Problems with this Internet Company
Callum is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Problems
If you own Netflix, or think you might want to own Netflix, have a look at all these problems facing the company today to see if it really is worth your money.
Large Profits, Structural Decline, and Competition
One problem I have with Netflix is that it’s most profitable division, the DVD rental service, is on the decline; what's more, according to Reed Hastings it will continue to decline forever. The DVD rental service made up 59% of Netflix's net income from its domestic market and is the reason why Netflix turned a profit. Management has given up on the DVD service, and has said it won't spend any effort or time marketing that service. This is largely due to the fact that consumers have been switching to streaming from the traditional DVD model to meet their entertainment needs.
Some have said that in a decade DVD's will become obsolete, and considering that year over year physical DVD sales are down 17% in 2012, they may be correct. Netflix has recognized this and is aggressively pushing its streaming service, but with only $798 million in cash and $2.1 billion in streaming obligations (that will need to be paid in less than one year) and $2.9 billion in long term streaming obligations (as of Q3 2012), Netflix will need to start making money fast.
Margin Problems
Rising content costs is what is really killing Netflix. Content costs rose 27.5% year over year. Unless the company can find a way to pass through a price increase or develop their own popular titles (like Arrested Development), they will grow themselves to death. To put this into comparison, revenue only grew 10% and earnings were down 88% in that same time period. Gross margins got whacked, falling from 34.7% to 26.8%. Also, in 2010 Q4, the company had an operating margin of 13.2%, but by 2011 Q4 that was 8.1%, and by 2012 Q4 that will be in the negatives. If this trend continues, Netflix won't be able to remain profitable.
Tough Competition From Amazon
In the streaming space, there is a ton of competition. Competition from Amazon (NASDAQ: AMZN) gets tougher and tougher each year, and Amazon Prime is a big worry for Netflix for several reasons. First, Amazon can outspend Netflix any day of the week when it comes to content. Second, Amazon already has a strong membership base that is growing rapidly. It is hard to tell what that number is right now, but JPMorgan estimates it to be at 13 million (as of September 2011) and Piper Jaffray's sees that coming in much lower at 5 million (end of 2011). Regardless of whom is right, that is up significantly from 2 million in 2009 (estimated by Piper). Amazon CEO Jeff Bezos talks about what a great offering Amazon Prime is all the time, and has also alluded to a possible price increase in the near future. Finally, according to a survey by Piper, 92% of Amazon Prime members want to renew their subscription; that means consistent revenue for Amazon and a lower churn rate.
Coinstar and Verizon get in there too
Coinstar (NASDAQ: CSTR), which owns the Redbox kiosks, is taking up a lot of market share in the DVD/Blu-ray retail space. Year over year Coinstar has increased its market share of the DVD rental business by 7% to 38.5%. It continues to roll out new kiosks every day, which will take away Netflix subs that just want the DVD rental service. 86% of Coinstar's revenue comes from their Redbox division, so they are going to do whatever they can to beat out Netflix.
Coinstar is also going to compete with Netflix in the streaming content space with their new joint venture with Verizon (NYSE: VZ) which will be called Redbox Instant, and it will have a lot more money to spend on content than Netflix. In fact, while Netflix has $798 million in cash (and short term investments), Verizon has $10.31 billion in cash that it can add to Coinstar's $321.64 million in cash. With that kind of cash, VZ and CSTR (which owns 35% of the joint venture) will be able to buy up all the content they need to be competitive with any streaming player.
Final Thoughts
Netflix offers a great service that I use often, but I simply can’t get behind it or encourage anyone else to do the same as of right now. It finally is trading at a more reasonable P/E level, but even then with its primary source of income becoming obsolete in a matter of years (according to Netflix's CEO), that still is too high. Margin compression and tough competition will also be hard on Netflix. From a trading standpoint I could see Netflix bouncing up past $80 in the months to come, but from a long term investing standpoint, I'm going to have to recommend that you stay away from this stock. Maybe in the distant future Netflix will look more appealing and will turn itself around, but for now I'm glad to watch from a safe distance. It is a great service, but so is Groupon, and look where that ended up. I'm bullish on the new Arrested Development series, though.
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