- Netflix is at the forefront of a disruptive transformation in video content delivery.
- Content delivery is shifting from traditional broadcast modes (over-the-air, cable, satellite) to Internet delivery.
- Big Media companies such as the owners of Hulu are delaying the transformation in order to maximize return on their investments in the existing broadcast infrastructure.
- This only helps Netflix gain subscribers.
Hardly a week goes by that some new article doesn't appear bemoaning or denouncing the "excessive" valuation of Netflix (NASDAQ:NFLX). Netflix is at the epicenter of a profound disruption in the video entertainment (feature films and TV) industry. I've argued in the past that the valuation of such companies cannot be assessed by conventional means. The price of Netflix stock is subject to the law of supply and demand as all stocks. This market values disruption very highly.
Fighting the Future
The disruption I'm talking about is in the mode of delivery of video content. Big media companies such as 21st Century Fox (NASDAQ:FOX), Comcast (NASDAQ:CMCSA) (NASDAQ:CMCSK) and Disney (NYSE:DIS) are heavily invested in the traditional broadcast mode of distribution of their content through over-the-air broadcast, cable and satellite. Big Media knows that the future is in Internet-based distribution.
In the high speed Internet connected future, all household telecommunication needs are supplied through very high speed (100+ Mbit/sec) Internet connections. There may be some mix and match of wireless connections, but for the most part, stationary connections don't need wireless, and wireless bandwidth is at such a premium that it will be mostly reserved for mobile applications.
Video content will be delivered to the home via these connections, using the same protocol used for other forms of Internet traffic. At the connection level, it's all just packets of data. With a 100+ Mb/s link, a household could watch a couple of different ultra HD video streams (properly compressed) and still have plenty of bandwidth left over.
I think everyone in the industry realizes that this is the future, and it's a future in which broadcasting in the traditional sense ceases to exist. Everything is on demand, and users can elect to watch a "live" stream as it's generated or wait until later.
Many of us who already have fast enough Internet connections can get a taste of this future with Netflix or Hulu, but only a taste. It's not that the owners of Hulu, the aforementioned Big Three of Fox, Comcast (parent of NBC) and Disney (parent of ABC) don't understand the future of video distribution. The do, all too well. They've simply made a calculated decision to maximize the return on their investments in broadcast media for as long as they possibly can.
So the Big Three invest in Hulu, but hobble it as much as possible with a broadcast TV like experience, which means commercial interruptions even for the pay version. Except that the commercials aren't even as good as you get on TV. You know what I mean. How many times have we had to listen to the Daily Burn pitch?
The whole approach of Big Media is to make Internet video a second class experience, so that it's only desirable as an adjunct to a cable or satellite subscription. Or Internet delivery is tied directly to a cable programming subscription, such as HBO Go. Similarly, NBC streamed the Winter Olympics over the Internet, but you could only watch the stream if you had a subscription from a qualified cable or satellite service.
The recently announced deal between Disney and DISH Network whereby DISH will distribute premium Disney channels over the Internet represents only a slight variation of this approach. Under the terms of the agreement, DISH will be able to offer Disney content without making people subscribe to DISH satellite service or any other cable service. This represents a small victory for cable-cutters, but what is being offered is a cable-like experience, just delivered over the Internet. Most programming will be sent in traditional broadcast mode, with on demand programming limited to what's currently available to cable subscribers. This may change in the future.
And there will be plenty of commercials. In order to settle a lawsuit by Disney concerning the Auto-Hop feature of DISH provided DVRs, which automatically stripped out commercials from a recorded broadcast, Auto-Hop will be disabled for three days for Dish satellite broadcasts and be unavailable for the Internet streaming service.
Playing into the Hands of Netflix
The approach of Big Media to the Internet is typical of incumbent businesses facing disruption, but it plays right into the hands of Netflix by making Netflix one of the very few viable Internet destinations for cable-cutters, especially those who don't like commercials.
Last year I was skeptical about Netflix because I assumed that eventually Big Media would crush Netflix through superior resources and content. All they had to do was get rid of the commercials on Hulu and put up the premium content they were already distributing. It never happened.
And the resources of the Big Three are really huge compared to Netflix, as the table below shows (from WSJ MarketWatch):
2013 Annual Revenue
2013 Annual Net Income
2013 Cash and Equiv.
Current ROIC (%)
So it wasn't that the Big Three lacked the means, they simply abdicated in order to protect their existing broadcast investment. As a consequence, Netflix has added new paid subscribers at a consistent rate of about 2.5 million per quarter, and as of the end of 2013 Netflix had 41.4 million paid subscribers worldwide.
Rationalizing the Market?
I wouldn't try to justify the current valuation of Netflix. I think it's pointless. But I would point out one metric that I think is relevant, which is the Return on Invested Capital I included in the table. A good explanation of ROIC can be found in Investopedia. Basically, the idea is to assess the return a company is getting on its capital assets. Netflix is making huge investments in infrastructure and programming, and has borrowed $500 million to fund these. If the ROIC percentage is greater than a company's cost of capital, then the company is adding value for shareholders. The APR for the money Netflix borrowed is 5.38%, so by this metric, Netflix has a strong ROIC and is enhancing shareholder value.
The fact that Netflix passes the ROIC test conveys to me that it isn't just an empty bubble waiting to collapse. Although Netflix has been compared to many a dot-com bubble, I doubt that many of the bubble stocks of 1999 would have passed this test.
Will Netflix's share price suffer setbacks in the years to come? I can only hope.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.