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Netflix: Misunderstood and Mispriced

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

I don’t know about you, but I really hate television commercials. Not only do they interrupt what was otherwise an enjoyable experience, they increase the amount of time I have to sit in front of my TV to see my favorite shows. I used to think to myself, “Man, there has got to be a better way!” Well, there is, and it is only getting better as time passes. Netflix (NASDAQ: NFLX) offers a great product that eliminates those pesky television commercials. This product allows users to instantly stream movies, television shows, and documentaries directly to their TVs, computers, or mobile devices. Fortunately for investors, this company is generally misunderstood and its shares are, in my opinion, attractively priced.

A great way to determine if a company is generally misunderstood by the financial markets is to look for precipitous drops in the price of the company’s stock. This alone is quite useless but can shed light on the situation if put side-by-side with company press releases and news stories in the same time frame. As you can see in the chart below, NFLX hit a peak of $300 in July of 2011. Looking further across the chart, we see a gut-wrenching drop that probably caused some people a lot of pain. Why the large drop? A blunder in the PR department while instituting a price increase was certainly a factor. In addition to that little hiccup, management decided, and later reversed its decision, to split off the DVD business from the streaming. This split would have caused a bit of an inconvenience for customers of both services and stockholders began to dump their shares in droves.


<img src="/media/images/user_624/0742chart_ws_stock_netflixinc_2011102581051top__large.png" />

Source: http://g7finance.com/global-news/netflix-stock-sinks-36-as-subscribers-flee/

The company has experienced a number of other setbacks in the past year: customers leaving the service due to the price increase/DVD debacle, the loss of a content contract with STARZ, rising content costs, and growing competition in the streaming segment. All of these factors have contributed to the drop in the price of Netflix shares, although I believe the doom and gloom is mostly exaggerated.

Let’s take a closer look at these threats. First, following the missteps in late 2011, the number of customers lost was higher than management originally calculated. Management expects the DVD subscriber base will continue to shrink due to the new subscription options and consumers dropping services that they often didn’t use. On the other hand, management has said they expect growth in streaming subscriptions throughout the year, although some seasonality may affect next quarter’s numbers.

Also, Netflix continues to expand its business in Canada, Latin America, and the UK. Latin America has proven more of a challenge than originally expected due to issues with internet connection and payment options, but Canada and the UK are seeing promising results. The virtuous circle that is Netflix’s business model will continue; as more content is acquired, the number of subscribers increases.  

Next, let’s look at the STARZ contract and how rising content costs are affecting the company. Management decided to let the contract for STARZ content expire, as the price to renew was too high. Netflix has a great advantage when at the bargaining table; it knows exactly how many people are watching particular shows or movies and how much the company would be affected by losing specific content. In the case of STARZ, the renewal price was not worth paying when compared to the number of people accessing its content.

As more competitors enter the streaming space, content prices may continue to climb, but Netflix has the advantage of a huge subscriber base. Whereas a company starting out in the streaming world will have to split its costs across a small base, Netflix has close to 30 million subscribers.

Speaking of competition, it seems that competitors are coming out of the woodwork to challenge Netflix’s dominion of streaming content. Amazon (NASDAQ: AMZN) offers free streaming of videos and television shows to its Prime members and continues to acquire content at a rapid pace. Amazon has deep pockets and a well-seasoned leadership team, which could be a threat to Netflix in the future. Having read many reviews stating Amazon’s streaming is just not up to par with Netflix’s service, I do not see that big of a threat today.

Coinstar (NASDAQ: OUTR) is another name tossed around by those predicting the fall of Netflix. Coinstar’s DVD dispenser unit, Redbox, is similar to NFLX’s DVD service, except one need not wait for the disc to come in the mail. Anyone wanting a new movie can simply find the nearest Redbox and have the disc instantly.

Unfortunately for Coinstar, there is not a Redbox on every lawn, whereas there is a mailbox. Besides, Netflix sees streaming as the future of content consumption, so Coinstar is a bit behind the curve. Apple (NASDAQ: AAPL) has also been said to be a potential competitor, but I just do not see it. Yes, the company has very deep pockets, and yes, it was very successful with iTunes. If anything, I believe Apple would be more likely to acquire Netflix than to openly compete with it. With over $100 billion in cash, Apple can buy Netflix 25 times over.

The last competitor I want to talk about is Comcast (NASDAQ: CMCSA) as it has, in my opinion, the best chance of causing damage to Netflix. Comcast uses its Xfinity streaming service to offer television shows and movies to its subscribers. It also is a large provider of high-speed internet access. Talk of data caps on internet service has been circulating in the news lately, which I believe may be a great danger to Netflix. Netflix CEO Reed Hastings posted a status update on his Facebook page calling out Comcast’s practice of not counting its own streaming services when calculating data usage for the consumer. Hastings believes this violates net neutrality and would like to see the FCC look into Comcast’s practices. If Comcast institutes data caps on internet usage unopposed, Netflix may need to reassess its situation.

Despite all the bad press we continue to see regarding Netflix, I still firmly believe that shares of Netflix are sufficiently undervalued to warrant an investment. Being only a $4 billion company, there is still a long runway out ahead in which management can continue to execute. Also, if my suspicion that the level of competition is overstated turns out to be true, we may just see $300 per share again in the not too distant future. 

Fool Blogger Kyle Campbell (RoyalScribe) owns shares of Netflix. The Motley Fool owns shares of Apple, Amazon.com, and Netflix and is short Apple. Motley Fool newsletter services recommend Amazon.com, Apple, 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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