A Happy Ending for Netflix

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The Netflix (NASDAQ: NFLX) movie has everyone sitting on the edge of their seats. Once a market darling because of its innovative drive and amazing growth prospects, it became a beaten down underdog over the last year as investors sold the stock en masse due to concerns over falling profitability and increased competition.

But just like in the best movies, the plot took another unexpected turn recently, and Netflix is back with a vengeance: the stock has risen by more than 180% in the last month, including an amazing upswing of more than 40% in a single day after the company blew earnings estimates away last week.

In spite of its recent spike, Netflix is still well below historical highs, and investors are recovering their faith in this disruptive player. So stay tuned, because this exciting movie is far from over.

Alice in Wonderland

This started as an amazing adventure story with plenty of happy times as Netflix delivered fantastic returns for investors by disrupting the video business. The company made a smart and creative move by implementing DVD deliveries, and it took innovation one step further by becoming the pioneer in online video streaming in 2007. Both customers and investors loved Netflix, and it seemed like nothing could stop the company on its road to becoming one of the most successful business of our times.

Netflix wasn’t just the first mover in video streaming, the company built an amazing technological platform that allows it to analyze and project the viewing habits of its customers. This is a fantastic advantage when it comes to making recommendations and buying new content for its platform. Management was praised for its vision and leadership on a regular basis, and the company´s Chairman and CEO - Reed Hastings - was named business person of the year by Fortune Magazine in 2010.

Apocalypse Now

Things changed dramatically for Netflix investors in the summer of 2011. The company then announced a separation of its DVD and streaming services; this meant materially higher prices for subscribers. The move backfired, and many subscribers decided to leave Netflix infuriated by this initiative. Netflix reversed the decision quite quickly, but it still had big costs for the company in terms of lost customers and a tarnished image.

If that weren´t enough, competition became more intense after new players decided to step up their efforts in the race for the future of video streaming. Amazon (NASDAQ: AMZN) is a fierce disruptor which has killed or seriously injured many competitors in different industries over the last years, and it has deeper pockets than Netflix.

 Amazon is famous for operating with razor thin – or even negative - profit margins in its drive to gain market share, and that´s a big problem for any company that stands in its way. Amazon Prime offers streaming video in addition to expedited shipping for $79 annually, and the company grabbed a lot of attention back in September when it added content from Epix to its nascent arsenal of movies and TV shows.

Apple (NASDAQ: AAPL) is considered a big challenge for Netflix by many Wall Street analysts, but that´s not necessarily the case at this stage. Apple has an “a la carte” business model for video, which means buying and downloading movies on demand. There is some overlap among Netflix and Apple, but both companies can coexist in a friendly manner as there is plenty of room for both players and they target different pricing segments. If Apple decides to go after Netflix, however, things could get more complicated.

Netflix stumbled in the summer of 2011, then competition started increasing and it became apparent on the company´s financial statements that content acquisitions – and creation – are taking a big financial toll on its margins and cash flows. This adventurous love story had become a horror movie as the stock price came down from more than $300 in July 2011 to nearly $50 in October of 2012.

Diehard

Netflix was believed to be dead, but something we have learned from the movies is that tough guys don´t go down easily, and the company has proven to be a smart and dynamic player. Netflix announced an agreement with Disney last December, securing the rights to first-run Walt Disney movies, including those from Pixar and Marvel, starting in 2016.

Netflix is already very popular with kids, a strategic demographic group for the company, and the Disney deal will solidify its position in that segment. Besides, the agreement shows that Disney, a top notch content creator, believes in online streaming as the future of video and in Netflix as a main player in the new paradigm.

In the same way our favorite action hero gets back on his feet and blows the bad guys away after being left for dead, Netflix delivered an amazing earnings report on Wednesday, and it showed strength across the boards. The stock made an explosive move after the release, and it now trades above $170, well below its historical highs above $300, but still an amazing recovery from its lows near $50 only four months ago.

Analyze This

Part of this volatility is probably the result of Wall Street´s usual exaggeration, but it also shows an important thing to consider. If Netflix continues growing its subscriber base and recovering from its past mistakes, the stock still has plenty of upside potential.

 This is a risky investment, the business is under financial pressure and it may need to raise new capital in the middle term to finance its expansion. It doesn´t make much sense to rush into a position after such a big move, especially considering that Netflix is prone to abrupt movements.

On the other hand, a happy ending is looking like an increasingly likely possibility for Netflix investors in the long term.


acardenal owns shares of Apple, Amazon and Disney. The Motley Fool recommends Amazon.com, Apple, Netflix, and Walt Disney. The Motley Fool owns shares of Amazon.com, Apple, Netflix, and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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