A Believer In Netflix... It's Not Too Late

| About: Netflix, Inc. (NFLX)

I have written about buying Netflix (NASDAQ:NFLX) in the past, and have certainly been what you'd call a believer. However, after spending several hours going through its financials, its model, and more, I'm now more convinced than ever that his might be a good time to take a longer term position. In case you're wondering about my conviction, I've only done 2 such trades in the past 2 years, going long on Facebook (FB) in 2012 and Apple (AAPL) last year, both of which I still hold.

Is It Too Late?

If you look at the charts, it's easy to see why I'm considering the possibility that I missed out on the rally.

credit: stockcharts.com

Yes, clearly I could have gotten on this bandwagon 18 months ago, but after some analysis, I think NFLX will head much higher. A decade or so ago, Wal-Mart (NYSE:WMT) seemed to hold the ultimate model to dominate retail building superstores all over the country, and was destroying its competition through all kinds of methods. A young Jeff Bezos had devised a way to build a better retail model, and while he was ready to jump in, it was clear that he could not build the next generation Walmart by competing head-on. Instead of building a traditional retailer, he built a store that sold books, and it was only over time that Amazon evolved into what is clearly much more than books. Bezos charged ahead, and while you can argue that it has yet to prove it can generate significant profits, it is clear that Amazon is the way retail will be done going forward.

Enter Netflix

I think all of you would agree that the current TV & movie system is broken. It has been for a very long time, but no one player was going to break it. Customers hate paying $100/month or more to access all kinds of channels that they don't want, but there was no other way to do it. Netflix was going to change that but how? It's not like it could create its own content and start charging for it. How would that even work? Back then, no one had access to Netflix, and the percentage of the population willing to watch internet shows was (and still is) very small.

Step #1 - Build a Distribution Network

Netflix started off the traditional way; by renting out DVD's that were shipped by mail. Not only was it the easiest way to get licensed content, it also meant that Netflix was not perceived as competition by the major players in the industry. Netflix gained millions of users and eventually started offering a streaming service. CEO Reed Hastings was so clear on the future of his company; he declared that "physical movie distribution" would no longer be offered by Netflix, but rather by a newly created company. The concept was brilliant, but it was very poorly executed. Moreover, it created a "scandal," which forced Netflix to backtrack and get its members to switch through more traditional methods (pricing differences, benefits for those streaming, etc).

What Netflix did brilliantly was to decide not to build its own ecosystem. With this, they were not seen as competition, and thrived within the existing system. Netflix made deals with the likes of the Xbox, Playstation, AppleTV, smart TV's, DVD players, etc. Netflix was everywhere, and the company gained tens of millions of users. The biggest drawback was that the costs of acquiring content were very quickly rising because of the competition (Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG), Apple, etc), giving leverage to content owners when negotiating pricing.

Step #2 - Becoming HBO before HBO becomes Netflix

Netflix eventually announced it would soon start creating its own content. Why? There are many different reasons I would imagine, but I think these are a few:

-It's difficult for Netflix to promote its service with specific programs or movies because that would give leverage to those licensing such content.

-The margins in producing its own content were much more interesting to Netflix.

-While Netflix has always had a lot of high quality content, it would always be very challenging/expensive to access the "current" hit shows like "Game of Thrones", "Newsroom", etc.

-One major benefit that Netflix had was that HBO, a traditional TV channel is "stuck" in the traditional model. Consequently, small moves, such as offering its service on a platform outside of cable is incredibly challenging to do in the US. Netflix was never built in that "old" system so it is able to experiment, test, and adapt.

Of course, the major challenge would be to create content that was at the highest possible level. Netflix did exactly what was needed, going all-in with a $100M original series starring Kevin Spacey, "House of Cards."

Did House Of Cards Pay Off?

I'd argue that the value of the hit show is worth several billion dollars. Why? Within a year, Netflix was able to produce an award winning show that is being discussed in the mainstream media, and socially all over the world. Reed Hastings can now promote Netflix as the only place to see "House of Cards" and other Netflix original series that are gaining momentum, like "Orange is the New Black." These productions will generate millions of new members. One other major benefit is that Netflix owns ALL rights to the shows, and can easily now start offering some kind of service in new markets like Asia. House of Cards has proven to be a big hit in China which generates money but also a big boost in its brand name.

Netflix is now also producing its own documentaries and scored its first Oscar nomination for The Square after winning awards in the Emmy awards and the Golden Globes for House of Cards. Such awards help raise its profile all around the world.

Essentially, Netflix has no added cost to offer its shows in new markets even at little to no cost as an incentive to gain market share. HBO on the other hand has to deal with cable companies and all other levels of power at Time Cable before taking on similar experimentation.

If you've heard about House of Cards, you also know that a few more shows like this and it will become increasingly difficult for non-members to stay, non-members. If the hit shows are happening on Netflix, you'd be crazy to not try it right?

Step #3 - Expanding the Offering

In a rather surprising move, Time Warner (NYSE:TWX) got tired of the admiration towards Netflix, and released some numbers regarding HBO. Here is a quick summary:

HBO US members: 114 million
Netflix members: 33 million

HBO annual revenues: $4.9B
Netflix annual revenues: $4.4B

HBO operating income: $1.68B
Netflix annual income: $228M

You might think that while the revenues are comparable, Netflix is so far behind in terms of income that it stands no chance. I'd argue exactly the opposite.

I think these numbers confirm that Netflix is doing exactly what it should. Of course, producing its own content provides much bigger margins. We all knew that. But if Netflix had tried to become HBO from the very start, it would have needed to go through cable networks, and the whole conventional model. Instead, Netflix build a solid distribution, and can now expand its offering. It can start producing more content, thus becoming less dependent on licensing content. Over time, that should translate into bigger revenues. Who do you expect to have stronger revenue growth over the next few years, Netflix or HBO? It's easy to answer and I'd argue that 5 years from now, Netflix will also be generating higher profits.

credit: ycharts

Step #4 -Better Alternative to Cable

I'd also invite you to think forward. Just as Amazon was not only targeting the book industry, I'm confident that Netflix will eventually become a viable alternative to cable. What if Netflix starts bidding on some live events such as sporting events, Oscars, etc? It would likely move to Tiered pricing (which Hastings has already indicated Netflix is considering) which would mean subscribers would be paying for the level of service that they want. Sound familiar?

If you think that it's impossible for Netflix to bid for live content, I'd point you to those who thought it would be impossible for ESPN to one day carry NFL football and tennis grand slam finals. But as we know, they've been able to outbid the main networks, and I think it's very likely Netflix will one day be competing with ABC, NBC, FOX and others.

How big is the market?

Think about it... only in the US do you have tens of millions of cable subscribers paying close to $100/month, millions more paying for movies, etc. Netflix is barely scratching the surface.

Risks Involved

Of course, there are many risks and uncertainties involved in Netflix fulfilling its potential.

-Internet Speeds, neutrality: Recent questions about the future of the internet, how ISP's will end up treating traffic, and the continued improvement in internet speeds and bandwidth capabilities are critical. If you think about the fact that Netflix is already a major source of internet traffic, and is just getting started, it gives you an idea of how demanding it could become in the next few years. Netflix struck a controversial deal with Comcast recently that generated a lot of comments. It's a challenge to comment on it given how little we know, but it does seem like Netflix is now ready to strike similar deals with other ISP's.

-Competition: Players such as Google, Hulu, and a few others also could make a case that they are very well positioned to face off with Netflix. HBO is also on a mission to compete with Netflix at home and abroad.

In The End

I do continue to believe that Netflix will end up becoming one of the most important entertainment companies of the 21st century by disrupting the traditional cable model. Furthermore, I believe they will be rewarded greatly for it. It has set itself up perfectly for the next steps on its journey.

I expect revenue growth to remain steady in the US and accelerate significantly in its international markets. The game-changer though will be expanding margins as Netflix starts to leverage its own content.

How high can Netflix go? At $2B of income 5 years from now, Netflix would be earning over $20 EPS and still be in hyper growth mode. That is a bargain in my opinion!

Disclosure: I am long AAPL, FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.