Is Netflix Overpriced?

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

Netflix's (NASDAQ: NFLX) stock price has taken investors on a wild ride over the last few years. After beginning calendar year 2010 in the low $50s per share, the stock zoomed upward to a high just under $300 before crashing to $70 at the end of 2011. However, the stock has since risen to above $200, causing skepticism among investors that the company is actually worth what the market is willing to pay for it.

Netflix's stock price volatility is indicative of the company's operating performance; there have been some missteps and some scares, but the company's outlook is generally perceived to be bright. However, investors would be wise to examine what could go wrong before buying the stock at 50 times its highest level of earnings (achieved in 2011).

Cool business

Netflix has benefited from consumers' increasing taste for viewing content online rather than on a television set. The company has also reaped a windfall for being the first major company to stream content; its large subscriber base -- and knowledge of its customers' likes and dislikes -- gives it a tremendous advantage over the competition.

For instance, its hit original series, House of Cards, was created using customer data to determine which formula would most interest its viewers. Nobody else in the business has a database with this information.

In addition, Netflix recently penned a deal with Dreamworks Animation (NASDAQ: DWA) that gives it exclusive access to more than 300 hours of original shorter-form television content from the legendary animation studio. Although the economics of the deal are not publicly available, the deal gives Netflix an important children's content source that competitors do not have.

But the deal could be just as good for Dreamworks. Television programming is less risky than movie production, and Dreamworks gains a more reliable source of cash flow to even out big bets on movies that usually turn out to be either blockbusters or flops. It also expands its merchandising opportunities because it can create more shorter-form content than blockbuster movies.

Having previously inked a deal with Netflix to distribute its film library, the original content deal appears to solidify a long-term commitment between Dreamworks and Netflix. This could work out to the benefit of both companies.

Internet levels the playing field

Perhaps the most difficult task in business is building a durable competitive advantage in an Internet-based business. Netflix has a head start on the competition, but its deep content library may not be enough to fend off the likes of Amazon (NASDAQ: AMZN) and other competitors.

Although Netflix's library is arguable more robust, Amazon's entry into the market has raised the cost of content acquisition; Netflix may still be signing new content deals, but Amazon is bidding up the price.

In addition, Netflix was playing catch-up when it signed the children's content deal with Dreamworks; Amazon already has a deal with Viacom for Nickelodeon content.

Amazon's wider product offering gives it a significant advantage in attracting customers. Amazon Prime subscribers can access streaming content free of charge. Additional cross-selling opportunities may arise as Amazon expands its offering.

Ultimately, it will be difficult for any company to create a moat around an online streaming business. Netflix will eventually have to move all of its DVD content to streaming as consumers become less willing to wait for DVDs in the mail. In addition, there is nothing -- save for years of movie ratings that generate decent recommendations -- stopping Amazon from poaching subscribers, especially given its cross-selling abilities.

Bottom line

There are no moats in online streaming services. Although Netflix, Amazon, and Hulu may lead the space for years to come, content providers will ultimately have the upper hand as content-starved distributors bid up prices. As a result, investors should make a cautious appraisal of Netflix's true earning power before buying the stock.

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Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends, DreamWorks Animation, and Netflix. The Motley Fool owns shares of 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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