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Building More than Just a House of Cards

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"House of Cards," the original series that Netflix (NASDAQ: NFLX) released a few weeks ago, is a hit. The Kevin Spacey-led political drama quickly became the most-watched show on Netflix, with a lot of subscribers binge-viewing and taking in the entire series in a weekend or even a day. Given that the news comes from Netflix itself and lacks specific numbers one might want to take it with a pinch of salt, but there's a lot of positive buzz about the show and third-party polling companies have reported large numbers of viewers as well. The real question is whether the success of "House of Cards" is enough to fuel the growth that Netflix needs to stay on top.

"House of Cards" cost Netflix $100 million to make, and Netflix is hoping that cost is an investment that will result in new customers for its streaming service. To sweeten the deal they're producing several more original series, including an additional season of fan-favorite "Arrested Development" and a kid-friendly co-production with DreamWorks Animation (NASDAQ: DWA) called "Turbo: F.A.S.T." that serves as a series spin-off of DreamWorks' upcoming "Turbo" feature film. Netflix also has four other original series in production for this year spanning a wide range of genres including a horror series from Eli Roth, a prison comedy from the creator of "Weeds" and a show written by and starring Ricky Gervais. A second season of last year's "Lillyhammer" is also planned for the fall.

It's estimated that it may take an increase of 10% or more in digital subscribers to foot the bill for these productions. The math gets a bit tricky in some spots since Netflix is working in conjunction with other production companies so they don't have to foot all of the bill; DreamWorks Animation is obviously assisting with "Turbo F.A.S.T" since it spins off of one of its own properties, while Lillyhammer was produced in association with Norwegian Rubicon TV AS for the Norwegian Broadcasting Corporation. This is good for Netflix, since it not only helps to reduce costs, but also gives them a bit of wiggle room on exactly how much they need to increase their subscriber base and still have a viable business strategy going with these exclusives.

But Wait, There's More

The creation of must-watch original programming to draw in new customers is a pretty solid business strategy when you look at it in a vacuum, but we all know that business doesn't exist in a vacuum. Netflix is facing a few problems at the moment, and how well it manages those problems will determine whether its original programming becomes a boon or a liability. While the issues facing any corporation are usually complex, many of Netflix's problems can be linked to either increasing competition or to problems originating within the company itself.

Netflix is essentially the big fish in the movie-rental-by-mail-and-streaming-content pond, but that's largely by virtue of it being one of the first major players in its particular market. Netflix isn't the only fish in that seriously hyphenated pond, however; Amazon.com's (NASDAQ: AMZN) Amazon Prime service continues to grow in popularity and offers the option to rent movies and TV shows that aren't available for free with the Prime subscription, an option that isn't available from Netflix and that makes new releases accessible that customers might otherwise miss. Coinstar's (NASDAQ: OUTR) Redbox service is also entering the instant streaming business with help from Verizon Communications (NYSE: VZ) with a service known as Redbox Instant; currently in beta, the new service offers customers unlimited movie streaming and also provides four 1-night DVD rentals per month from any Redbox location. There are other streaming services out there as well such as HBOGo and YouTube Movies, though none are quite positioned as well to take on Netflix as Amazon Prime and Redbox Instant are.

Of course, Netflix would be doing better if competition was its only problem. Unfortunately, a struggle to get new releases onto the streaming service and unpopular price hikes have led some users to give up Netflix out of frustration. A lawsuit and potential SEC action in regard to accusations of making misleading statements to manipulate investors and make the company's streaming service seem more popular than it actually was have added more fuel to the fire. Some existing subscribers are seeking out alternatives (such as Amazon Prime and Redbox Instant), and if the migrations continue then it will become harder and harder to hit those needed subscription numbers.

Reading the Cards

Netflix share prices soared in late January, more than doubling between Jan. 22 and Feb. 19. This was due in large part to a perfect storm of positive earnings in the previous quarter, high-profile deals that have paid out a bit now and are primed for larger payoffs in the coming years, and the certified hit status of "House of Cards." The company will really need to get its house in order if it expects this to be more than just a temporary surge. The current lineup of original programming is made up of a number of relatively safe bets... "Arrested Development" will be a hit because the existing seasons are among the top-watched shows on Netflix. Horror produced by Eli Roth? Guess who's directed some well-ranking horror films. Crime-related comedy by the creator of "Weeds?" A children's show based on a DreamWorks Animation children's movie? These aren't exactly risks, and the decisions on what to produce have largely been made based on the company's viewing demographics. When it will become riskier is in future rollouts, when everyone's used to the Netflix original programming and there aren't quite as many untouched genres to choose from.

Netflix will also have to compete with increasing pressure from its competition, and a full slate of original programming will only take the company so far. Consumers who want streaming and DVD rentals may be drawn to Redbox instant because it offers both without the premium cost of renting a few movies.  Add in the potential for unexpected hits from Amazon's in-house production studio (which isn't drawing top-name talent, instead relying on the community for pitches and even scriptwriting services) and Amazon Prime could end up with a few exclusives of its own. Given that both Redbox Instant and Amazon Prime are priced competitively against Netflix's streaming offerings and are cheaper than a Netflix subscription with both instant viewing and disc delivery, the convenience of Redbox Instant and competing original programming from Amazon both have the potential to make it difficult for Netflix to stay on top in the long run.

One other factor to consider is the potential for the US Postal Service to stop Saturday delivery, a cost-saving move it hopes to execute in August and has been considering for some time. If the USPS does cut Saturday delivery, this could have an impact on Netflix's DVD and Bluray customers by eliminating 4 or 5 days that they could receive new movies each month. From a financial standpoint this could benefit Netflix to a point since the slowing of disc delivery would result in a slight reduction in postage costs for the company, but at the same time it could drive away disc subscribers who don't want to pay the same rate for fewer movies each month. Netflix is already having problems maintaining its disc subscription numbers, and the influence of the Postal Service might push more customers to the waiting arms of Redbox or other alternatives.

And the Winner Is...

At the moment, neither Amazon Prime nor Redbox Instant are necessarily in the position to be called "Netflix killers." Prime offers a decent catalog of free options with a subscription, but these offerings overlap heavily with those of Netflix and the premium rental fee for other releases may turn off some viewers. The lack of a month-to-month payment option could also be a hindrance, though Amazon did test a monthly subscription offering last year that could potentially make a return at some point in the future. Likewise, Redbox Instant's limited streaming catalog and lack of TV shows could make it harder for them to draw in customers who want more selection (and often complain about the lack of options in Netflix's much larger streaming catalog.) If Redbox Instant can offer more first-run movies and increase its catalog of "movies that matter" over time then it might become a much stronger force in the streaming entertainment industry than it has the potential to be right now.

Even without a major competitor ready to knock it down, it's unlikely that Netflix's current high is sustainable in the long-term. The company's unlikely to completely bottom out, especially as it expands into new territories and has started offering 3D streaming services as an added draw in some areas. It even has the potential to reascend to loftier heights after a decline if it manages to create additional "must see" originals, especially once some of its deals such as being the first-run provider for Disney films starting in 2016 really start to kick in. While I feel that the company is currently overvalued, if it plays its cards right I could definitely see it retaining a high value even in the face of stepped-up competition.

Croaxleigh has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, DreamWorks Animation, and Netflix. The Motley Fool owns shares of Amazon.com and Netflix. 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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