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Thursday, January 28, 2010

Shares of Netflix "Go Crazy" on Strong Results, Upgrades, Short Squeeze

Shares of Netflix (NFLX, $63) are up 23% today following a strong earnings report yesterday (access here) that brought some brokerage firms to upgrade the stock and still lingering "shorts" to cover. Although short interest is down over the past six months, the level remains extremely high at 32% of float (per Yahoo! Finance). In our view, the short call (possibly on valuation) is especially dangerous since fundamentals remain strong (even prior to yesterday's results).
We mentioned in May 2009 (link here, including mention of NFLX) that we generally like subscription business models (e.g. j2 Global Communications/JCOM). The below summary from Netflix's highlights presentation reveals the power of the company's business model:


But, last October, we wrote "Netflix Buying Back Shares with No Room for Error; Probably Better to Hoard Cash" (link here) when the company was repurchasing shares in the mid-$40s (19x newly issued midpoint 2010 GAAP EPS guidance of $2.39, or a 5% earnings yield). In 4Q09, the company repurchased 1.6 million shares at an average price of $49.09 (per conference call commentary).

We're not going to recount results here, but all key metrics all moved in the right direction: aside from 24% Y/Y revenue growth for 4Q09, margins were higher and net subscriber additions were up nicely Y/Y while churn and customer acquisition costs were both down Q/Q and Y/Y.

We still prefer that companies allow excess cash to pile up on the balance sheet rather than repurchase shares at elevated P/E multiples. However, in light of Netflix's operating leverage and continued growth, the prior buyback appears more sensible than we acknowledged. That said, if the company continues to repurchase at current levels, the forward P/E (GAAP) would be in the mid-20s, which is less compelling. On a trailing free cash flow basis (non-GAAP, as reported by Netflix, after acquisitions of content library and other items), shares of Netflix are currently trading with an implied yield of only 3%.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long JCOM.
© 2010 Jeffrey Walkenhorst
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