I realize there's no shortage of Netflix (NFLX) analysis here at Seeking Alpha. In fact, there's probably no better place in the world to understand all the different perspectives on this hotly-debated stock than this unique forum. It was, after all, the exclusive site of The Great Hastings vs. Tilson Debate.
The most contentiously debated investments are always the ones in which the participants have made personal investments in the products themselves or have similar emotional factors at stake. Perhaps this is why a company with a relatively scant sub $10 billion valuation receives so much attention. Netflix users are passionate about the service, just as Apple (AAPL), Amazon (AMZN), and Microsoft (MSFT) users are. Frequently, and with good reason, that personal bias colors one's analytical perspectives either positively or negatively.
It's important not to disregard these personal experiences categorically. After all, it is the products and services these companies deliver that ultimately drive the performance of their business in the marketplace. On the one hand, it does matter if you conclude that Netflix's service is awesome or that Microsoft's new operating system sucks. But on the other hand, your personal perspective is one among millions and may not be representative of the entire market's opinion.
I'll confess upfront that I'm a huge fan of the Netflix service and have been a subscriber almost since day one. I am a shameless sucker for new technology and my shelf is littered with first gen Kindles, proto smartphones, and beta operating systems.
I also just made Netflix one of my 10 Predictions for 2013 - I swear I didn't have any inside information about this week's conference call! - so I had and still have a dog in this fight. But I don't mind getting laughed at when I'm wrong, so hopefully all these factors balance out and we can still have an intelligent conversation about this unique business.
The Netflix Knowns
Before this week, if you'd done a search you'll find that the exact same themes surface for Netflix again and again:
- Higher costs for content acquisition.
- The slow, inevitable death of its high margin DVD business.
- Sluggish earnings.
- A possible takeover.
- Competition from Amazon Prime.
We've all been debating these factors for a long time. Consensus opinion is on board with all of these ideas. If I was one of those guys who had to get up on TV and deliver a series of 30 second sound bites, I'd say something like "all that stuff has already been baked into the stock price. It's time to have a new conversation about Netflix."
And as it turns out, all that stuff was baked into the price. It wasn't until this week's earnings call took all those concerns and turned them on their head.
We also know that what drives the short & medium term performance of Netflix's stock is momentum. Everybody attributes the stock's collapse from $300 to $100 to the Qwikster / price hike PR debacle. But really, the stock was in a bubble beforehand, over-owned by momentum players and trend followers who were buying the stock simply because it was going up and because, well, the company had a pretty cool story. How much of the company's fundamentals and their trajectory really changed between 2008 and 2013? The data suggest: not a whole lot. Qwikster was just a pin.
And before we get too excited about crushing estimates, we should also ask, "is Netflix a 30% better company than it was on Tuesday?"
More than anything, this week is a reminder that what will drive the stock over the next few months (or even years) will be a completely different set of factors than what analysts spend most of their time debating.
Forget about the woes of the last 24 months and forget about the company obliterating analyst estimates this week.
When we talk about Netflix, what we're really talking about is the Netflix of 2020 or 2030. We all have a reasonably good idea what the technology will look like a decade hence, i.e. a whole lot more streaming and a whole lot less DVD by mail & scheduled cable content. We just don't know the extent to which Netflix will be involved in that world.
Which brings us to...
Own both Netflix and Amazon.
Why not? We know that streaming is here to stay and each of these companies have different goals with it. Amazon uses it as a fringe benefit to get people to sign up for Prime, and the one thing Amazon knows is that people who subscribe to Prime buy a whole lot more stuff from Amazon than people who don't.
Technically, Amazon doesn't need Prime Video to be a superior product to Netflix. After all, the Kindle Fire HD isn't in an absolute sense superior to the iPad and probably never will be; it's mostly a tool to accomplish other, more important objectives. Prime Video needs to be just good enough and represent good enough value to justify its existence. Best case, Amazon dominates the world of streaming video. Worst case, it's a plenty good #2 and the product can be leveraged for the rest of their business. There's no need for Amazon to take expensive risks with Prime Video.
Netflix, on the other hand, is playing an all or nothing game. For them, the stakes are considerably higher. They either beat Amazon and beat them good, or their role in the digital world will be relegated to second-tier status and that business model eventually dwindles toward irrelevance while they try to invent another new business model. Even after this week, this question is still unanswered.
So allow me to suggest a two-tailed outcome for Netflix a decade hence. It's either worth virtually nothing or substantially more than its current $8 billion valuation. Wouldn't you agree? Because there's probably only going to be one dominant player in the streaming world. And it'll be either Netflix or Amazon.
If you're one of those people that still believes that Netflix is competing with cable companies like Time Warner (TWC), DirecTV (DTV), or Charter (CHTR), it's possible you've never used the service or that you don't own a device like a Roku Box or an Apple TV or any other hardware that puts Netflix in your living room. I know they're competitors in the sense that there are only so many things we can spend our attention on. But Netflix competes against the cable companies in the same way that HarperCollins or EA (or me, here at Seeking Alpha) does. We're each fighting for a few minutes of your time. Netflix and Amazon don't view the cable companies as real competitors and you shouldn't either. Whether we all some day cut our cords or not, hasn't streaming digital video won on its own terms?
So if you're worried Amazon will eat Netflix's lunch, why not bet on both? They each have very different risk/reward distributions. They each have very different operational strategies and strategic outlooks. Heck, the stocks don't even really correlate that much anymore:
Is there a better hedge for owning Netflix than owning Amazon?
(Pipe down all you options traders! We're keeping it straightforward today.)
Netflix's Final Frontier
It's possible, however, that Amazon is less of a threat to Netflix than you think. Reed Hastings admitted that they view their biggest competitor as HBO, not Amazon or the cable companies. If you read between the lines, you'll see Netflix's strategy for combating Amazon: original content.
If Netflix has taught the analyst world one lesson, it's that content costs money. Netflix became Netflix because they negotiated this crazy-awesome deal with Starz and built out an incredible new content delivery service with an incredible new business model. Since then the world has taken another look at how to value content in a world where the marginal cost of delivering is rapidly approaching zero. Disney (DIS), too, has made its feelings about this known. Iger & Co. shelled out close to $10 billion for perhaps three of the most powerful content factories on the planet: Marvel, Pixar, and Lucasfilm.
When you look at all the Netflix analysis here at Seeking Alpha and other places, there's hardly any discussion about Netflix's response strategy and their move into proprietary content.
My guess is because this is one of those analytical wild cards that are difficult to talk about quantitatively. How many new subscribers will this add? What will it do to their earnings? I doubt even Netflix themselves can say with confidence how this strategy will move the needle. I could have some fun and conjure some numbers out of thin air in an effort to justify my perspective, but as an analyst, I'd feel intellectually dishonest.
This is the year when the big move into original content starts, too. Lilyhammer was just a low-budget proof of concept. But House of Cards kicks off February 1 and my Netflix sub-prediction for the year is that this show winds up with huge critical acclaim and possibly a slot at the Emmys. (If you don't believe me, go check out the 22-year old source material. It's awesome. And think twice before betting against the talent of David Fincher to do the adaptation justice.)
Later in the year is also a new, exclusive installment of Arrested Development. That'll create more buzz among subscribers, but again, it's difficult to tell whether they'll actually acquire any new ones.
Just because we can't do the math and can't determine how it will or won't affect earnings, doesn't mean we should ignore the question of how much more systemically and culturally important a company like Netflix is with a library of high-quality content to rival HBO et al. Why should those "premium channels" have a monopoly on first-class serial and episodic programming? Why couldn't a creative, forward-thinking company with a reasonably strong balance sheet like Netflix become a content factory?
Before you laugh off the suggestion of original content as a core concept in the Netflix business model, consider that it accomplishes the following goals:
- It eventually helps Netflix mitigate the cost of third-party content and be more selective with the content deals it does negotiate.
- It builds viewer loyalty and makes it easier to retain subscribers and convert new ones.
- Ultimately leads to pricing power. And THAT is the final key to better margins in this space.
Pricing power by way of proprietary content might be the only key to better margins in the streaming space. Can you think of a better idea? Because Reed Hastings hasn't, and if he has, he isn't telling.
It's worked for HBO, Netflix's admitted chief competitor. Profit margins for HBO, Cinemax, Starz, and Showtime are all in the 30-50% range.
I know Netflix will never enjoy 50% margins with its streaming business because they have a radically different cost structure. But there are significant economies of scale here and with a competitive lineup of proprietary content - to go along with all the other value Netflix provides - why couldn't their streaming margins double or triple in the next decade?
Long Story Short
Netflix is a deceptively simple choose-your-own-adventure. Here's the cheat sheet for which pages you should personally turn to:
- If you are convinced Netflix will fail, avoid it.
- If you think proprietary content has little or no value, avoid it.
- If you understand momentum and technical analysis, trade it.
- If you are convinced Netflix can develop attractive original content, own it.
- If you are convinced Netflix will become a dominant player in streaming video, own it.
- If you are kinda convinced but kinda worried about Netflix's ability to do these things, own Netflix as well as the primary beneficiary if they lose, Amazon.
Personally, I think the strategy will work. In retrospect, I wish I could have taken my recent prediction about Netflix back. I seem to have already gotten it right, but for the wrong reason: dumb luck and a quarterly beat that nobody saw coming. That's great, but I'm of the belief that this story will take a whole lot longer to play out than 2013.