JACKSON SECURITIES, LLC

Research for the Prudent Investor

Date 3/21/07 Netflix (NFLX): Initiating

Current Price $22.48
Coverage with a “HOLD”
52WK HI $33.12
52WK LO $18.12
recommendation
EPS (TTM) $0.71 • Industry: Internet Services HOLD initiated 3/21/07: $22.48
Shares Outstanding 70M • NILE: NASDAQ; $22.48 Target: $23.00
Market Cap. $1.5B • 12-month price target: $23
Dividend Yield NA
Price/Earnings (TTM) 31.7X
Price/Sales (TTM) 1.4X
EV/Revenue (TTM) 1.07X
EV/EBITDA (TTM) 11.4X
EBITDA (TTM) $93M

Company Description
Netflix is the largest online movie rental subscription service providing
Brian Bolan more than 6.3M subscribers access to a library of more than 70,000
Director of Equity Research movie, television and other filmed entertainment titles on DVD. The
company offers a variety of subscription plans, starting at $4.99 a month.
Technology
There are no due dates, no late fees and no shipping fees. Subscribers
Jackson Securities, LLC select titles at the Netflix web site, receive them on DVD by U.S. mail and
300 S. Wacker Dr., Suite 2450 return them to us at their convenience using prepaid mailers. Netflix is
Chicago, IL 60606 also offering certain titles through its new instant-viewing feature.
Ph: (312) 253-0578
Fax: (312) 986-0560 Valuation and Recommendation:
[email protected] The overwhelming number and size of competitors makes an investment
in Netflix a hard pill to swallow. That said, continued growth and a
standard of operational excellence not only gives Netflix a fighting chance
against numerous competitors, it puts them in a great position to capture
more of a growing market. We initiate coverage of Netflix with a HOLD.
Jackson Securities, LLC seeks to do business with companies covered in its
research reports. As a result, investors should be aware that the firm may have a
conflict of interest that could affect the objectivity of this report. Investors should
consider this report as only a single factor in making their investment decisions.
Please also refer to the important disclosures found on page numbers 11 and 12.
Analyst Certification is found on page number 11.
Netflix (NFLX)

Introduction to Netflix

Netflix is the largest online movie rental subscription service

providing more than 6.3M subscribers access to a library of more
than 70,000 movie, television and other filmed entertainment titles
on DVD. The company offers a variety of subscription plans,
starting at $4.99 a month. There are no due dates, no late fees and
no shipping fees. Subscribers select titles at the Netflix web site,
receive them on DVD by U.S. mail and return them to us at their
convenience using prepaid mailers. Netflix is also offering certain
titles through its new instant-viewing feature.

The subscription rental service has grown

NFLX Rate Card rapidly since inception, and the company
continues to point to the San Francisco
PlanRentals/month Price/month area as a measuring stick for nationwide
adoption. As of 4Q06, Netflix states that
4 DVDs at-a-time Unlimited $23.99 it has a customer base of 14.8% of all Bay
area residents. The company also noted
3 DVDs at-a-time Unlimited $17.99 that they have penetrated around 10% of
the homes in several other large markets.
2 DVDs at-a-time Unlimited $14.99
The internet delivery of movies will be a
1 DVD at-a-time Unlimited $9.99 new wrinkle for customers in 2007. This
new format will come with no increase in
1 DVD at-a-time Limit 2 per month $4.99 price for consumers, so they see the
service as being more valuable. Investors,
Source: Netflix however, will see additional costs and
shrinking margins which could hurt the stock price.

Online video rental market

Arriving at an addressable market for Netflix is not an easy

undertaking. The company has put forth such numbers as 60M
households with pay TV packages, and even a 45M DVD rental
market number. Where the actual number falls is likely to be
somewhere between the 30M that Blockbuster has noted as its
rental base and the total number of households with pay TV. Any

JACKSON Brian Bolan 2

SECURITIES, Director of Research – Technology
LLC
Netflix (NFLX)

number in that range represents a large potential market, and

plenty of room to grow from a base of 6.3M.

Content Acquisition
Netflix currently stocks more than 75,000 titles on more than 55
million DVDs. Netflix acquires content either through revenue
sharing agreements or through direct purchases. Under these
revenue sharing agreements with studios and distributors, Netflix
generally obtains titles for a low initial cost in exchange for a
commitment to share a percentage of the subscription revenues for
a defined period of time. In addition to revenue sharing
agreements, Netflix will also purchase titles from various studios,
distributors and other suppliers on a purchase order basis. For titles
delivered through the instant-viewing feature, they will license
content on a fixed fee or per-view basis from various studios and
other content providers.

“Total Access is clearly helping us to retain

customers. It has improved traffic in our The myriad of competitors
stores and is attracting new customers to
Blockbuster from our online and store-based Competition comes from numerous sources, but mostly
competitors. It has dramatically improved the investors will point to Blockbuster (BBI) as the major
growth of our online subscribers from competitor. BBI offers online rental much the same
approximately 100,000 net subscribers per way Netflix does. However, the Blockbuster Total
quarter to approximately 700,000 last Access plan allows for customers to return DVD’s to
quarter, a number that we should exceed in most of its over 5,000 domestic stores. This eliminates
the first quarter of this year. And Total the wait that Netflix customers experience when they
Access has improved our online churn, trial ship the movies via the United States Postal Service
conversion, and customer satisfaction level.” (USPS).
– Blockbuster 4Q06 conference call, source:
SeekingAlpha.com There are other smaller DVD rental competitors as well
as the Movie Gallery chain. Movie Gallery has had
significant struggles but maintains its hold on the more
rural market. The buyout of Hollywood Video has
done little to improve the competitive position of the
combined company as the stock has traded in the low single digits
over the past year. With a market capitalization of less than
$200M, it is hard to compare the financials of MOVI with BBI and
NFLX. Recently, through a debt restructuring and purchase of
MovieBeam, Movie Gallery has improved its competitive position.

JACKSON Brian Bolan 3

SECURITIES, Director of Research – Technology
LLC
Netflix (NFLX)

It has also announced plans for an online rental program of its

own.

Retail chains such as Wal-Mart and Best Buy could also be

considered indirect competition as their model focuses on selling
DVD’s. This indirect form of competition can also be found
online from numerous sites including Amazon.

Video on Demand (VOD) via cable television (Comcast) and the

internet (Vongo, Movielink and CinemaNow) can also be
considered indirect competition. Other competitors include Apple
and their iPod as well as Google and its YouTube division as well
as Yahoo! With the barrier to entry in the distribution side being
as low as it is, we expect to see several other competitors emerge,
but most will ultimately fail.

Key business metrics

• Churn: Churn is a monthly measure defined as customer
cancellations in the quarter divided by the sum of beginning
subscribers and gross subscriber additions, then divided by three
months. It is reported quarterly in the earnings release.
• Subscriber Acquisition Cost: Subscriber acquisition cost is
defined as total marketing expense divided by total gross
subscriber additions. This metric is also found in the earnings
release and is a good measurement of how effective the ad
spending has been.
• Gross Margin: Gross margin is a key metric for investors
to follow as it tells how effective the underlying model is
performing. The higher the gross margin, the better the model is
working. From time to time, the company has opted to reduce
gross margin in order to help secure more market share in hopes
that over time the customers will become more valuable to them.

JACKSON Brian Bolan 4

SECURITIES, Director of Research – Technology
LLC
Netflix (NFLX)

Industry Outlook

One of the toughest questions that would come up when

considering an investment in Netflix is whether the current
business model will survive what will be a game changing event.
That event is the onset of Internet2. Internet2 is a much faster
version of the internet as most people know it, and it will make
downloading a movie an experience that will only take a few
minutes. At current speeds, downloading of movies, while do-
able, is not as common as the downloading of music.

Access to Internet2 is limited and will be several years away from

the “retail consumer”, but it is still something that an investor
needs to be aware of before making an investment decision on
Netflix.

Another aspect that has to be considered is the control that the

movie studios might eventually have over the distributors such as
Netflix. While the studio’s currently need the distribution that
companies such as Wal-Mart and Best Buy in order to fully
monetize their product, there will come a day when that middle
man can easily be eliminated. This could impact the rental
business as well as fundamental changes in the delivery and
storage of movies would affect all aspects of delivery and movie
consumption.

Management Discussion

Reed Hastings founded Netflix in 1997 and launched the

subscription service in 1999. Netflix grew to one million
subscribers in less than four years, and surpassed 6.3 million
subscribers in December 2006. Prior to founding Netflix, Reed
founded Pure Software, which he built into one of the world's 50
largest public software companies. After a successful public
offering and a number of acquisitions, Pure was acquired by
Rational Software in 1997.

Barry McCarthy has served as Chief Financial Officer at Netflix

since 1999. From 1993 to 1999, Barry was Senior Vice President
and Chief Financial Officer of Music Choice, a music

JACKSON Brian Bolan 5

SECURITIES, Director of Research – Technology
LLC
Netflix (NFLX)

programming service distributed over direct broadcast satellite and

cable systems.

Earnings Analysis

In looking at our estimates, we should fall right in line with the

consensus on the street. The guidance that NFLX has given tells
us that the company expects EPS to fall slightly on a year over
year basis.

We wanted to highlight this as we know that investors tend to care

most about earnings, and more specifically the growth of earnings.
Seeing as earnings are project to decrease this year from the
previous, we would not expect investors to get overly excited
about the stocks prospect for this year. The result of this is likely
to carry forward on each earnings announcement date, where
investors may choose to protect themselves from downside risk as
opposed to buying shares in hopes of an upside surprise.

Ad Spend

Blockbuster flooded the airwaves in the early part of the first

quarter as they promoted their TOTAL ACCESS plan, while
Netflix has not been heard from as much. Over the course of the
year, we expect NFLX to spend sparingly on advertisements with a
slight ramp up occurring towards the end of the calendar year.

As with a previous competitive bout with Blockbuster, we expect

the first quarter of 2007 to be a slightly difficult one for NFLX.
With advertisement spending likely to be lower, the company will
probably spend most of its efforts in retaining customers that may
be looking to switch to Blockbuster as opposed to trying to gain
new customers. We also anticipate that the first quarter of 2007
will produce a much higher churn rate than the one we saw in the
previous quarter as well as the churn in the same period a year ago.

JACKSON Brian Bolan 6

SECURITIES, Director of Research – Technology
LLC
Netflix (NFLX)

Risks

The risks involved in purchase of shares of Netflix include, but are

not limited to: consumer demand for its products, the costs
associated with procuring agreements with movie studios and the
costs associated with fulfillment of the DVD’s or content.

Along with other boilerplate style risks that most technology

companies face (ability to stay current with technology platforms,
drive customer to the website, retain qualified personal to maintain
and operate the technical operations), Netflix faces some unique
risks.

There exists a risk that the distribution model changes course and
that studios begin to offer a digital service that effectively limits
the need for a rental service and could cause a severe financial
impact to Netflix and thus its shareholders. This is something that
is not likely to happen over the course of the next nine months, but
as delivery options continue to expand, it is an idea that must be
present in an investors mind.

Other risks of investing in shares of Netflix can be found in there

recently filed 10-K which can be found at www.sec.gov or through
the Netflix website.

Valuation

Like any stock, we believe the primary reason an investor should

purchase shares is to capture earnings growth or earnings value.
Coverage of the internet sector is synonymous with earnings
growth, and a high growth rate at that. Netflix is not exhibiting the
type of growth necessary to support a large multiple.

A large multiple could be granted by investors should the number

of subscribers increase dramatically. The more subscribers Netflix
has, the more possible revenue and thus the potential for higher
earnings. Following this train of thought, we believe that investors
will continue to closely follow the growth of subscribers and
derive a valuation from that growth. We continue to believe that

JACKSON Brian Bolan 7

SECURITIES, Director of Research – Technology
LLC
Netflix (NFLX)

earnings are the most important metric for Netflix (as well as any
stock investment) and believe that the company is currently priced
for perfection.

A multiple of 29x fiscal year 2007 bring us to our target price of

$23 per share, or just about where the stock is trading today. Over
the course of the year, we will pay close attention to the growth in
subscribers as well as the costs of running the business. These key
items will help us determine if we should adjust our price target up
or down.

Thesis

The sheer number of competitors tells us that there is money to be

made in the rental business, but it also tells us that the barriers to
entry are low. Down the road, the rental business may face a
serious challenge from VOD and other downloading options. Its
unclear at this point how Netflix will fair when that point arrives.
For now, we believe a valuation based off the number of
subscribers is the best way to look at shares of Netflix.

JACKSON Brian Bolan 8

SECURITIES, Director of Research – Technology
LLC
 Netflix (NFLX)

Earnings Model for Netflix

Netflix, Inc.
Consolidated Statements of Operations
(in thousands, except per share data)
Mar 31, June 30, Sep 30, Dec 31, Mar 31, June 30, Sep 30, Dec 31,
2006 2006 2006 2006 2006 2007 E 2007 E 2007 E 2007 E 2007 E

Subscription revenues $ 224,126 $ 239,351 $ 255,950 $ 277,233 $ 996,660 $ 303,600 $ 317,550 $ 328,230 $ 341,940 $ 1,291,320
Cost of revenues:
Subscription 126,220 128,605 135,210 142,586 532,621 166,980 171,477 178,885 187,212 704,555
Fulfillment expense* 22,045 21,974 23,583 26,762 94,364 30,360 32,390 36,105 39,323 138,179
Total cost of revenues 148,265 150,579 158,793 169,348 626,985 197,340 203,867 214,991 226,535 842,733
Gross profit 75,861 88,772 97,157 107,885 369,675 106,260 113,683 113,239 115,405 448,587
Operating expenses:
Technology and development* 11,206 12,043 11,929 13,201 48,379 18,216 19,053 19,694 20,516 77,479
Marketing* 52,968 47,031 59,367 66,158 225,524 66,792 63,510 68,108 74,372 272,782
General and administrative* 8,292 6,773 9,948 11,142 36,155 12,903 13,496 13,950 14,532 54,881
(Gain) loss on disposal of DVDs (1,387) (964) (1,142) (1,304) (4,797) (1,500) (1,000) (1,200) (1,300) (5,000)
Total operating expense 71,079 64,883 80,102 89,197 305,261 96,411 95,059 100,551 108,121 400,142
Operating income 4,782 23,889 17,055 18,688 64,414 9,849 18,624 12,688 7,284 48,445
Other income (expense):
Interest and other income 2,452 3,701 4,687 5,064 15,904 5,400 5,420 6,200 6,100 23,120
Interest and other expense - - - - - -
Income before income taxes 7,234 27,590 21,742 23,752 80,318 96,411 95,059 100,551 108,121 400,142
Provision (benefit) for income taxes 2,830 10,553 8,961 8,892 31,236 5,947 9,377 7,366 5,220 27,910
Net income $ 4,404 $ 17,037 $ 12,781 $ 14,860 $ 49,082 $ 9,849 $ 18,624 $ 12,688 $ 7,284 $ 49,082
*Amortization of stock based comp
included in expense line items:
Fulfillment 260 223 213 229 925 275 255 235 240 1,005
Technology and development 965 867 884 892 3,608 975 1,000 1,100 1,000 4,075
Marketing 554 529 540 515 2,138 550 550 550 550 2,200
General and administrative 1,531 1,468 1,532 1,494 6,025 1,650 1,625 1,775 1,600 6,650
$ 3,310 $ 3,087 $ 3,169 $ 3,130 $ 12,696 $ 3,450 $ 3,430 $ 3,660 $ 3,390 $ 12,696

Non-GAAP net income reconciliation:

Net income $ 4,404 $ 17,037 $ 12,781 $ 14,860 $ 49,082 $ 9,849 $ 18,624 $ 12,688 $ 7,284 $ 48,445
Add back:
Stock-based compensation 3,310 3,087 3,169 3,130 12,696 3,450 3,430 3,660 3,390 13,930
Income tax effect of stock-based com (1,294) (1,179) (1,306) (1,171) (4,950) (1,346) (1,338) (1,427) (1,322) (5,433)
Non-GAAP net income $ 6,420 $ 18,945 $ 14,644 $ 16,819 $ 56,828 $ 11,954 $ 20,716 $ 14,921 $ 9,352 $ 56,942
Non-GAAP net income per share:
Basic $ .12 $ .32 $ .22 $ .25 $ .91 $ .17 $ .30 $ .21 $ .13 $ .81
Diluted $ .10 $ .27 $ .21 $ .24 $ .82 $ .17 $ .29 $ .20 $ .13 $ .79
Weighted average common shares outstanding:
Basic 55,213 58,383 68,081 68,424 62,577 69,000 70,000 71,000 72,000 70,500
Diluted 66,456 69,175 70,345 70,670 69,075 71,000 72,000 73,000 74,000 72,500

Source: Jackson Securities and company reports

JACKSON Brian Bolan 9

SECURITIES, Director of Research – Technology
LLC
Disclosures:

Analyst Certification
I, Brian Bolan, hereby certify that the views expressed in this research report accurately reflect my personal views about
the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly,
related to the specific recommendations or views expressed in this research report. I may be compensated in part based
on the overall profitability of Jackson Securities, LLC, which includes earnings from investment banking and all other
aspects of the firm’s business.

Conflicts of interest:
Neither Jackson Securities nor any of its publishing analysts or their immediate family members has a position in the
securities described herein.

Compensation:
• The research analyst has not received compensation based upon investment banking revenues or from the
subject company in the last 12 months.
• Jackson Securities has not in the last 12 months managed or co-managed a public offering of securities, received
compensation for investment banking services from the subject company or any compensation for products or
services other than investment banking
• Jackson Securities does not expect to receive or intend to seek investment banking compensation from the
subject company in the next 3 months.

Position as Officer or Director:

Neither the research analysts nor members of their immediate households occupy positions as an officer or director with
the company/companies mentioned in this report.

Market Making:
Jackson Securities does not make a market in this stock

Explanation of Ratings:
Buy - Expected 12-month absolute performance of +10% or higher than the market price at which time the rating was
issued.
Hold - Expected 12-month absolute performance of +5% to –5% from the price at the time the rating was issued.
Sell - Expected 12-month absolute performance of –10% or lower than the market price at which time the rating was
issued.

Distribution of Ratings:
Jackson Securities, LLC has a distribution of ratings among its coverage universe as follows:

Buys – 54.6% (18 of 33 active recommendations)

Holds – 42.4% (14 of 33 active recommendations)
Sells – 3.0% (1 of 33 active recommendations)

Jackson Securities has provided investment banking services within the previous 12 months with the following percentage
of the companies they have rated:

Buys – 3.0% (0 of 33 active recommendations)

Holds – 0% (0 of 33 active recommendations)
Sells – 0% (0 of 33 active recommendations)

Risks: General economic conditions, economic slowdown/recession, adverse industry news.

Other Important Disclosures and Disclaimers

Disclaimer: This communication is neither an offer to sell nor a solicitation of an offer to buy any securities mentioned
herein. This material should not be construed as an offer to sell or the solicitation of an offer to buy any securities

Brian Bolan
Director of Equity Research – Technology
mentioned herein in any jurisdiction where such an offer or solicitation would be illegal. We are not soliciting any action
based on this material. This document is for general information only, and it does not constitute a personal
recommendation or take into consideration the particular investment objectives, financial condition or financial needs of
any clients. Before acting on any advise or recommendation in this research report, clients should consider seek
professional advice. Past performance is not a guide to future performance. Future returns are not guaranteed, and a loss
of original capital may occur.

The information contained herein has been obtained from sources that we believe to be reliable, but we do not guarantee
its accuracy or completeness. Any opinions expressed herein are statements of our judgment on the date appearing on
this material only and are subject to change without notice. We endeavor to provide updates on a reasonable basis of the
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Brian Bolan
Director of Equity Research – Technology