More Reasons to Avoid Netflix
Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Netflix (NASDAQ: NFLX) took another blow with rival streaming service Amazon Prime gaining access to content that was formerly Netflix exclusive. On the day of the Amazon (NASDAQ: AMZN) announcement Netflix's share price plunged 10%, a pretty steep one-day discount, but I'd caution jumping in because more pain is on the horizon.
There are several looming issues on the horizon, including the pending launch of yet another competitor, Redbox Instant by Verizon. As you would expect, the new service is a joint venture of Verizon (NYSE: VZ) and Coinstar’s (NASDAQ: CSTR) Redbox division and further crowds an already crowded space.
Amazon’s deal with Epix is just a symptom of a larger issue for Netflix. Due to the nature of streaming content, competitive advantages are hard to come by and content is rapidly becoming the only significant point of differentiation. The problem for Netflix is twofold: they need exclusive content and to also maintain as much content overlap with competitors as possible. With the expiration of its own deal with Epix ( a joint venture of Viacom Inc., Lion’s Gate Entertainment, and MGM Studios) Netflix has lost a major selling point.
More importantly Netflix’s loss of exclusivity with Epix leads to another issue: content costs. Epix is expected to license its content to all interested parties, which ultimately will put it in a position to name its own price. As competition heats up for content, prices will rise, and rising content costs have already begun squeezing margins. When coupled with the need to amass as much content as possible, this becomes increasingly problematic, particularly since competitors have demonstrated a willingness to spend. Thought Netflix currently has a dominant share of the streaming market, its competitors have deep pockets and some have a track record of ignoring their own margins to gain control of a market, which doesn’t bode well for Netflix.
While I’m certainly not a Netflix bull, it is worth pointing out the company isn't taking the added competition laying down. It's been pursuing international expansion, with 13% of total Netflix streaming subscribers now a part of their international segment. The international segment was also responsible for slightly more than half of the net increase in streaming users over the last quarter. The company has also indicated that along with continuing to build out its current international operations, it will also being expanding into yet another international market in Q4, though it is holding off on details until later in Q3. International revenues are growing, though currently the segment is not profitable and is being subsidized by its domestic business. Ultimately the international build out should add to the bottom line, particularly as it reaches a profitable scale in each country.
The only major drawback to international expansion is that it is weighing heavily on the company's bottom line and is expected to continue to do so in the near future. In their most recent letter to shareholders Netflix acknowledges this and points out that the next market they enter is expected to push them back to a consolidated loss. I also think it is worth pointing out that despite no expansion plans for the current quarter, their Q3, guidance for net income between -$6 million to $8 million for the quarter, after swinging to a global profit for the previous quarter. Long-term international expansion is a sound strategy, but given Wall Street's focus on short-term results, Netflix is looking at a bumpy road ahead.
International expansion isn't the only trick up Netflix's sleeve; the company is also working on building its own original content library. Since content is the lifeblood of a service like Netflix, I think this is a strong move even though it will take time and considerable investment to build a sizable library. The company does have several series in the works, including a second season of their well received “Lilyhammer” and a new season of the critically acclaimed “Arrested Development,” but has a long way to go.
There is also the threat of content providers continuing to crowd the streaming space and leveraging their already developed libraries. Content providers like Time Warner Cable's (NYSE: TWC) HBO have been reluctant to separate from premium cable, arguing as recently as August of this year that cord cutting isn't as prevalent as people think.
But, despite TWC's CEO insisting HBO is more lucrative as an add-on to cable, it appears HBO is offering a cable-free subscription to several Nordic countries beginning in mid-October. The company did point out that this doesn't affect its domestic plans, but it isn't a stretch to think that success may bring standalone HBO to the U.S. sooner rather than later. The threat of HBO and other premium content providers entering the streaming fray is a serious one, particularly since Netflix's fledgling library would be dwarfed by comparison.
Both international expansion and original content development have the potential to help Netflix remain the market leader, but as it stands its competitive advantage appears to be rapidly eroding. In the near term Netflix is likely to experience more pain and accordingly I expect its share price to continue to decline as profitability declines. That isn't to say I'm forecasting the complete downfall of Netflix, but there are several good reasons to stay away, at least for now.
TigerAnalyst 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.