If you like your Netflix (NASDAQ:NFLX) service for $7.99 per month, don't get used to it. And if you like your Netflix shares soaring higher (they're up 140% in the last year - and more than 500% since the end of 2011), don't get used to that, either.
Mark my words: Prices are going up. And share prices are going down. Here's why…
Strange Bedfellows, Indeed
On Sunday, Netflix caved and struck a deal with Comcast Corporation (NASDAQ:CMCSA). If you're wondering why in the world a streaming-video provider is doing business with a traditional cable television company, you're not alone. Even the Financial Times admits that the two companies make for "strange bedfellows."
Strange, yes. But thanks to the rising popularity of Netflix's service, the deal was inevitable. You see, cable companies do double-time as broadband internet providers. Comcast alone provides high-speed internet access to roughly one-third of U.S. homes. And obviously, without the internet, a Netflix subscription isn't worth squat.
It's important to understand, though, that Netflix originally built its business model on the premise of unlimited bandwidth. Apparently, no such thing exists, which management is quickly figuring out. As U.S. Netflix subscribers swelled to 33.4 million, so did the amount of bandwidth required to deliver the videos. Fast-forward to today, and Netflix users account for upwards of 30% of all internet traffic at any given moment. It's as if Netflix customers are hijacking the internet on a daily basis!
The only problem? The internet can't handle it. The network connections (or "ports") that are crucial for streaming video are "so full that today a significant amount of packets are being dropped," according to Cogent Communications' (NASDAQ:CCOI) CEO, Dave Schaeffer. For consumers, the congestion manifests itself in slow loading times or outright page failures. Put simply, it causes major annoyances, which could ultimately lead to a rash of cancellations.
Historically, broadband providers would foot the bill to upgrade internet infrastructure and solve the customer service nightmare. They'd do it far in advance, too, when ports reached about 50% capacity. But not anymore. Since the amount of data being passed through the network is so lopsided in Netflix's favor, they're refusing. A gutsy move on their part, for sure. But it just paid off.
A Win-Win-Lose Situation
The lack of maintenance has caused Netflix's performance to drop measurably in recent months. This weekend, Netflix finally buckled under the pressure and signed the deal. In short, the agreement calls for Netflix to pay an undisclosed sum to Comcast to ensure that its video data moves faster across the cable company's network.
In other words, Netflix gets preferential treatment for a price. No doubt, Comcast is going to use those payments to fund the necessary upgrades. (Winner!) Netflix customers with Comcast internet service promise to get a more consistent experience. (Winner!) As for Netflix, it gets socked with rising expenses. (Loser!) And that's just the start of it.
Prepare for a Double Whammy
I'm convinced that the deal with Comcast is a harbinger of things to come. Namely, Netflix will keep finding itself paying up to deliver its services. Look for Verizon (NYSE:VZ) to come exacting a ransom next.
I'm not alone, either. Schaeffer says, "Once you pay, it's like blackmail… They've got you, there's nowhere else to go. They'll just keep raising the price."
That's not the only rising cost Netflix is facing, though. The company must also pay for content. And with Amazon (NASDAQ:AMZN) and Hulu joining the streaming video race, those costs are increasing, too. Consider: Over the last two years, Netflix's content costs are up roughly 90% - accounting for around $0.90 of every dollar in streaming revenue. That's not a sustainable business model. Not at $7.99 per month. And not when we factor in paying for bandwidth.
A House of Cards
Add it all up, and Netflix's margins are about to get squeezed, which is something the company can ill-afford. It needs to keep increasing profits to even stand a chance at maintaining its sky-high valuation. (At current prices, the stock trades at a price-to-earnings (P/E) ratio of 232, which is a staggering 1,199% higher than the average stock in the S&P 500 Index.)
The only solution is to raise prices and add a ton of new subscribers, thereby passing on the cost increases to customers.
However, history proves that Netflix customers don't take kindly to price hikes. The last attempt in July 2011 prompted a mass exodus and sent shares tumbling almost 60% in a span of three months. And although the company is coming off a record quarter for subscriber growth, it can't bank on that momentum continuing indefinitely.
Basic economics dictates that each incremental subscriber will be added at a higher cost, as the market draws closer to saturation. That's even truer now that Netflix is facing increased competition from the likes of Amazon Prime and Hulu Plus.
Bottom line: Netflix's deal with Comcast signals a key turning point for the company - and ultimately, the stock. Given the stock's strong growth, I wouldn't look to sell shares short. That's too risky and volatile an approach. Instead, I'd limit my downside and use leverage to my advantage by betting against the stock with long-dated put options, expiring in January 2015 or 2016.
Disclosure: No positions