Should You Join Icahn In Buying Netflix, Inc. (NFLX)?

ICAHN CAPITAL LPIt’s been a wild ride at Netflix, Inc. (NASDAQ:NFLX) the past several years. The stock was trading at about $26 per share five years ago, bubbled up to a peak of about $300 in the summer of 2011, plummeted into the 60s in the third quarter, roughly doubled from there to $125 per share earlier this year, fell close to $50 in September, and had gone back to $70 in the last month. Now the stock is up 14% on the news that billionaire activist investor Carl Icahn owns a combination of shares and call options that could give him a total of 10% of the shares outstanding. According to our database of 13F filings, the entire position was initiated between the beginning of July and the end of October. Research Carl Icahn’s recent holdings.

In our recent analysis of Netflix, Inc., we had noted that earnings had dropped 88% in the third quarter of 2012 as the company’s strategy of aggressive international expansion has yet to result in an improved bottom line. The company reported 29 million subscribers, including increased penetration in international markets, and revenue was up 10%. Read our previous take on Netflix.

Netflix, Inc. trades at a whopping 186 times forward earnings estimates, based on analyst consensus of 44 cents in EPS for 2013. This reflects a rapid recovery in earnings next year as the company is expected to go into the red in both this quarter- resulting in only 4 cents per share of earnings for 2012- and in the first quarter of next year. And there are problems lurking in Netflix’s financials: domestic revenue was up only 4% last quarter versus a year earlier, and with the international losses the company is now getting 100% of its operating profits from the domestic DVD business (with domestic streaming being entirely offset by international operations). Domestic DVDs appear to be a cash cow: great profits, probably not much of a growth opportunity. And while international revenue more than tripled, so did operating losses in that segment. John Griffin’s Blue Ridge Capital had owned 2.5 million shares of Netflix at the end of June, making the Tiger Cub’s fund the largest hedge fund holder of the stock according to our database of 13F filings (see more stocks that Blue Ridge owned).

Netflix’s closest peers, each representing one side of its business, are Coinstar, Inc. (NASDAQ:CSTR), owner of the Redbox DVD rental kiosk brand, and Amazon.com, Inc. (NASDAQ:AMZN), which operates an instant streaming service. There is an incredible spread in P/E multiples among these peers: while Amazon’s forward P/E of 128 rivals Netflix’s, Coinstar trades at only 9 times forward earnings estimates. Amazon actually reported a loss in its most recent quarter despite a 27% revenue growth rate, and given its forward multiple we wouldn’t consider either it or Netflix a value stock. Coinstar’s earnings were about flat in the third quarter versus the same period in 2011, also despite a double-digit revenue growth rate; even with very high short interest (30% of the shares outstanding held short as of the most recent data) we think that company is a better buy.

We can also compare Netflix to other companies offering streaming services, including DISH Network Corp. (NASDAQ:DISH) and potentially Time Warner Cable Inc (NYSE:TWC). These peers are also cheaply priced, at 14 times forward earnings estimates, though any upside from streaming would only be a small part of their larger business and so their growth rates would not be as impressive as Netflix’s. In their most recent quarters, DISH’s net income was down 33% from what it had earned a year earlier off of flat revenue while Time Warner Cable experienced moderate growth in both top and bottom lines. These stocks also look like better buys than Netflix and Amazon.

We don’t think that Icahn’s purchase makes sense based on the current status of Netflix. We will have to see if he has a plan for improving its operations, or if he will urge the company to spin out or sell one of its business units, or if he suggests (to give an example) abandoning the international business. For now, we’d advise against buying the stock, and if Icahn doesn’t deliver promising news soon a short position could be worth considering.

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