3 Media Stocks to Watch

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

While many have argued that the shift towards online streaming is an inevitability (count Netflix CEO Reed Hastings among them), I believe that the best media businesses are those that are diversified. Media is dynamic and changes quickly, so the best way to hedge against the downside while generating above industry-average returns is to spread out through several mediums, cross-promote, and add synergistic value through growth into new mediums. Below, I keep this consideration in mind in assessing Netflix and Disney.

Netflix (NASDAQ: NFLX): Why You Should Avoid It

Netflix is perhaps the most bullish media company on streaming. They, after all, essentially spurned their successful DVD delivery business to make this priority clear. Netflix has made it possible for customers to have a wide choice of viewing options that includes laptops, iPads, smartphones, and gaming consoles. It is, however, clear that this new approach is not going to entirely replace the DVD mail service, because competitors, like Coinstar and Amazon, are offering alternative streaming options with the possibility of renting.

A bill passed by Congress lifted restrictions on companies to share video rental history. This history sharing may be integrated into Facebook and thereby give Netflix more awareness. But Netflix in the past has seemingly done everything in its power to shut down its social networking viability. First, there was the decision to end the "Friends" network. This network previously allowed movie lovers to share and recommend movies to their connected friends. It was essentially a social network within Netflix and, in my view, had much untapped potential. In its relentless way of irritating customers, Netflix made no attempt to grow this area of the business, and, accordingly, you don't hear much of it today. When you add in the pricing hikes and recent outages during holiday times, Netflix is a PR nightmare on Facebook.

But investors have nevertheless been excited about the recent agreement with Walt Disney, wherein Disney will supply theatrical titles to by 2016 (for the main part of the deal). But this is a way's out, and investors have no idea what to expect by then. What we do know, however, is that Netflix will have to pay around $300 million annually to honor the contract. This will force Netflix to increase the current number of subscribers so as to pay off the obligation. It has attempted this through expanding abroad, but margins have declined in the process. Management could argue that this is value-adding in the long-term, but investors are likely to start discounting the future due to concerns over the business model's sustainability. For that reason, I recommend avoiding it in the short term, especially given the rally.

Disney (NYSE: DIS): Pros, Cons, and a Peer to Consider

There are several reasons to be bullish on this diversified media company. First, Disney is a direct part owner of Hulu's video streaming. This gives the company a particularly strong tailwind from the proliferation of 4G LTE and complementary smartphones and tablets. Further, Disney has a solid track record and reassuring growth potential. So it's not like investors are going to be starry-eyed about the future but fearful about the day-to-day stability.

To be sure, there are several reasons why you may be tempted to avoid Disney. There's the recent $200 million loss arising from the failure of the movie ‘John Carter’ and the $50 million loss arising from a failed animated movie. The games division of Disney is also experiencing consistent losses. Disney has, however, managed to rise to its 52-week high from beating analyst expectations overall. Four of the last five quarters have beaten expectations (3Q12 was in-line) with an average beat of 8%.

With that said, Disney's value has largely been articulated to the market. For this reason, investors should consider a small cap peer in the movie production space, Lions Gate (NYSE: LGF). Lions Gate has doubled from the 52-week low and now stands around the 52-week high. At 12.6x forward earnings, however, the stock is still cheap. Analysts forecast 26.4% annual EPS growth over the next five years, and this bullishness is reflected in the consensus ratings. 16 of 25 reporting analysts rate the stock a "buy" or better; the others call it a "hold." Factor in a 10.9% return on invested capital and a low price-to-book ratio of 2.4x (versus a 4x industry average), and you have a very attractive complementary stock to add alongside the stability of a Disney investment.

TakeoverAnalyst has no position in any stocks mentioned. The Motley Fool recommends Netflix and Walt Disney. The Motley Fool owns shares of Netflix and Walt Disney. 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. This article was written by the staff of TakeoverAnalyst, which does not intend on opening a position in the next 48 hours.

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