Too Cheap to Ignore or Value Trap?

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

It's interesting how different companies go through phases in their lifetimes. Many fast-growing companies start out with both their earnings and stock price growing fast, and then an event happens that changes everyone's perspective. With Netflix (NASDAQ: NFLX) everything was going along fine until the company's fateful decision to drastically change its pricing plans. This huge and unexpected change caused many subscribers to cancel in outrage, and investors were left wondering what was the company thinking? While this event is now over a year old, it still has left a negative impression on many former customers, and the stock has never been quite the same. However, when a company falls this far, I can't help but wonder if the stock could finally be a good value.

Streaming Star or Content Producer?

Netflix has always reminded me somewhat of Amazon.com (NASDAQ: AMZN), which is ironic because Amazon is now one of their primary competitors. Both companies have been expanding both domestically and internationally trying to take over their market segment. The difference is while Amazon has expanded its offerings and seems to be constantly entering new fields, Netflix started out as a DVD rental business and is now transforming itself into a streaming media business. By all accounts, the transformation of Netflix is nearly complete, as the majority of its subscribers are streaming members. The problem for Netflix investors is understanding if Netflix in the future will be a streaming company that offers content from multiple studios, or if the company will become a studio itself. The Motley Fool's own Rick Munarriz has been consistently bullish on the company. In fact, he recently wrote two different articles showing the two different sides of Netflix. The challenge for investors is Netflix needs to either stick to what it knows or move forward with the transformation to a content producer.

The Netflix We Know:

To be clear, I firmly believe that Netflix offers a particular value to a segment of the population. The service isn't for everyone, and there seems to be constant complaints about not enough content. However, over 30 million people have subscribed to the service and this number has consistently grown, aside from their pricing debacle of last year. In one of his articles Rick asked, "Is Netflix Finally Too Cheap To Ignore”? Clearly he wasn't referring to the price of the stock relative to earnings, as much as the price of the stock relative to where it used to trade. He pointed out that Netflix's emphasis on streaming is giving the company a scalable advantage that few will be able to catch up to. The problem is, he also made the argument against streaming in mentioning its lower price point, weaker contribution profits, and losses incurred in expanding internationally.

Netflix The Next HBO?

If Netflix expects to become the equivalent of a premium television channel, then the company needs to make major changes to the way that it presents it service. Rick has also written about this by suggesting that, “You Need Netflix More Than It Needs You." His idea is the company's original content such as Lillyhammer, Arrested Development, House of Cards, and others in the future are the key to Netflix's future profitability. He even says, "just wait until Netflix has just one original programming hit and learns to milk it appropriately.” There are a few issues I see with this theory. First, Netflix has positioned itself as a cheap way to stream thousands of titles as much as the customer wants, and on the customers own schedule. Pay-TV channels do offer the ability to stream titles, but original content is not available on the customer's schedule and is based more on the studios production schedule. In addition, most pay-TV channels like HBO and Showtime cost about twice as much as Netflix. With many Netflix members tied to the $7.99 price point for thousands of titles, asking them to pay twice as much for a small amount of original content just doesn't seem realistic.

Conclusion:


Netflix's most likely future path is a combination of unlimited streaming and original content for an additional price. The easiest way to envision this type of transformation is to look at Netflix's primary library similar to a traditional cable lineup. Members who wish to watch titles from the existing catalog can continue to do so for $7.99. If members are interested in the company's original programming, those shows will cost extra on a month-to-month basis. I know the company has been reluctant to accept this strategy before. However, at $7.99 a month it's very unlikely that Netflix will be able to afford ever-increasing content licenses in addition to original content costs. The only other option is for Netflix to continue down its current road losing money each time it enters international markets.

As the ever dwindling DVD subscribers continue to disappear, the company's cash flow will be challenged by thinner margins even with a higher streaming customer base. I believe this will cause Netflix to reach a fork in the road where it will yet again have to make a transformative decision. Offering unlimited streaming for the existing catalog, and additional pricing to access original content makes good sense. The company must adjust its pricing to more closely match what it's offering to customers. CEO Reed Hastings might not want to hear this, but his current strategy won't work over the long term.

Want to Learn More?

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.


MHenage 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 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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