Netflix (NFLX): Upgrade to Buy at Merriman

Merriman’s Eric Wold is upgrading his rating on Netflix (NASDAQ:NFLX) to Buy from Hold with a $155-175 valuation range.

The analyst notes they downgraded NFLX to Neutral on July 6, the shares have dropped 55% vs. a 15% decline in the S&P 500. At this point, they believe their near-term concerns are more than reflected in the valuation – which no longer gives Netflix credit for its industry positioning and long-term potential. Firm is upgrading NFLX to Buy in spite of the near-term headwinds as their downside 2012 EPS analysis still shows solid growth potential over 2011. They are making no changes to their estimates at this time and see upside to $155-175 using a P/E of 25-28x.

The details (in short):

Downside 2012 EPS scenario still shows growth. In our downside analysis for 2012, we come up with a potential range of $4.49-5.95. The midpoint of $5.22 still represents a solid 21% growth over our current 2011 EPS estimate of $4.33. Given the consensus range of $5.38-9.69, we believe it is apparent that there are numerous drivers that could push results either way. However, we believe our analysis shows a realistic downside scenario that should give investors comfort in Netflix’s still strong industry position – and that 2012 solely represents a potential pause before strong margin/EPS growth resumes in 2013.

Starz savings could offset earnings pressures. During 2012 we see three main earnings headwinds that could potentially push EPS below current expectations: 1) migration of DVD-only subscribers; 2) international launch operating losses; and 3) competition causing upward pressure on SAC. However, we believe the $250M in 2012 content savings from the Starz cancellation gives management some wiggle room should they not find
alternative content (or choose not to spend the surplus).

Two biggest drivers firmly in control. At this point, we believe it is increasingly clear that the two biggest earnings drivers in 2012 – marketing and content spend – are firmly in management’s control. This is key in that should spending on those two areas not generate positive results, we believe management could easily pull back the reins to maintain solid profitability by catering to existing subscribers instead of pushing to add new ones.

Division split more of a content decision. We understand some believe management’s decision to split the streaming and DVD divisions is to better position the streaming division for a sale to a larger competitor. However, even though this may help to improve the sum-of-the-parts valuation multiples afforded by investors, we believe the larger driver was to aid in content negotiations with a smaller number of streaming subscribers driving cost discussions (i.e., lowering the cost) vs. the entire pie (including DVD-only subscribers).

Near-term risks remain in spite of upgrade. Our decision to upgrade to Buy from Neutral today is not based on any improving outlook for the near-term and continue to see risk in subscriber trends through yearend. Furthermore, based on our EPS analysis, we believe there is a morethan- likely chance that 2012 consensus estimates (and possibly our belowconsensus estimate) may need to be reduced. Nevertheless, we believe NFLX shares already more than reflect these risks and should our downside analysis prove aggressive, we could see the shares rebound sharply in 2012 on an improved growth/margin outlook.

Notablecalls: Eric Wold nailed it on July 6th when he downgraded NFLX to a Hold from Buy saying the co would be entering a period of restrained operating margins.

He played the name so well on the way up and looks like he played it even better on the way down. Some of this performance can surely be attributed to blind luck (at least ONE of the analysts among many should get it right) but I do like his style. As was the case with the downgrade, Wold is not being pushy but rather pointing out things may not be as bad as the market suggests. According to Wold, 2012 may bring a sharp bounce-back.

Another thing that caught my eye this morning is that the analyst community is not overly excited about the DISH movie streaming package. It appears to cost more and have way less content that the NFLX offering. So n-t overhang lifted there.

(Now we can all go on and start worrying about what AMZN will unveil in 2 days).

Anyway, I wouldn’t be surprised to see the stock lift following the Merriman upgrade. Hopefully another brilliant call for Eric Wold.

Give Kudos when it’s due. I do!

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