Netflix, Inc. (NFLX) Caving To Comcast Will Lead To Margin Pressure

Netflix, Inc. (NFLX) Caving To Comcast Will Lead To Margin Pressure
NFLX Photo by Matt Perreault

Cantor Fiterzgerald analysts Youssef Squali, Naved Khan and Kip Paulson rate Netflix, Inc. (NASDAQ:NFLX) as a Hold as Netflix and Comcast announced a multi-year interconnection agreement.

The Netflix-Comcast paid-peering deal, while likely creating headwinds to margin leverage near-term, removes a major structural concern. No terms were disclosed, but we believe that this agreement is likely to precipitate others in the U.S. and internationally. The stock’s valuation and lack of visibility into the contribution margin impact of this deal (and potentially others) are keeping us on the sidelines.

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Netflix, Inc. (NASDAQ:NFLX) and Comcast Corporation (NASDAQ:CMCSA) announced a multi-year interconnection agreement on Sunday, which is expected to provide a higher quality Netflix streaming experience to Comcast subscribers. We believe this is a paid-peering deal, not an open connect one, where Netflix will get direct access to Comcast’s broadband network (instead of using middlemen like Cogent), in exchange for payment.

Deal with the largest MVPD to set a precedent

A combined Comcast Corporation (NASDAQ:CMCSA)-Time Warner Cable Inc (NYSE:TWC) (deal announced on 2/13/14), if approved, would aggregate 32M households in the U.S. (~30% of payTV HH), and therefore would create the template for other MVPDs to follow. We note that AT&T Inc. (NYSE:T), Verizon Communications Inc. (NYSE:VZ) and TWC have all refused to connect to Netflix’s servers without proper compensation. In time, we believe that this type of deal could be replicated with other ISPs outside the U.S. as well.

Is Netflix operating from a position of weakness?

While management stated on the 4Q call that ISPs would most likely avoid a consumer-unfriendly path to discrimination, and avoid further galvanization for government action, it appears that Comcast was persuasive enough to get Netflix to pay to improve its streaming quality. The average speed of streams on the Comcast network had declined 27% from Oct. to Jan., according to the WSJ and to Netflix, Inc. (NASDAQ:NFLX)’s own ISP speed index ratings data (2.07 Mbps in Oct. ’13 vs. 1.51 Mbps in Jan. ’14). For comparison purposes, in Jan. ’14, Google Fiber clocked in at 3.78Mbps, followed by Cablevision at 2.92Mpbs.

Expect incremental pressure on margins

Netflix, Inc. (NASDAQ:NFLX) reported domestic streaming contribution margins of 23.4% in 4Q:13, a 420bps increase Y/Y, consistent with management’s guidance of +400bps/year. While we expect margins will continue to improve (we’re modeling 25% for 2014), we believe that this agreement, and others that could follow, are likely to act as headwinds to Netflix’s margin leverage story.

Netflix valuation and risks

Netflix, Inc. (NASDAQ:NFLX) is trading at 4.7x revenue and 50.3x EBITDA on FY:14 estimates. Our $405 PT is based on a 7-year DCF using a 12% WACC, 3% terminal growth rate, and assuming ~75M domestic/55M int’l streaming subs by 2021. Risks include competition and execution mishaps.

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