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Analysts: Netflix’s Streaming Service Is Underpriced

Netflix spends more on content as a percentage of subscriber revenue (62%) than cable networks, including: Discovery Communications (25%), AMC (34%), Showtime (35%), Scripps Networks Interactive (38%), HBO/Cinemax (48%) and Epix (58%), according to an analysis by Morgan Stanley.

That indicates that Netflix’s $8-per-month Internet streaming service is too cheap, Morgan Stanley analysts Benjamin Swinburne, Scott Devitt Ryan Fiftal, Hersh Khadilkar and Andrew Ruud wrote in a research note Tuesday.

“We believe the profit-maximizing strategy [for Netflix] is to raise rates rather than go for sub growth,” they wrote.

Netflix released Q3 earnings after market close Tuesday. The company added a net 1.16 million U.S. streaming subscribers, at the low end of its previous guidance, and said it would miss full-year subscriber targets (see Netflix's Streaming Growth Slows).

Wall Street values Netflix -- which will invest about $2 billion on streaming content rights in 2012, more than Discovery, Scripps and AMC combined -- at just 2X its content spend, vs. an average of 20X for cable networks. The average basic cable network has an EBITDA margin of about 50% vs. 10% for Netflix, Morgan Stanley estimated.

Today, the over-the-top distribution model is not as profitable: “Netflix is an entirely on-demand retail service, while cable networks are sold wholesale to distributors and benefit from monetizing repeats,” the analysts wrote. “Netflix needs to continually supply its customers with new content or face escalating churn. Churn for basic cable nets is a non-factor as they do not incur [subscriber acquisition costs] and [are] distributed irrespective of platform (cable/telco/sat).”

On the other hand, Morgan Stanley expects that profit margins for U.S. cable networks will decline over time, as programming costs rise and pay-TV subscriber growth flattens.

For cable networks, “extending distribution rights to new devices, inside and outside of the home, will help lift subscription fees,” the analysts said. “But over the long term, competition for eyeballs (which drive advertising revenue and affiliate fees) will come from new entrants.”

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