Netflix Downgrades Miss Their Mark

There has been a recent onslaught of downgrades on Netflix (NFLX), which might be more triggered by insider sell off than industry insight. NFLX for the past several years has averaged between $15 and $30, so it is no surprise that insiders are unloading now. However, the big picture is that NFLX has been a quietly expanding performer since its inception, nearly 10mm subscribers strong, battle tested, and has overcome gigantic competitors like Walmart (WMT) and Blockbuster (BBI) through a quality product, good service – all at a great value.

NFLX has three business lines: packaged media through-the-mail rental (most familiar), Internet on-demand rental service (hot topic), and a not yet capitalized data provider business. The packaged media through-the-mail rental business is clearly their bread and butter. With nearly 10mm subscribers, NFLX represents a top 5 provider of digital video in the US - behind Dish (DISH), DirectTV (DTV), Comcast (CMCSA), and Time Warner Cable (TWC). NFLX's target base is represented by 131mm DVD players residing in consumer homes and offers its customers the largest selection (100k+) of movie titles in the business (bar none).

While the Achilles heel of this business is their turn around time for returned disks, NFLX has the best, most strategically located, mail distribution centers in the business – allowing 2 day turnaround from most locations in the US. This business line has also expanded to include the largest library of high definition titles (via blu-ray disks) of any video provider out there – it had over 2,000 blu-ray titles at the end of 2008. The Internet on-demand video rental service has been widely criticized for its slow maturation. From its inception, which included only a couple thousand titles, investors were disappointed by the number of titles offered and the service's limitations which initially allowed only personal computers to access the streaming service. However, through this slow maturation, the service has greatly stabilized and expanded its compatibility. Today, the service offers over 12,000 titles (100s in HD) and is accessible through Microsoft's (MSFT) Xbox live (a service available to 18mm Xbox consoles world wide), Roku boxes (over 100,000 of which were sold last year and last year announced an HD software upgrade), and a growing list of consumer electronics - LG (LGERF.PK), Samsung (SSNLF.PK), Tivo (TIVO), and Vizo - who either currently offer or plan to offer the popular NFLX streaming service from their set-top-box, blu-ray players and/or their televisions.

While currently the service is free to subscribers (similar to Cable's VoD in that digital video subscribers subsidize the on-demand service), clearly NFLX could just as easily offer a streaming ONLY service that is discounted over its through-the-mail rental service. Surprisingly, NFLX's chief rival is not cable or telco but rather its long nemesis Amazon (AMZN), which seems to be matching its moves. Unlike WMT however, AMZN is here to stay, and the two will likely be battling each other for years to come.

The third business line is what I would call NFLX's wild card – a potential data provider business. Like Macrovision (MVSN) and Tribune Media Services (private), NFLX too could be selling value-added data to providers of video services as it is sitting on over 1billion movie recommendations from its subscribers who tend to be video connoisseurs. NFLX also has a growing library of movie information (similar to Amazon's IMDb) but which also includes movie trailers and or course those valuable recommendations, which together could provide the basis for a strong video guidance data service.

While it is difficult to place a dollar value on these data assets, several companies including MVSN have approached NFLX about gaining access to these recommendations rather than go out and try to gather a billion recommendations from scratch. The significance of these recommendations is that they allow video service providers to expose their full VoD library to their customers. So rather than always watching the new releases, which are still hot off the presses (fresh in the viewer's memory), viewers can be made aware of equally good or better options that are residing in the video library.

In the future, look for NFLX to increasingly get involved in broadcast content and guidance technology providing things similar to Time Warner's start over, all within an interactive environment that is able to collect reviews on broadcast shows (which will ultimately become available on DVD or blu-ray anyway). Also, as WiFi and/or Ethernet becomes standard equipment on most televisions, expect to see the NFLX movie option become increasingly accessible and visible to the point where I wouldn't be surprised if they negotiated their own button on a remote control. NFLX would be wise to work with Consumer Electronics and become a catalyst in helping them claw back the market full featured television sets.

After all, once users have NFLX on-demand and high quality broadcast television programming, premium programming channels like HBO and ESPN will be hard pressed not to strike deals with the NFLX delivery vehicle. I believe NFLX is as close to offering LIVE programming in a la carte fashion as anyone - they have the guidance technology, the delivery platform, customer support, etc.

LAST WORDS – It will be interesting to see how consumers react to metered broadband when given the choice of a NFLX la carte video over IP versus what is available over Satellite, Cable, or telco. NFLX representing a pure movie network (no commercials) over an advertiser supported cable and satellite programming may also impact consumers. But how long will it be before NFLX too is inundated with advertisements? Can they break the rules and remain commercial free – sustained solely by subscriptions? In the old days of cable, subscribers didn't just pay for the programming; they paid to see uninterrupted, commercial free programming. Today, on average you watch 1 minute of commercials for every 2 minutes of premium content on cable and satellite.

Disclosure: no positions

Comments

[Davis Freeberg:]

Great insights. Somehow I don't see them ever monetizing their data by selling it to third parties. Their ability to know whether or not a customer will like a movie is certainly part of their secret formula. By reintroducing older movies to their customers, it helps to bring the content costs down, especially for the streaming service.

I found your comment about live streaming especially interesting. To be honest, I've never actually considered this before. I'm not sure if the studios would be comfortable simulcasting on Netflix and TV at the same time, but it's an interesting concept that my brain is still mulling over. It seems like there could be a lot of promotional benefit to giving away free live streaming for DVD/Watch Now premiers. They could use a Friday night movie of the week or something as a way of introducing watch instantly to people who haven't subscribed yet.

Having said that though, I suspect that live streaming would still be a ways off because of the technically difficulties of streaming concurrent feeds to all of their viewers at once. When you look at what happened during the Obama inauguration, it's clear that live streaming still has some bugs to work out. Still, it's an interesting idea that I'd love to see them experiment with.

Feb 11 02:16 PM