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Is Netflix Headed For Another Pullback?

 March 01, 2012 03:00 PM

Walking through the halls of Netflix's (Nasdaq: NFLX) headquarters in Los Gatos, Calif., during the holidays must have been a gloomy affair.

Legions of employees that receive some of their compensation in company stock saw their holdings plunge in value as the video service company saw its shares fall below $70 by year end, just a fraction of levels seen earlier in 2011.


Well, Santa Claus finally showed up for these folks: Since this year began, shares have risen nearly 60%. That's a stunning two-month move.

This is a bad time to spoil the fun, but recent events have helped create a fresh set of troubles for Netflix.

The economics of Netflix's business model are weakening, competition is surging, and investors may soon start to focus on a 2013 price-to-earnings (P/E) ratio that has moved back up above 40. Add it up, and Netflix's next move may be back down, perhaps back toward the $70 mark or lower.

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You can understand why Netflix's shares soared ever higher until last summer. Even with the rising costs of physical distribution, postage fees and an expanding roster of content relationships, Netflix still managed to become extremely profitable. EBITDA margins rose from around 26% in 2007 through 2009, to around 38% in 2011.

Netflix became popular so quickly that movie studios and TV production houses were simply caught off guard. These content providers asked for too little from Netflix, assuming the company represented just one of many distribution channels.

Netflix's impressive profit gains changed the industry's thinking. Over the course of 2011, as a number of content relationships came up for renewal, Netflix was asked to pony up a lot more money. In some instances, the increases were so egregious that Netflix simply walked away. Cable channel Starz proposed replacing a $30 million annual content agreement with a purported $200-300 million deal. So the two companies have parted ways.

To its credit, Netflix has maintained that it would never sacrifice profit margins by overpaying for content.

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