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The US market for online streaming subscriptions is now worth $1.1 billion. This represents a fivefold increase from the previous year. While this drastic increase is good news for online media companies, it has caused more and more companies to enter the industry, making competition even fiercer than it already was. As competitive pressures mount, problems for the incumbent giants will multiply. Netflix (NFLX) is a good example of a company suffering due to heightened competition in the Online Streaming Industry.

As a counter strategy, NFLX has signed a new deal with Disney (DIS). This deal will allow NFLX's customers to stream Disney films after their first cinema run. While some see this new deal as a potential game changer for NFLX, we feel this would actually add to NFLX's existing problems. The biggest problem of high content acquisition costs will not be resolved after the deal with DIS. We reiterate our sell rating for NFLX.

Our analysis includes the effects of a series of disasters that NFLX faced in 2012. Things started getting worse for NFLX after the company could not add as many subscribers as it promised at the start of the year. NFLX's business model is vulnerable to costs being higher than revenues. Subscription cost being higher than ARPU seems to be a major problem with its business model. We feel that this is one reason why its gross as well as net margins have decreased over the past few quarters. The following table shows a comparison of its performance relative to Q12011

Q22011

Q32011

Q42011

Q12012

Q22012

Q32012

Total revenue

10%

14%

22%

21%

24%

26%

Total cost of revenue

12%

22%

31%

42%

47%

51%

Gross profit

7%

2%

7%

-12%

-12%

-14%

Operating income

13%

-5%

-39%

-102%

-84%

-84%

EBITDA

12%

-3%

-34%

-92%

-76%

-76%

Net income (reported)

13%

4%

-42%

-108%

-90%

-87%

The relative performance of NFLX is not great as well. While digital companies are mostly valued on EV/EBITDA, it makes more sense to value NFLX on P/E because of NFLX's inability to convert top line growth into profitability. NFLX is trading at a P/E of 178x. We feel that the company does not deserve such a high valuation while it struggles with its operational aspects. The company seems overvalued from a relative perspective.

NFLX is also struggling from a strategic perspective. This year has been a story of several unfavorable strategic headwinds, and NFLX has been losing ground to its competitors, especially Amazon (AMZN). Amazon, the online retail giant, has also entered the Online Streaming Industry, and has been giving tough competition to NFLX. Owing to its diverse nature of operations, AMZN has not only been able to increase the number of its contracts with media providers but it has also been able to offer augmented services (by offering kindle related promotions to customers). This has enabled AMZN to snatch a big chunk of NFLX's market.

Another twist in the tail is Ichan's no stance for NFLX. A few weeks ago, Carl Ichan, the famous turnaround specialist, had identified NFLX as an undervalued stock and had announced that he owned 10% of the company's shares. He expressed his intention to take over the company and turn it around. Although the stock jumped up by 34% after its October 24 low, things are quite different now. "The thought had certainly entered my mind. I have to admit I think about it, but we haven't made that decision." This statement by Ichan crushed the hopes of many investors.

The growing competition in the industry has put a lot of pressure on NFLX. While giants like AMZN have made things bad for NFLX, the real threat has been the new players in the industry, both national as well as international. While it has been struggling with price increases, Coinstar (CSTR) and Verizon Communications Inc (VZ) have joined hands to cause greater damage to NFLX. Their service, Redbox, aims to provide streaming services to customers at $6 a month, as compared to $7.99 being charged by NFLX. While NFLX gained 18% over the whole year, this news caused a 7% drop in one day.

Although this offer from Redbox seems quite attractive, some would argue that NFLX still holds the advantage of having the most diverse media content offerings. However, analysts feel that NFLX will suffer from a loss in customers because of Redbox's offer. Kraft predicts that Redbox would have fewer streaming titles initially but it would be able to induce some Netflix customers to switch. "Incorporating, all under one roof, the streaming library and new releases available via the kiosk or VOD rentals will be a competitive differentiator" said Kraft.

What has given some hope to investors and has pushed prices up by 14% is NFLX's deal with Disney. NFLX will surely benefit from this deal in 2016; however, we feel that this deal would add more to costs than to benefits. As mentioned before, content acquisition cost is NFLX's main expenditure, and the company has been facing an alarming increase in this cost over the past quarters. In this highly competitive industry, NFLX will not be able to charge premium pricing. This means high content costs can't be passed on to the consumers.

In case this deal goes through, NFLX will have to invest a significant amount into realizing the deal. This is why we feel that this deal could do more harm than good. Moreover, the streaming of films will start from 2016. Till that time, this deal would not earn NFLX any significant revenue. "These costs are going to sink Netflix," said Michael Pachter from Wedbush Securities. We agree with Michael's comment and feel that this investment is not feasible for NFLX, given its current operational performance.

We agree with many sell side analysts and reiterate our sell rating for NFLX. While the stock has gained temporarily, we do not foresee this rise to sustain in the long run and expect prices to fall because of heightened competition. We think this 10% hike in NFLX's stock price presents a good opportunity to start building a short position in the stock. Its short ratio of 2.5 days is not high enough to make us conscious about a short position.

Source: Short Netflix: Deal With Disney Is No Solution In Super Competitive Market