Investing in Streaming Stocks Could Be Risky

Delian 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) offers some of the best investment opportunity among the major music and video streaming stocks. The company has solid fundamentals, attractive valuation based on a number of metrics, and a competitive position that should allow the company to continue to grow in this evolving area. While other companies, such as Sirius XM (NASDAQ: SIRI) and Pandora (NYSE: P), are also fast growing, their business models must overcome much larger competitive threats in the next few years in order to thrive. Accordingly, their common stocks appear much riskier than Netflix.

Fundamentals and valuation

Netflix has 56.1 million shares outstanding, for a market capitalization of about $13.7 billion. In comparison, Sirius has 6.4 billion shares outstanding and a market capitalization of $23.2 billion, and Pandora has 174.8 million shares outstanding for a market capitalization of $3.2 billion. Below is a table with several fundamentals and valuation measures for each company.

A quick look at the numbers shows a different situation for each company. Price-to-book value is not very important when investing in growth companies, although Pandora is clearly overvalued based on that simple measure. Further, Pandora does not have significant fixed assets, as it does not take a lot of fixed assets to re-transmit music over the internet.

Netflix is the clear winner based on price-to-sales ratio, new subscribers, and international reach. International markets are important for content-creating companies, such as Netflix and Sirius, as they create their own content and, if they can sell it internationally, the return on investment is nearly 100% because the content is already there. A problem with international distribution is illegal viewing. For example, Netflix's original series' are reportedly pirated abroad within 24 hours after their release.

Pandora has only recently started operations in New Zealand and Australia, and the large rise in paying subscribers was due, primarily, to the fact that it limited the number of hours its mobile users can listen for free to 40 hours per month. As a result, many hardcore listeners switched to Pandora One. Sirius has operations only in Canada. It seems like Netflix is still growing healthily while having relatively inexpensive shares.

 

Netflix

Sirius

Pandora

Price-to-book value

16.8

6.2

38.5

Price-to-sales

3.6

6.6

6.7

Enterprise value

$13.4 billion

$25.1 billion

$3.1 billion

Current ratio

1.5

0.7

1.5

% of stock owned by officers and directors

9.7%

0.4%

31.6%

Revenue growth (latest quarter this year vs. same period in 2012)

17.7%

11.9%

32.8%

Net new subscribers in last quarter

2,028K

452.9K

700K*

International revenues as % of sales

13.9%

1.2%**

nil

Source: CapitalIQ, Thomson Reuters, SEC filings, author's calculations.
* Includes only Pandora One paying subscribers
** Due to a 38% equity stake in Sirius XM Canada

Competitive advantages and disadvantages

Pandora relies primarily on advertising for its revenue, and advertising can be volatile, as it decreases during recessions and in years when there are no political elections. At the same time, its music licensing and royalty fees are fixed, and currently represent over 65% of Pandora's revenue. Traditional radio companies and satellite radios pay much lower licensing fees than Pandora does. For example, Sirius' royalties fees represent about 16% of the company's revenue, and traditional radio companies pay an even lower portion of revenue for licensing. Pandora is actively lobbying Congress to change the law, and it also purchased a real radio station, KXMZ-FM, in Rapid City, South Dakota, in an effort to reduce its licensing fees. While Sirius has also launched a customizable radio station, My SXM, it is still able to acquire content at reduced rates. It is difficult to predict whether Pandora can successfully lower the amount it pays for music.

On the positive side, Pandora is able to target its users with better ads because it has their demographic information, and is also able to give exact information to artists about their audience. As a result, Pandora is seeing an increased interest in local advertisement and is adding sales people on the ground in 28 major markets. Also, Pandora is benefiting from the switch to mobile, as 79% of the 4.2 billion hours of music its users listened to in the latest quarter were on mobile devices. Also, mobile ads generated two-thirds of the company's revenue.

Netflix, which recently surpassed HBO in the number of subscribers (29.2 million for Netflix versus 28.7 million for HBO), is able to negotiate directly with content providers. For example, earlier this year, it negotiated over 300 hours of exclusive content with DreamWorks Animation. The first release of DreamWorks content, Turbo F.A.S.T., is expected for Dec. 2013. In addition, Netflix (and Sirius, to a lesser extent), creates its own content. The company's popular show, House of Cards, cost $100 million to make and is expected to be the first “web only” show to be nominated for an Emmy.

Finally, Netflix is increasingly partnering with ISPs (internet service providers) that offer Netflix as a promotion for their higher speed internet products. This is beneficial for Netflix as it gains customers and also avoids paying third-party CDNs (content delivery networks) like Akamai, Limelight, and L3. ISP providers also benefit because they have another carrot to wave in front of consumers to entice a switch to their service.

Overall, Netflix, Pandora, and Sirius have formidable sources of competition. The companies that compete with each of them are both established media companies and newer entrants, as well as emerging technologies (in the case of Sirius).

  • Netflix faces competition in original content from Hulu, Amazon Instant Video, and Xbox Entertainment Studios, and in video distribution from Hulu, Vudu, Redbox, Vdio, Amazon Instant Video, Apple TV, and YouTube.

  • Sirius' service could become redundant if cars are equipped with 4G internet, which some car manufacturers plan to launch starting in 2014.

  • Pandora is competing with traditional radios that have an internet presence, including Clear Channel's iHeartRadio. Also, Apple recently announced the launch of an internet radio, and there are a number of smaller companies competing with Pandora including Microsoft Xbox Music, Slacker, Spotify, and Songza.

Despite increasing competition, Netflix has the advantage of being the leader in “all you can eat video” for a monthly subscription rate. With plans for making north of 20 shows per year of original content, it is likely to become the leader in original content.

Sirius could see its satellite-based radio service become obsolete if cars are equipped with an internet connection. Also, both Pandora and Sirius have very limited foreign capabilities, which have become essential for successful technology-based media companies.

Conclusion

There are uncertainties with investments in technologically-intensive and consumer-oriented areas. It seems like Netflix, compared to Sirius and Pandora, has the best balance between growth, established user base, competitive position, and international diversification. All this, together with a relatively fairly-priced stock and solid fundamentals, leaves Netflix as the logical investment choice in the media streaming space.

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Delian Naydenov has no position in any stocks mentioned. The Motley Fool recommends Netflix and Pandora Media. The Motley Fool owns shares of 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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