The Good, The Bad, and The Ugly News For This Digital Streamer

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Netflix (NASDAQ: NFLX) management has adopted takeover defenses which could stymie activist investors who endeavor to unlock shareholder value. The stock is also trading at high valuations. Even though the outlook for Netflix is wonderful, good companies are not always good stock investments.

The Good News: Streaming Growth

Revenues are up for streaming media. Spending on home videos was up for the third quarter of 2012, marking the increase in sales of online services including Netflix, movie purchases through the Internet, and even DVD rentals from kiosks such as Redbox. These sales are on the rise, in direct contrast to DVD sales, which are going down. Sales on home video spending went up to $3.94 billion, according to the Digital Entertainment Group, which marks an increase of 0.2 percent.

Subscription streaming, or paid streaming online, has also gone up, with revenues double those of 2011. Revenue from Internet purchases of TV shows and movies is also up.

Studios are banking on increasing revenues through these digital and online sales, as well as paid online video services, all of which are making up for losses on DVD sales. A new service, UltraViolet, is enjoying support from studios. It allows consumers to buy a TV show or movie, and then watch it on a variety of Internet-linked machines.

Studios are also cashing in on the increase of digital sales. Warner Bros., owned by Time Warner (NYSE: TWX), recently announced that it would provide movies to Redbox Instant, a new online program by Verizon (NYSE: VZ) and Coinstar (NASDAQ: OUTR), both of which own Redbox.

The Bad News: Takeover Defenses

In a bid to safeguard itself against a hostile takeover, Netflix adopted a plan to make such buyouts too expensive. The stockholder rights plan 'poison pill' would be triggered once an institutional investor buys 20 percent of stock or an activist investor acquires 10 percent of that stock. The plan was thought to be a response to billionaire investor Carl Icahn's purchase of nearly 10 percent of Netflix shares.

Icahn, who indicated that he was inclined to invest in Netflix because it was undervalued based on its prospects for expansion, described the stockholder rights plan as an example of poor governance. According to the board, however, the poison pill is said to be in the best interests of shareholders and would not negatively affect any approved mergers. Piper Jaffray analyst Michael J. Olson indicated that the company was working towards achieving its profit and growth goals. According to Olson, "The management team is going to make efforts to avoid getting taken out before the investment phase is over."

Netflix has neither received an offer for a takeover nor has Ichan discussed the possibility of ownership. Many stakeholders, however, have declined to be identified or to comment on the plan, stating that it is a private affair.

The Ugly News: Competition and Development Expenses

In an effort to keep up with the competition from Netflix by attracting the holiday shoppers, Amazon (NASDAQ: AMZN) introduced its option for monthly subscription for its Amazon Prime line of products. Amazon Prime, which was previously sold for $79 a year, will now be available for a monthly fee of $7.99. Amazon free two day shipping is expected to swing more customers to their side with their new payment option expected to give them a competitive advantage over their bitter rivals Netflix. Whereas the shares of Netflix have remained stable over the past year, those of Amazon have increased by 1.4% in 2012.

Amazon recently reached an agreement with channel Epix to be providing films on their Prime services. This has significantly raised the number of channels available on Prime to over 25,000. The free shipping offer is viewed as an incentive for more people to prefer Amazon to Netflix. Kim Sean an analyst said, "For $7.99 on Amazon, you're getting less video but you're getting all this other stuff." Amazon itself considers this free shipping deal as a way of testing the market response of the people. Most of the top leaders do not have much information for the public regarding this issue.

Redbox Instant is also a direct challenge to Netflix which is expected to launch by Christmas. About 500 of Verizon's employees have tested Redbox Instant. This streaming service's title list will initially focus on newer movies. Redbox Instant will compete against Netflix and Amazon for online and mobile device viewers. It is envisioned that viewers will be able to download content directly to game consoles, set-top boxes, and mobile devices, easily. Coinstar's CEO mentioned that the venture is going to focus on value pricing.

Even Worse News: Extreme Valuation

Netflix trades at high multiples:

<table> <tbody> <tr> <td> <p><strong>Ticker</strong></p> </td> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>P/E</strong></p> </td> <td> <p><strong>P/S</strong></p> </td> <td> <p><strong>P/B</strong></p> </td> <td> <p><strong>P/FCF</strong></p> </td> </tr> <tr> <td> <p>CSTR</p> </td> <td> <p>Coinstar</p> </td> <td> <p>9.15</p> </td> <td> <p>0.63</p> </td> <td> <p>2.24</p> </td> <td> <p>4.84</p> </td> </tr> <tr> <td> <p>CMCSA</p> </td> <td> <p>Comcast</p> </td> <td> <p>16.19</p> </td> <td> <p>1.53</p> </td> <td> <p>1.93</p> </td> <td> <p>12.94</p> </td> </tr> <tr> <td> <p>TWX</p> </td> <td> <p>Time Warner</p> </td> <td> <p>16.93</p> </td> <td> <p>1.47</p> </td> <td> <p>1.42</p> </td> <td> <p>22.38</p> </td> </tr> <tr> <td> <p>VZ</p> </td> <td> <p>Verizon</p> </td> <td> <p>38.69</p> </td> <td> <p>1.03</p> </td> <td> <p>3.14</p> </td> <td> <p>13.53</p> </td> </tr> <tr> <td> <p><em>NFLX</em></p> </td> <td> <p><em>Netflix</em></p> </td> <td> <p><em>102.41</em></p> </td> <td> <p><em>1.27</em></p> </td> <td> <p><em>6.27</em></p> </td> <td> <p><em>246.92</em></p> </td> </tr> <tr> <td> <p>AMZN</p> </td> <td> <p>Amazon.com</p> </td> <td> <p>3217.57</p> </td> <td> <p>1.78</p> </td> <td> <p>13.51</p> </td> <td> <p>96.34</p> </td> </tr> </tbody> </table>

Its high price-to-earnings ratio and high price-to-free cash flow multiples are tough to justify.

Expect that competition and forecasts for extreme market growth will inspire spending on research and development, making future cash flows negative for Netflix. Netflix CEO Reed Hastings, said, "Internet video is the way of the future. It's what gives us the confidence to make these big and aggressive bets." The company estimates that there will be a prolonged period of negative cash flow because of the initial outlay on programming and other content. In a statement Hastings said, "We have enough cash on hand to fund our planned originals in addition to our ongoing expenses, maintain an adequate reserve, and then return to positive free cash flow."

You should also expect earnings and sales price multiples to grow from competitive pressure. Its competitors are jumping into the streaming video market which will cut into sales and force price competition, lower margins, and ultimately higher price multiples. Today the price-to-earnings ratio of Netflix is higher than those of Coinstar. Watch out, and steer clear of Netflix.

Conclusion

Valuation matters, even when firms presently dominate a market, because high growth and high margins can attract the attention of new entrants. Expect product pricing and margins to drop as new entrants jump in and crowd the market. Investors should avoid Netflix.


BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and Netflix. Motley Fool newsletter services recommend Amazon.com, Netflix, and Time Warner. 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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