The world is moving from linear TV to Internet TV and Netflix is leading that evolution.
Some may call the statement hubris, but I call it prescient.
The implications of the content consumption model are becoming abundantly clear as time passes. With more broadband accessible devices (TVs, tablets, computers, and smartphones) continuing to diffuse around the world, linear TV (as Netflix likes to call it) appears to be on its way to a multi-decade, secular decline. CEO Reed Hastings outlined the thesis in the Q1 letter to its shareholders:
People love TV content, and we watch over a billion hours a day of linear TV. But people don't love the linear TV experience where channels present programs at particular times on non-portable screens with complicated remote controls. Consumers click through a grid to choose something to watch. DVRs and VOD add an on-demand layer, at the cost of storage and increased complexity. Finding good things to watch isn't easy or enjoyable. While hugely popular, the linear TV channel model is ripe for replacement.
Now with nearly 30 million U.S. subscribers and 8 million internationally, Netflix, in my mind, has developed a critical mass of users that will allow it to continue to fund new, original content series and license exclusively third-party content. The way I see it, exclusive and rich content is the moat for the content distribution turned exclusive content creators such as Hulu -- jointly owned by Comcast (NASDAQ:CMCSA), Disney (NYSE:DIS), and 21st Century Fox (NASDAQ:FOX) -- and Amazon (NASDAQ:AMZN) Prime.
For me, it's easy to imagine a world where consumers "subscribe" to their favorite content. Google (NASDAQ:GOOG) is moving in that direction as well, allowing content owners to create subscription channels on Google's ubiquitous content distribution service, YouTube. No longer will consumers be subject to package deals from linear TV providers with loads of content they don't care about but are required to pay for. Rather, Netflix offers a better way to consume content and consumers only pay for what they want via a quasi a la carte service.
What is interesting regarding the competitive dynamics between the content distributors such as Netflix and content owners such as Starz (NASDAQ:STRZA)/(NASDAQ:STRZB), CBS Corporation (NYSE:CBS), DreamWorks Animation (NASDAQ:DWA), and Cartoon Network (a subsidiary of Time Warner (NYSE:TWC)) is that by allowing Netflix to exclusively license some of the less-heralded content of each content owner, Netflix is able to expand its wide-casting subscriber count. Netflix has demonstrated that with the sticky revenue from its subscribers that it had enough cash flow to go out and produce its own highly valued and rich content, which garnered 14 Emmy nominations for its original series, including "House of Cards" and "Arrested Development." That is some instant credibility and, in my mind, Netflix now has the upper hand in the content creation and distribution game. Not only does it have a loyal and expanding user base on its platform, but it now is developing some of the best content.
The situation described above is not dissimilar from the "Innovator's Dilemma" described by Clayton Christenson. By giving away the low end of the market, the content owners were able to focus on higher margin goods, services, and distribution mediums. Meanwhile, they were allowing a hungry and innovative business with an industry-disrupting operating model to gain a significant foothold in the market, thereby allowing it to climb its way up the value chain.
In my mind, the best way to value a high-growth model like Netflix is on a price-to-sales basis or -- even better -- a price-per-user basis. With 38 million subscribers, prospective investors are essential paying $380 per subscriber, which should diminish as the subscriber count grows. In October 2012, investors were only willing to pay around $100 per subscriber. Clearly, someone was wrong in October 2012: The stock quintupled to its current valuation in short order. As far as net additions to subscriber counts, Netflix management is targeting 1.1 million U.S. and 0.9 million net adds internationally. Cumulatively, that's 2.0 million more subscribers next quarter, representing 5.2% growth in subscribers sequentially.
Therefore, investors are paying about $362 per sub based on next quarters expected subscriber counts. Netflix certainly isn't as cheap as it was nine months ago, but it does, in my mind, represent a disruptive operating model. With launches in the United Kingdom, Ireland, Brazil, and soon the Netherlands, Netflix is beginning to capture more of its huge total addressable market.
With international growth up 155% year over year (on an admittedly smaller base than U.S. sales), the bears deride that Netflix as a can't-lose short candidate because of content costs. Bears must not like growth; adding 26% revenue growth in the U.S. in addition to international, Netflix is rapidly expanding its platform and brand recognition. That said, I do have trouble buying something that has quintupled in value in less than a year, so I'm sitting on the sidelines to see if the risk/reward equation tilts back in favor of buyers -- in other words, a large price decline.
I just hope I don't fall victim to what Whitney Tilson describes as the second most dangerous set of four words in investing: "Rats, I missed it." With a disruptive model, price and value could continue to increase at a rapid pace.
Netflix was hammered in after-hours trading on Monday, and was down around 4.5% as I write this. The key to investment success, as I have discussed before, is low expectations. However, Netflix, in my opinion, has a disruptive operating model and an incredible amount of tarmac in front of it to continue to grow its franchise.
While Hastings would like to keep his company, in my opinion, Microsoft (NASDAQ:MSFT) -- as I pointed out in a recent column -- should seriously consider acquiring Netflix. The future is in platforms and ecosystems, in which exclusive content will play a central role.