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Netflix (NFLX) has been a favorite short target of Stone Fox for a while. Luckily we've never engaged in more than short term short positions on this stock as it's been one of the bright performers during this recession. The recession and high gas prices have in fact likely helped business as consumers have migrated to the cheapest forms of entertainment - DVD rentals via mail. It saves gas and eliminates late fees, all for a low monthly subscription fee.

Getting DVDs via the mail is clearly a doomed business as even highlighted by the CEO in this Wall Street Journal interview. It's actually pretty incredible that the business model as done so well considering the huge competition in the DVD rental space and the fact that renting by mail was actually seen as a step back for that market. After all, why wait days for a item via the mail when you could just stop at the local store and pick up whatever you wanted and the price of $2-4 per rental didn't seem overly costly? That's where the catch for the current and future business models comes in.

Current model: Netflix is able to provide a huge catalog of 100K+ titles that far exceeds anything that you can get at stores like Blockbuster (BBI). NFLX was able to obtain these movies whether the studios would license the titles to them or not. They could just go buy the movies at Wal-Mart (WMT) if needed. Plus, cost conscious customers could save money and via planning ahead have that desired movie in time for watching on the weekend. This gave NFLX an advantage with the access to unlimited titles.

Mr. Hastings's biggest challenge in reorienting Netflix is getting Hollywood to go along for the ride. Netflix's selection of more than 100,000 DVD rental titles is made possible by the "first-sale doctrine" of U.S. copyright law, which permits buyers of DVDs to lend them out without studios' consent.

In Netflix's early days, its buying team would sometimes purchase DVDs at local Wal-Marts or Best Buys if it couldn't get copies through studios, says Ted Sarandos, Netflix's chief content officer.

Future model: Providing on demand streaming video of movies is definitely the future of the movie rental business. Instant and cheap access to movies is exactly what the consumer wants. This sector will probably have more competition then video stores because of the barrier to entry is low assuming you can get rights to movies. It doesn't take a huge infrastructure to provide the service like it did with physical stores. You've also got to deal with Video on Demand provided by cable operators and so on. The issue really comes back to the amount of titles. According to the WSJ article, the internet streaming division only has 12K titles, far smaller then the 100K for the mail rental side of the business. In this case, the studios have been balking at NFLX having access to their movies. Likely a desire to use their own outlets instead and even a desire to keep DVD sales higher to keep that profitable business going.

In contrast, to deliver movies and television shows over the Internet, Netflix has to license them from studios. So far, it has gotten only about 12,000 titles, a hodgepodge of older films such as "Diehard," episodes of popular TV shows including "30 Rock" and a smattering of new releases.

The main reason: Netflix must compete with television subscription services like Time Warner's HBO, Viacom Inc.'s Showtime and others that gain exclusive rights to show studio movies on cable channels or through on-demand systems. These pay channels have bigger audiences than Netflix and a longer history of hashing out complicated licensing agreements to secure movie rights. Their lucrative deals can prevent Netflix from getting Internet rights for movies until years after they're released on DVD.

Mr. Hastings says he plans to stick to what he knows, software and online services. On the Internet, he is certain to face more powerful competitors than he has in the DVD-rental business, as Netflix competes for consumers with video services from the likes of Apple (AAPL), Amazon (AMZN), Google Inc. (GOOG) and Hulu, a joint venture of media companies including News Corp., owner of Dow Jones & Co., which publishes The Wall Street Journal.

"As a capitalist, I'd rather have Blockbuster as my primary competitor than all those Internet companies," Mr. Hastings says.

The shift in the ability to re-sale the movies via the internet is a huge issue for NFLX. Not to mention that movie rental $$$ will likely be in decline for a long time. It's difficult to bet against NFLX as they clearly recognize the importance to move beyond mail rentals, but it doesn't appear to be in their control. The movie studios clearly want a bigger piece of the pie which likely will leave NFLX out. They may likely grab a decent share of the old movie pie, but I don't see them getting new releases at a price that is reasonable enough for their service. VOD will likely dominate in that sector as the movie studios get a lot more money out of that deal.

For now the stock price is technically still strong as NFLX will likely continue to shine for awhile. After that though, they will likely begin to fade away as a company like an AOL. Until then, we'll continue to watch for the correct time to enter. This might be a stock we can ride down for a long time. The balance sheet is just ok having $250M in cash but making it difficult to compete with much bigger pockets like Apple or cable companies.

Disclosure: No position at this time.

Source: Why Netflix Is a Short