Good Company, Expensive Stock

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

Netflix (NASDAQ: NFLX) is the world leader in internet subscription video on demand for watching movies and TV shows. The company faces intense competition from many businesses ranging from cable companies to online retailer (NASDAQ: AMZN). Some of the biggest competing services to Netflix are HBO GO, Amazon Instant Video, Hulu, and Redbox. Hulu is owned by a joint venture between Walt Disney (NYSE: DIS) ABC, Comcast (NASDAQ: CMCSA) NBC, and News Corp (NASDAQ: NWS) Fox.

The four largest players in internet subscription video on demand are Netflix, Hulu, Amazon, and HBO. In September, in North America, Netflix, Hulu, Amazon, and HBO accounted for 33%, 1.4%, 1.8%, and 0.5% of peak period downstream internet traffic, respectively (Sandvine). In a report titled “Global Internet Phenomena Report,” Sandvine states, “The dominance of Real-Time Entertainment is due in large part to the continued market leadership of Netflix, which now accounts for 33% of peak period downstream traffic. Competing video services such as Amazon (1.75%), Hulu (1.38%) and HBO Go (0.52%) are often mentioned in the same breath as Netflix, but the data shows these services are unlikely to challenge Netflix for market dominance anytime soon.” Netflix had 32.7% and 20.6% share in the second half of 2011 and 2010, respectively.

As the market leader, Netflix is in an advantageous position. While it is the main target of the competition, it is also the most well known service provider in the industry. This means that more people know about Netflix and new customers often try Netflix first. Netflix has over 30 million streaming subscribers. The key factor to realize is that subscriptions to internet video on demand are cheap. Netflix, Hulu, and now Amazon each charge $7.99 a month. That is less than $100 a year. Attracting new subscribers comes down to content and each service has its own pile of exclusives. Since Netflix is the market leader, new customers often try out Netflix’s service first. The advantage of being the most well known option and the general low cost of the service should be enough for Netflix to continue to earn new subscribers. In addition, the service is cheap enough that people thinking of leaving Netflix sometimes subscribe to multiple services instead to access a broader amount of content.

In Q3 2012, in Domestic Streaming, International Streaming, and Domestic DVD, Netflix had net subscription additions of 1.16 million, 0.69 million, and negative 0.63 million, respectively. Since the pricing debacle of last year, Netflix has recovered its subscriber growth. One complaint about Netflix has been the lack of new content. However, this is more of an industry issue than purely a Netflix issue. According to Netflix, of its top ten TV shows, six are not available on Hulu, Amazon Instant Video, or HBO GO. In its top 50 shows the ratio is higher.

In addition, Netflix is investing in original content. This is a great move by the company. As the market leader, Netflix just needs to continue to provide additional content so that people stick with its service. Originals are good investments because they are exclusive to Netflix. Furthermore, it provides the company with more bargaining power in future content negotiations. Netflix is making the correct moves. Netflix expanded internationally, is available on a wide range of devices, and is now investing in original content.

Looking forward, the industry has a strong future. The modern world is clearly transitioning to online media and away from physical media. Americans are projected to watch more online movies than physical movie formats in 2012. In the US, paid, legal viewing of online movies is projected to rise to 3.4 billion and physical video format viewing is projected to decline to 2.4 billion (iSuppli). Of course, this rosy future could be disrupted by bandwidth caps being implemented by ISPs. However, the trend is clearly there. In its letter to shareholders, Netflix states, “Society has had over 50 years of linear TV dominance where channel owners decide what and when people can enjoy content.  With Internet TV, consumers get power, control and convenience. They can decide what, when, and where they want to watch. They can pause and resume anytime. They can enjoy content on a broad range of amazing devices.”

Overall, Netflix has strong advantages. Its brand name and position as the market leader give the company a big edge in attracting new customers. Once subscribed, exclusive content and the low cost of the service provide strong incentives for customers to stick with Netflix. In addition, online media is clearly on the rise. However, at a PE of 100.52 the company is too expensive. If investors use 2011 EPS, Netflix's PE is under 20. However, Netflix's current performance is far from its 2011 performance. Also, with Carl Icahn taking a stake in Netflix, there is a chance that the company will get bought. However, hoping for a buyout is not a sound strategy. Investors should put Netflix on the watch list for now and hope for a pullback.

Alvin has no positions in the stocks mentioned above. The Motley Fool owns shares of, Walt Disney, and Netflix. Motley Fool newsletter services recommend, Walt Disney, 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.If you have questions about this post or the Fool’s blog network, click here for information.

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