The technology industry is a highly competitive one, making it difficult for a company to stay on top for a long time. The only technology companies which have managed to occupy a leadership position on a sustained basis, are those with valuable technology (Qualcomm (QCOM)) and a huge moat around their business model (Microsoft (MSFT)). Even then new technology trends can quickly erode these competitive advantages. You have to be constantly on your toes and keep innovating just to stay level. Those companies which fail to adapt have become irrelevant at best or bankrupt at worst.
On the brighter side, technology stocks also have the potential to appreciate quite dramatically over a short period of time. Investors looking to make money in a future Google (GOOG) or Apple (AAPL), tend to get irrationally exuberant over a new technology. However, most of these technology fads fail to generate profits, leading to massive losses to investors who had invested near the top. Groupon (GRPN) and Zynga (ZYNGA) are recent examples of this phenomenon. Netflix (NFLX) was another example of a stock which ran up dramatically based on the Internet streaming business model. However a couple of mistakes led to a sharp fall in the stock. The stock has gone up by an eye-popping ~60% after reporting Q412 results which beat expectations. However, we don't think Netflix is a good investment for the following reasons.
What we don't like about Netflix
- Neither a Content Creator nor a Content Transporter - Netflix occupies a strange position in the digital content supply chain, as it is neither a content creator nor a transporter of content. Currently the highest revenues and profits are being made by content creators (examples Disney (DIS)) and those who are in the business of transporting the content to the end users (examples Comcast (CMCSA), DishTV (DISH etc). Netflix licenses content from the creators and then streams this content to the end users. Most of the value is being captured by the content creators and transporters leaving little for Netflix. NFLX is trying to enter content creation, by producing its own content and through partnerships with major studios. However, it is too early to tell whether Netflix can become a one shop content creation and bundling shop.
- Valuation - Valuation has always been a sore point with Netflix with its trailing P/E multiple exceeding 200. Like Amazon (AMZN), Netflix is given a high valuation for its fast growth and a loyal base of users. It is expected that Netflix will start making better margins after maturity through economies of scale. However, we think it is a risky bet to buy Netflix as the stock can fall off a cliff, if the growth expectations miss only by a little. A small mistake made by the management can have catastrophic consequences for investors. This was proved after the stock fell sharply as subscribers reacted negatively to increase in prices.
- Low Entry Barriers and Margins - We find that Netflix does not have high entry barriers as users can switch directly to content providers. Even NFLX suppliers can become strong competitors by directly streaming content to users bypassing Netflix . Netflix's value proposition is to provide a wide variety of content at a low monthly price. This value proposition also means that Netflix has limited room to expand margins.
- Bargaining Power rests with Content Providers - Netflix has not got a lot of bargaining power vis-a-vis major content providers. Content remains king with end users and Netflix has to pay "top penny" to content creators. Even with a large user base, Netflix cannot drive better bargains with content providers, as alternative delivery channels exist.
- Net Neutrality is not given - Netflix is not liked by telecom and cable utilities because it eats up too much of the Internet bandwidth. There have already been cases where Internet providers have reduced the bandwidth for Netflix applications. While net neutrality is the law in the US, it may not be so internationally. Google is reportedly paying Orange to provide access to its network in the African countries.
- Competitive Threats will grow if Netflix succeeds - Amazon is already a strong competitive threat to Netflix with its Amazon Prime Service. If the Netflix model succeeds, bigger technology players like Google and Apple will also try and muscle in this space. Google's Youtube is already a strong competitor with millions of users. Youtube has also started premium pay channels for subscribers. These companies have already got much larger resources in terms of massive server farms and large cash hoards.
Netflix Upside Risks
- Buyout Target - Netflix is not a big target for a giant technology player like Apple looking to make a move into the Internet streaming space. However, we remain skeptical about a company buying NFLX at these valuations.
- International Growth - While US subscriber growth has slowed down considerably, NFLX is growing strongly in newer geographies like the Nordic region and Latin America. With the broadband infrastructure growing internationally, Netflix is taking advantage and expanding into newer markets.
- Brand and Quality - Netflix has become a household name in the US with its brand name associated with a high degree of trust and quality. The growth of new digital devices like tablets and smartphones has increased the consumption of Netflix services.
We think that Netflix does not have strong competitive advantages and has an inferior position in the digital supply chain. The company does not have a lot of opportunity to increase margins in our view, given that it does not have a lot of bargaining power either with suppliers or with customers. Its business model of bundling content at a low monthly rental to customers means that its earnings growth will be mainly dependent on volume growth. Increasing ASP is very difficult, as customers have low switching costs. The valuation makes the stock highly vulnerable to any slowdown in growth. Also we think that Netflix has low entry barriers and the company faces big tail risks from entry by bigger technology companies. The company could also face additional cost pressures if net neutrality is reversed in the US.