Netflix downgraded at Jefferies

Jefferies & Co. downgraded rating of online DVD rental company Netflix, Inc. (NFLX) to 'hold' from 'buy' given the 270 percent run-up in the stock since January 2010, with a price target of $195.

Netflix is up about 270 percent since January and is up 25 percent since the company reported third quarter results in October. The stock is trading at 29 times of fiscal 2011 EBITDA of $364.6 million, putting it at the very high-end of our coverage universe. While we continue to like the story longer term, we find limited upside to our $195 fair value in the short term, and prefer to step to the sidelines, said Youssef Squali, an analyst at Jefferies.

The company announced that its chief financial officer Barry McCarthy is resigning to pursue broader executive opportunities outside the company, effective Dec. 10. And McCarthy is being replaced by David Wells, vice president of financial planning.

While in the last 12 months, the company has comfortably outperformed expectations, the stock's success has been in no small part, driven by Barry McCarthy's ability to astutely guide the Street, set appropriate margins and investment targets.

McCarthy's been the financial architect behind the company's success, and the number 1 cheerleader for its stock with analysts and investors alike, Jefferies said in a report to clients.

Squali said McCarthy leaves behind big shoes to fill, particularly at the current juncture, considering that virtually everybody is gunning for it, from tech platforms like Google Inc. (GOOG), Amazon (AMZN) and Apple Inc. (AAPL), to content owners like Time Warner (TWX). Having said that, chief executive officer Reed Hastings remains firmly in charge as the man behind the vision.

Greater insider selling sends negative signal to Street. In addition to several other executives who have sold stock in the last six months, Barry McCarthy sold the most. Just last week, he sold 100,000 shares, or about $20 million worth of stock and as of Dec. 7, still owns about 51,000 shares and 100,000+ options, which he will likely sell upon leaving, Jefferies said.

Our current estimates reflect a 33 percent growth in subscriber base in fiscal 2011 for a total of 25.45 million subscribers at year-end, up from 19.2 million in fiscal 2010. We also expect DVD usage to decline 23 percent year-over-year in fiscal 2011 following a 18 percent decline this year, which should allow higher investments into streaming content, said Squali.

On the cost side, Squali views the $180 million to $200 million annual payout to Epix as a baseline for future deals, and estimate that a renewal with Starz next year should result in a payout of about $100 million a year or more, up from $25 million a year currently.

Squali estimates that the roll-out of a $1 price increase to the existing base in January will yield about $75 million to $125 million in incremental revenue. Squali expects to see a positive impact of EPS, but it's important to note that management is likely to re-invest the bulk of the overage in digital content acquisition to drive growth.

Squali expects management to outline plans for a more aggressive expansion into international geographies next year, and increase spending for international content acquisition in second half of 2011.

While this should fuel subscriber growth (at least some of which is reflected in Squali's forecast of 45 million subscribers by end of fiscal 2016), it is likely to keep margins constrained over the near-term. Squali's current forecast is for operating margin to remain virtually flat at about 12.9 percent.

Squali said lack of direct competition and growing brand awareness should allow the company to keep marketing costs and SAC in check. So far Squali has seen little impact from launch of Hulu Plus, likely due to limited content.

The difficulty in accessing content continues to limit the risk of larger players such as Apple and Amazon entering the market with subscription-based digital video offerings (a scenario we would see as damaging to Netflix), said Squali.

The brokerage maintained its 2010 EPS estimate for Netflix of $2.82 on revenue of $2.16 billion, its 2011 estimate of $3.78 on revenue of $2.84 billion, and its 2012 estimate of $7.16 on revenue of $3.55 billion.

Netflix shares closed Tuesday's regular trading down 1.89 percent at $189.81 on the NASDAQ stock market, while in after-hours the stock fell 3.38 percent to $183.40.