Did Netflix Investors Sell Too Soon?

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Netflix has seen its stock fall nearly 20 percent since its second-quarter earnings call, in which it failed to please investors due to just in-line revenue figures, higher subscriber acquisition costs and higher subscriber turnover. But were investors too rash in shedding their Netflix shares?

Probably, according to a research report issued by Morgan Stanley this morning that argues investor fears are overblown and that the long-term opportunity for Netflix might be bigger than had been anticipated.

In the report, Morgan Stanley analyst Scott Devitt argues that Netflix’s stock “overreacted” to the second-quarter results, overlooking strong earnings, as well as revenue and subscriber numbers that matched analyst expectations and its own forecast. As is often the case on Wall Street, meeting expectations wasn’t good enough; Netflix was really “expected” to surpass those forecasts.

Nevertheless, there were some other reasons for concern, including higher-than-expected subscriber acquisition cost (SAC), which jumped to $24.37, versus a record-low of $21.54 per subscriber in the first quarter. Netflix’s customer turnover, or churn, also increased in the quarter, jumping 5 percent from the first quarter to 4 percent. At the same time, average revenue per user continues to fall, as Netflix signs up more new subscribers on its cheapest plan, which offers one DVD out at a time and unlimited streaming for $9 a month.

The increase in SAC and churn were due in part to seasonality and Netflix managing its business for subscriber growth, as the second quarter typically tends to be weak in terms of subscriber additions. Viewed in that light, the addition of a million new subs in the quarter, down from 1.7 million in Q1 but up from 289,000 subscriber adds in the prior year’s second quarter, should be seen as a positive.

More importantly, Morgan Stanley believes that Netflix’s subscriber additions could accelerate in the near term, and that the long-term prospects for the company’s business are greater than once anticipated. The investment firm had previously downgraded Netflix on the belief that subscriber additions could slow after an initial bump from new subscribers on major consumer electronics platforms like the Nintendo Wii. But Netflix has seen better traction than expected on those platforms, and growth of its streaming business has caused Morgan Stanley to revise its thesis to believe that Netflix can exceed expectations on this front.

Furthermore, the investment firm sees Netflix’s addressable market increasing from the $10 billion home video rental market to compete in the much larger $35-$40 billion rental, sell-through and premium TV market. While a more competitive market, Netflix seems to be differentiated enough to compete against incumbents like major cable companies.

With the prospect of increased margin expansion, due to the lower cost of streaming versus its DVD-by-mail business, as well as Netflix’s ability to attract more and better content, Netflix’s future in streaming seems to be on the right track.

Related content on GigaOM Pro: Three Reasons Hulu Plus is No Threat to Netflix (subscription required)

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