.

Ultimately, investors who subscribe to the notion that Netflix is not only here to stay but also will expand broadly along with the widening digital world may wish to put the shares in their queue.

Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.

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