Netflix Valuation red Flag

Wall Street analysts raise concerns about risks of rising content costs, competition and slowing sub growth

Netflix’s volatile stock soared to new highs Monday after the Internet streaming company beat Wall Street expectations on sub growth — but investors retreated a day later, sending shares down 9%.

The decline came after several analysts sounded the alarm that Netflix is overvalued given risks of rising content costs, competition and other factors.

Netflix shares closed at an all-time high of $354.99 per share on Monday, and climbed another 10% after the closing bell following the company’s third quarter earnings announcement. But on Tuesday, the stock fell 9.2% to close at $322.52 per share.

With the after-hours rise Monday, Netflix shares were trading at 110 times the expected earnings per share for 2014 as forecast by Jefferies lead Internet sector analysts Brian Fitzgerald and Brian Pitz.

“We find it difficult to justify this valuation given the risks of rising content costs, heavy competition and the likelihood NFLX may need to raise additional capital to fund operations,” they wrote. The analysts reiterated their “underperform” rating but raised their price target on the stock from $160 to $215 per share on the better-than-expected earnings.

SEE ALSO: Netflix to Expand Into Original Movies, Will Double Spending on Originals in 2014

Even Netflix CEO Reed Hastings is concerned that investors have become irrationally exuberant. “In calendar year 2003 we were the highest-performing stock on Nasdaq,” he wrote with CFO David Wells in the Q3 letter to investors. “We had solid results compounded by momentum-investor-fueled euphoria. Some of the euphoria today feels like 2003.”

Hastings elaborated on the point on the company’s earnings call Monday.

“Every time I read a story about Netflix is the highest appreciating stock in the S&P 500 it worries me, because that was the exact headline that we used to see in 2003,” he said. “We have a sense of momentum investors driving the stock price more than we might normally. There is not a lot we can do about it but I wanted to honestly reflect upon that.”

Netflix said in 2014 it plans to double spending on original content. Meanwhile, the company is accelerating amortization of originals to reflect consumption habits early in the life of a series, which puts pressure on earnings, the Jefferies analysts noted. For the third quarter of 2013, the accounting change resulted in $27 million of extra amortization.

Netflix faces growing competition from Amazon, Hulu and others, which could drive up its cost of content.

“With more competitors bidding up content, the cost of key content continues to rise,” Fitzgerald and Pitz wrote. “Going forward we believe the cost of content will continue to rise as on-demand viewership is inherently focused on the best pieces of content across each genre.

Meanwhile, Netflix’s guidance on subscriber growth in the U.S. and international markets is overly optimistic, according to Bernstein Research analysts Carlos Kirjner and Peter Paskhaver.

“We are skeptical that Netflix will deliver 6 million domestic net (total or paid) adds in 2014, as we do not believe the addressable market will support such growth rate,” they wrote in a research note, saying they anticipate Netflix adding 5.4 million total net adds and 4.7 million paid net adds in 2014.

While Netflix added more international subs than expected in Q3, adding a net 1.44 million versus consesus expectations of 950,000, “we believe it is too early to justify a fundamental change on the view of the long-term potential,” the Bernstein analysts wrote.

Hastings said that Netflix expects Latin America to eventually become even larger than the U.S. business, but Kirjner and Paskhaver think the addressable market is limited by the availability and quality of fixed broadband access2 and high prices for connected-TV devices.

RBC Capital Markets analyst Mark Mahaney, who rates Netflix “outperform,” raised price target on the stock from $330 to $440 per share in a note Tuesday.

Netflix has plenty of upside, with long-term value potential that can increase “non-linearly” because of continued U.S. streaming sub growth, improving streaming margins, and better growth in subs and profits internationally. Other potential future catalysts for Netflix include potential price increases (though Hastings has ruled that out for the near future), as well as cable distribution deals and more successful original offerings.

“Netflix is becoming an Internet Video Utility,” Mahaney wrote.

But Mahaney also acknowledged among Netflix’s risks is that it faces a “broad and deep competitive set” and that its content obligations could be larger than forecasted.

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