Can Global Crossing And WorldCom Teach Us Anything About Netflix Or Pandora? I Think So

| About: Netflix, Inc. (NFLX)


Online content providers like Netflix or Pandora trade at nosebleed earnings multiples.

The content they provide is of value but their distribution service will become a commodity.

When it does, the earnings multiples for these stocks will fall sharply.

Rapid growth leads to rapidly saturated markets. This game will mature in a very few years.

When it does, investors who paid up for growth might get spanked.

In the golden days when fiber optics were being introduced on a massive scale we saw a number of giants emerge. Global Crossing grew from a $35 million venture investment in 1997 to a massive Tier 1 communications provider only 5 years later. Bankruptcy followed with the filing showing assets of $22 billion, an incredible rise in 5 years.

Worldcom followed similar path growing astronomically and engineering a multi-billion merger with MCI Communications in 1997. By 2002, it was also bankrupt.

What killed these companies was not only mismanagement but the lure of disruptive technologies that had two characteristics: (1) high capital costs and (2) very low marginal costs approaching zero.

Both companies correctly foresaw the incredible growth in data communications that was in store and continues today. Both invested huge sums to build fiber optics networks around the world capable of moving vast amounts of data at the speed of light. Both failed when the market for data transmission collapsed around them as they and other players met one another on price in a downward spiral of competition that could only end in failure for all.

As competitors with the ability to sell a service with a marginal cost close to zero meet one another head on in a fight for market share, the results can be devastating. With fiber optics providing virtually unlimited bandwidth, prices for wholesale data transmission fell while demand grew. The result was falling revenues.

Source: WorldCom Special Committee report

Despite management's efforts to prop up the company's reported results through an accounting fraud, Worldcom share price simply collapsed in 2002.

Click to enlarge

Source: Special Investigative Committee of the Board of Worldcom

You might expect a similar fight to the death to arise in the software industry where the costs of replication of a program or application approach zero once the development is complete and with the Cloud to deliver the product distribution costs are minimal. But the fact that software is unique and not a commodity is a barrier to such an event.

Not so with online content distribution. No one has any particular advantage when it comes to delivering streaming music, movies or television programs. They are pure data and the distributor does not own the content. The online distributors have dealt a death blow to bricks and mortar distributors like Blockbuster and to an extent Barnes & Noble (NYSE:BKS) not by offering better content but by making it less costly and more convenient online.

Now the online distributors fight each other.

Services from Netflix (NASDAQ:NFLX), Pandora (NYSE:P), Spotify, iTunes and Amazon (NASDAQ:AMZN) provide branded access to online content for a monthly or annual fee or in reliance on advertising revenue and consumers love the services. Investors have loved the stocks as well.

While diversified providers like Amazon have other robust sources of revenue and provide content as an add-on to their core businesses, Netflix, Pandora and Spotify all typify the companies most at risk to the eventual competitive war that will ensue.

In the early days of Global Crossing and Worldcom, demand outstripped capacity by a wide margin and both companies enjoyed high rates of growth and were very profitable. When capacity caught up to and surpassed demand, competition shifted and with a pure commodity the only weapon with which to compete was price. The vicious circle of downward price adjustments for incremental sales took both companies (and others) to the woodshed but the licking they took was not just temporary pain but fatal to them.

The question investors should ask about Pandora and Netflix and perhaps others in the same space is the following: "Do I care who provides the streaming content or is it just the cost of the service I care about, other things being equal?"

If a provider can generate intense loyalty with something other than price, they will succeed. Netflix's moves to generate proprietary content suggest that CEO Reed Hastings sees this future problem clearly.

My kids used to spend a lot of money on iTunes. It did not seem like much at about $1.00 per tune but with six kids and each downloading a few dozen tunes a month and it became noticeable. iPods cluttered our house and became part of our whole house entertainment system and I did not see many days pass where the kids did not have earplugs on listening to a tune. Smartphones followed and the iPods became redundant since the phone did the same thing.

Now there are services like Xbox Music where I can stream all the content I want for about $8 a month. Or the Pandora's and Spotify's where the music is more or less free at some level. There are countless other services of a similar ilk. I don't see iTunes charges on my credit card quite as much as I used to.

Within a few years I believe that everyone with a broadband connection will have real time access to every song ever written; every movie ever created; every book on earth; and, every television show from the invention of TV to the present. Will they care who provides the service?

I don't think they will except for differences in price. It is the content that has value, not the delivery service.

For a while I can see all the players in the space grow, earn income and generate very high market valuations. But within a few years, the distribution service will be a commodity and much like a grocery store - high volume, low margin and not very exciting.

When that happens, and it is hard to see it not happening, those investors who paid 200 times earnings for future growth in Netflix or Pandora are likely to get spanked.

I am short Netflix and have no position in Pandora, Google, Amazon or Microsoft at this point in time.

Disclosure: I am short NFLX. 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.