Netflix on Track, But Costs Curb My Enthusiasm

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

In the not too distant past Netflix (NASDAQ: NFLX) was pretty much the only game in town for content producers to distribute their content on the Internet in a profitable manner, and gave new life and profitability to their old libraries. The company's name became an Internet verb, "The movie was good huh? I'll have to Netflix it." The stock flourished, from $5 in 2003 to over $300 (a 60 bagger.)

Of course, the nature of capitalism is that success breeds competition and today Apple's iTunes and Google Play offer video on demand, Comcast, Disney, and Fox have teamed up and created Hulu, HBO, a unit of Time Warner (NYSE: TWX), has HBOgo, and Coinstar (NASDAQ: OUTR) and Verizon (NYSE: VZ) have partnered to create Red Box Instant, (due out later this year) not to mention Amazon (NASDAQ: AMZN).

Competitive Advantages over Netflix: 

Amazon: cheaper ($79 a year) which includes two day shipping on all items you purchase with Amazon. The video library is not as good as Netflix, however. If it was, they'd drive Netflix out of business for sure. 

Coinstar/ Verizon: Due out later this year, their service will offer newer movies on demand. Coinstar itself really capitalized on Netflix's Quixster moment, as many people who used to get their DVD's from Netflix, are now getting them cheaply, and on the same day, when they go to the grocery store. 

Other than first mover advantage, and the 24 million subscribers the company already has, there really should be no reason that Netflix's profits shouldn't decline amidst this massive wave of competition. The stock price has been hammered, falling as low as $52.81, 80% from its highs.

Many retail investors have been asking how much further the stock could drop, "it's starting to look much more reasonable valuation wise," is a refrain I have heard much more often over the last month or two.

The challenge for Netflix's it has no leverage over content. With all the other distributors, and the production companies having the option to distribute it directly themselves, Netflix's content acquisition costs have risen into the stratosphere faster than a space shuttle. And much of the content that users would like to stream ("Curb Your Enthusiasm" in my case) will never be available on the web site, as HBO strategically keeps it for itself.

A New Vision

You have to give founder Reed Hastings enormous credit for having led Netflix this far. He built a successful and viable business, granted with some missteps along the way (can anyone say "Quixster?") and now, sensing his empire crumbling, Reed chose to fight back and model HBO, and begin producing his own content.

The first Netflix produced show to come online is called Lillyhammer, featuring Steve Vanzant, former underboss of the Sopranos. I tuned in to watch the show, and was pleasantly surprised by its quality. To create a hit show is no easy task, and for every good show that makes it to air, 20 more bad ones appear, and hundreds more never get even get produced. Lillyhammer is well made, and surprisingly funny, but more importantly satiated my appetite for Netflix, making me believe my $7.99 was well spent at the all you can eat movie buffet. (Granted, without the lobster called Curb, or many hit newer movies I'd like to watch, I felt satisfied in part because Lillyhammer is available nowhere else. (legally I mean) 

I asked several of my other friends who subscribe to Netflix their opinion, and by and large they were in agreement with me. In other words, the production of proprietary content offers Netflix a competitive advantage that will not only help drive new subscriptions, but more importantly keep their customers happy, thus raising retention levels.

Of course, the challenge is that Netflix must now continue to create new content for subscribers. This is neither an easy or cheap endeavor- Netflix is rumored to have paid 100 million dollars for two seasons of David Fincher's "House of Cards," starring Kevin Spacey. Of course, HBO paid 50 million to produce the pilot alone of "Boardwalk Empire," but a substantial portion of that cost was to film the set representing 1930s Atlantic City, which will be re-used in every episode they shoot. Nevertheless, 100 million is no pittance, and is obviously an investment of substantial proportions, especially since in the fickle world of Hollywood; more money does not necessarily increase your chance of success.

Netflix has several other shows and development, and also recently purchased the Ricky Gervais show, "Derek." According to a blog in the NY Times  Mr. Gervais, said in a statement: “Netflix is the future. TV habits have already changed drastically over the last 10 years and this is the next phase. People want their favorite shows on demand whether they are homegrown or not.”
Mr. Gervais added: “As an artist you want the fruits of your labor to be seen by the largest number of people possible without having to compromise the product. This deal gave me the freedom and the huge potential viewers of the Internet but the production values of film and TV. They also made me an offer I couldn’t refuse. Come on, an artist gotta eat man.”

Concentrate on the last two sentences- the translation is, "Netflix drastically overpaid me and I'm laughing all the way to the bank." (And Ricky is already really, really rich)
Like it or not, Reed Hastings is betting the future of this company largely on becoming a studio of sorts. These TV shows a gigantic, and risky bets, but to give Hastings credit, without them Netflix would assuredly disappear or be purchased by a larger competitor.

The bottom line: I'll be happy to pay my $7.99 subscription to Netflix, but even though I respect Hasting's tenacity and instincts, and the fact that the content he's creating is going to be the only thing that will save the company, I still believe the stock is a little richly valued (with a forward price to earnings ratio of 73, (granted a substantial amount is being invested an expansion in foreign markets) is rather lofty for a company paying so richly for new content. I'm covered my short of the company I made in February, but I'm waiting for the stock to come down before I'm ready to go long.

However, rest assured, the Netflix's fate is directly tied to the proprietary content they are producing. Investing in Netflix is a direct bet that that this new content will continue to satiate viewers. With Lillyhammer Netflix has runners on base, but it by no means assures victory, especially if they continue to pay A-Rod prices for new content.  (give me a break, the World Series is fast approaching)

For a different view on the matter, allow me to recommend fellow Fool Demitri Kalogeropoulos's column

Interested in Additional Analysis?

The precipitous drop in Netflix shares since the summer of 2011 has caused many shareholders to lose hope. While the company's first mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep pocketed, rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These kinds of issues are a must know for investors, which is why The Motley Fool released a brand new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to both buy and sell the stock. They’re also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.

margiecfl has no positions in the stocks mentioned above. The Motley Fool owns shares of and Netflix. Motley Fool newsletter services recommend 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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