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Market Update

We Disagree with Carl Icahn, Netflix Remains Overvalued

Icahn envisions a great opportunity for international expansion, but Morningstar's Michael Corty thinks Netflix will have less of a competitive advantage outside the U.S. market as well as difficulties with original content.

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On Wednesday afternoon, Carl Icahn disclosed a near 10% stake in  Netflix (NFLX), whose stock price shot up from $60 to $70 on Friday and then again Wednesday afternoon to a closing price of $78 per share. The heavy short interest (near 30% of shares outstanding) likely added a turbo boost to the stock's appreciation during the past two trading days. Our fundamental analysis of Netflix does not change on this news and our fair value estimate is unchanged.

We've reviewed Icahn's interview on Bloomberg TV from Wednesday afternoon and with all due respect to him, we disagree with his assessment of Netflix and its competitive position within the video content ecosystem. In our view, Icahn is betting on another company stepping in and buying Netflix, which we can't rule out, as plenty of companies have overpaid for acquisitions in media and technology over the years. We're not factoring in a buyout premium to our fair value estimate, as we don't think the presence of Icahn as a large shareholder necessarily means a buyout is imminent, especially when various rumors and news of his ownership stake already pushed the shares from $60 to $78 during the past two days of stock market activity.

Specifically, we'll address a few key points from Icahn's interview that we disagree with. Icahn talks about the lack of existing competition from Netflix's direct peers like (AMZN), and we agree that Netflix is well ahead. But we view the long-term competitive pressure as coming from the existing pay-television distributors like  Comcast (CMCSA) (CMCSK) and  DirectTV (DTV), which will be offering more of the current and better television content on a streaming basis in the future. We believe the content owners hold the cards in video distribution, as this handful of studios has created several windows for viewing high-quality content, and Netflix is only able to bid on dated, second-tier content. We question what the ultimate market for Netflix is, given that its product does not include the better mainstream content, even when considering the cost is only $9 per month. Perhaps the reason that domestic streaming subscriber growth has decelerated is that some of the better content (Sony and Disney movies) has not been renewed and Netflix has hit a wall in its ability to add interesting new programming. We agree that the way video content gets consumed is changing and will continue to evolve, but we believe most of the economic profits will flow to the content owners.

Icahn envisions a great opportunity for international expansion, but we think Netflix will have less of a competitive advantage outside the U.S. market. To summarize our view, in most countries outside the U.S., the best and most current content is licensed to the existing pay-television distributors. Also, unlike in the U.S. where pay-television penetration has hovered around 90% of households, pay television has a great deal of growth potential. We believe this means the content owners have an even greater interest in keeping their best programming in the pay-TV ecosystem, which leaves Netflix to bid on less desirable content and puts the company in a tough position given the lack of brand recognition in new markets.

We don't agree with Icahn's view that Netflix can differentiate itself through investing in its own original programming. We continuously hear the comparison of Netflix today with HBO in the 1980s in terms of building a content powerhouse, and we think this comparison is quite a stretch. The level of competition that exists today versus what HBO had to face 30 years ago is much greater. In addition, starting an internal television or movie studio from scratch is a lot harder than it seems on the surface. There are a handful of large studios with a long track record of success and a business model centered on monetizing original programming. There is a huge gap between what Netflix can invest and what each of the studios invests on an annual basis.

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Michael Corty does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.