Why Netflix Will Continue To Dominate & Confound Bears

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

One of my investment choices over the past decade that proved me wrong in my thesis was shorting Amazon.com (NASDAQ: AMZN) in 2001. I just couldn't reconcile myself with the notion that selling a bunch of different products on the Internet could be very lucrative in the long run because what they were selling were products already being sold everywhere by numerous competitors. Sure, most of their competitors were "brick and mortar" stores but my logic was that if it became a successful model, numerous competitors would replicate the model, divert sales from Amazon and drive down the profits due to increased competition. The biggest problem seemed to be that barrier to entry into their market was non-existent.

Despite my thesis being incorrect, I was lucky. Amazon's stock quickly decreased after I bought the puts on it; so I ended up selling my puts for a 30% profit. But if the underlying stock had not happened to decrease for reasons unrelated to my conjecture, I could easily have lost all of my investment. The lesson learned about e-commerce and human nature has allowed me to see companies like Amazon, eBay (NASDAQ: EBAY) (which also has little barrier to entry) and Netflix (NASDAQ: NFLX) in a different light. Companies that innovate and offer products in a way that consumers prefer - are able to establish themselves as a juggernaut in their respective industries.

Having that critical mass goes a long way. Despite the fact that other companies can try to sell similar products and are only a click and URL away, competitors have a challenging time trying to elicit that same trust and loyalty requisite to gaining a foot hold - even if they offer it the exact same way as those who pioneered the services. Over the years there have been several eBay want-to-be companies pop up offering very similar services with lower fees. Such companies came to market after loud protests over eBay raising their fees but were still short-lived.

We heard similar protests regarding Netflix after they separated their streaming service from their DVD by mail service. The result has been a few loud protests for a time, but most of the customers have adapted. Those left making the noise now seem to be bellicose short sellers and analysts who are making excuses for their flawed analysis and lack of vision. Here are some examples of the wishful thinking of some such analysts - after - Netflix blew away the analyst's projections:

Thursday, January 24th headlines from Marketwatch.com:

There has been an onslaught of attacks on Netflix by the media pundits and analysts over the past few weeks. Many of them cite the same talking points about there being "little barrier to entry"… "increased competition" and "declining margins."

Learning from my past mistake with Amazon allowed me to see things a bit differently as expressed in my comment on a Jan. 17 SeekingAlpha.com column titled "What's Behind Netflix's Big Drop?" (in which the author disclosed he was SHORT Netflix):

(click to enlarge)

Thanks to that lesson from a past mistake with Amazon, I was able to lock in a gain exceeding 600% on my NFLX June 2014 calls with the $140 strike price. Not bad for a month of waiting. I took some profits off the table Thursday the 24th and immediately bought more time by purchasing NFLX January 2014 calls with the $200 strike. I did so because I fully expect Netflix to be at a minimum of $300 a share by next January (2014). I woke up to see those up 90% on Friday.

I never envisioned that Amazon would become a legitimate technology company as they have with their Kindle. They did a fabulous job in morphing into one. With Google starting out in "search," I didn't foresee their success in the smart phone industry. I had similar questions about whether Netflix would succeed when they began investing in their streaming business several years ago. There were more questions than answers about what the standard would become once the primitive DVD by mail became obsolete.  It seemed difficult to envision how they would make the leap to the television set. Netflix has since turned the corner.

I find it very easy to stream my Netflix account to my television but like many, find myself -choosing- to watch on my lap-top or Android more than anything else. Netflix has transformed itself from being another company with a website that relied on Benjamin Franklin's US Postal Service to one that has successfully made itself into a legitimate technology company becoming rapidly centered around innovative, proprietary web applications.

It may seem ironic that I'm using my mistake in a long ago "short sale" of Amazon - as an example since the formidable Amazon is trying to compete with Netflix. I am not concerned with Amazon beating Netflix for the same reason I wasn't concerned eight years ago when the analysts thought Wal-Mart (NYSE: WMT) was going to dominate the banking and video rental industry. Wal-Mart and Amazon are fine companies, but they do not do -everything- well. Strictly as a consumer, before going Long Netflix, I explored Amazon's movie rental platform and almost everything about it frankly annoyed me. I do not like downloading movies and their selection was underwhelming to me. Hulu also paled in comparison. Netflix is the absolute best at giving movie watchers what they want, how they want it. Know when the writing is on the wall. Consumers vote with their wallets.

Companies who try to snub Netflix out of obstinacy - do so at their own peril. It is easier for a Netflix to become a provider of great original content than it is for a producer of original content to become a Netflix. There's a lot of content out there. Companies like HBO and Starz risk decreasing their viewership and revenues by trying to compete with Netflix when the critical mass continues to go to the online distributor most people prefer. People have budgets and are not going to subscribe to a bunch of different subscription services. As a Netflix customer, my queue is full. If films produced by HBO and Starz were on the platform, I would watch them (although not exclusively) - but since they've been gone, I have not lost any sleep.

Besides my thesis that Netflix has formidable momentum that makes it more risky for content producers to avoid dealing with them, there are many more potential catalysts to further drive subscribers. I am confident right now that many of the short sellers are underestimating the significance that Facebook integration will have on Netflix's subscriber growth.

People LOVE to talk about and recommend movies to their friends, families and co-workers. It is undeniably one of the top conversation pieces in this entertainment driven world. As I wrote in my December column Netflix Positioned for Subscriber Boom with Social Media Integration - Facebook is a BILLION people who do little more than recommend. Those "Likes" and "Shares" are going to drive people, many of whom have no Netflix account yet - right to the film being shared and Netflix is by far the "path of least resistance.

These are some of the considerations that the prosaic analysis of the Netflix shorts completely overlook. Their equations and discounted future cash-flows are based on flawed opinions that underestimate the likely explosion to come in subscriber growth that I believe will far outpace projections for years to come. Declining profit margins are not so bad when a company's market share grows by historic proportions and possibly -becomes- the market itself. It requires vision - and Reed Hastings is indeed a visionary.

Sure Netflix could be acquired by a larger company for the reason of "You've beaten me George."With many large companies like Apple, Intel, Facebook and Google with plenty of cash and strong currency in stock - vying for content and distribution - Netflix is the "prettiest girl on the block". But either way, Netflix shareholders stand to be rewarded handsomely.

I believe that a buyout would not entice the energetic Hastings because Hastings knows what he's sitting on; however Apple could use a visionary CEO at this point.

I have no opinion whatsoever on where Netflix's stock price will go this week. I do however have a minimum price target of $300 by next year.


Scott Ryan Anderson currently has a position in ebay Call options expiring in January 2014 with a Strike price of $75.00.  Scott intends to repurchase the NFLX January $200 Call options.  The Motley Fool recommends Amazon.com, eBay, Facebook, and Netflix. The Motley Fool owns shares of Amazon.com, eBay, 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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