For those of you who know very little about it , Netflix (NFLX) can best be described as an online media distributor in North America (predominately in the U.S.). They have had tremendous success over the last five years, displacing traditional brick and mortar rental video chains like Blockbuster (BBI) and Hollywood Video. If you ask me, there are three main reasons why this business model has thrived up until now:
1) Internet model cost savings ideally suited for media distribution - Netflix presently employs about 600 people, in its heyday, Blockbuster employed over 60,000 full-time and part time workers. Blockbuster’s model required opening thousands of rental stores across America and stocking those stores with movie/TV/video game inventory.
Up until now, Netflix has run a rental ‘light’ model. By relying on online distribution, they significantly cut overhead, and do a much better job of managing their inventory. When you combine this approach with the fact that they share virtually the same content cost structure with brick and mortar stores, you can quickly understand why they have succeeded at being such a disruptive force. The company is a poster child for the success of the “free-era” of the internet.
With access to the net remaining extremely competitive and carriers constantly upgrading the speed of their networks, companies like Netflix needed to only come along for the ride. Of course this wouldn’t have worked so well if the companies controlling the content or traditional “on-line” distribution formats, like cable, had seen them as a threat to their business, but with DVD sales booming and cable and satellite subscribers still growing, that was not the case. Netflix was treated as nothing more than a threat to traditional rental chains, and was consequently left to grow as they saw fit.
2) Subsidized distribution costs courtesy of the US Postal Service - Let’s be clear, from a transitionary standpoint, a lot of businesses that have used the internet to replace traditional brick and mortar models would not have succeeded if the U.S. Postal Service was run as a for profit enterprise. If the USPS actually made money, Netflix would have had a harder time putting Blockbuster out of business.
A similar argument can be made with respect to state sales tax treatment of on-line purchases and companies like Amazon.com (AMZN). Basically, the U.S. tax payer has been subsidizing on-line rental chains like Netflix. This isn’t a shocker. Many for-profit enterprises depend on the government to run loss making businesses. The for-profit education sector is an example of such an enterprise. Netflix shouldn’t be faulted for profiting off attractive shipping costs, just as they shouldn’t be faulted right now for taking advantage of high speed internet connections to stream digital content. But there is one important distinction: The high speed internet connections that make streaming video possible are not being provided by subsidized loss making enterprises like the U.S. Postal Service.
3) Incredibly slow to adapt management at their primary competitor - All businesses succeed in part on the failures of others. It wasn’t enough for Netflix to identify that the “free-net” era would allow them to revolutionize DVD rentals. That, as they say, was only half the battle. To be successful, Netflix also needed Blockbuster management to fail to recognize that such a shift was coming. Had Blockbuster quickly invested in an online mail-in subscription based model, we most likely would not be writing this note today.
Regretfully, well at least for Blockbuster shareholders, they never did. That is the main advantage of being a disruptive business; established players often underestimate the threat you pose.
Moving into a purely digital world, Netflix no longer will benefit from a largely transitionary model. The use of post and centralized distribution to better leverage DVD content can no longer be counted on as business model driver. The era of the free internet is coming to a close, and companies that have thrived off of this model are likely to experience challenges.
What do I mean when I say the era of the free internet is coming to a close?
In its early stages, the internet was more about providing a duplicate platform instead of replacing one that already existed. This has been the case in retail, information consumption, and basic services. In 2000, you could buy a ticket online or you could book one through a travel agent. Today, odds are that the only place you are going to find a travel agent is in the Museum of Obsolete Trades. Basic services that could easily be moved online were probably the first type of industries to go from being duplicated by their net counterparts to ultimately being replaced by them.
In retail, we have witnessed a similar phenomenon, though the pace of transition has been somewhat slower and the odds of total replacement are probably lower. Content has been a different story. Outside of the music industry, online distribution has been more about duplication than replacement. This is probably because the technological hardware to support pure online digital media consumption was not there yet. Studios didn’t mind when clips of their content were posted on YouTube.com, and newspapers didn’t have an issue selling advertising on their web-sites while giving away limited versions of their print material. DVD sales were strong and online advertising revenue provided a nice ancillary boost to traditional print streams. The internet was viewed as a complementary distribution channel that was good for business.
That is no longer the case. Over the last few years, the internet has really started to wreak havoc on traditional content consumption models in the print and digital world. What content creators used to view as free advertising and potential duplicate revenue streams quickly morphed into a very serious business model problem as more and more people got hooked to free content. As a result, they have started to respond en masse to the digital shift, and are now going to great lengths to protect the value of what they view as high quality content.
This is where my longer term case against Netflix comes into play.
My basic view is that Netflix does not control its own fate. Content owners seeking to maximize the value of media libraries need a fragmented market for optimal pricing as they all are quite aware of the fact that exclusivity creates scarcity of value. Add in the fact that most studios are struggling to replace lost DVD sales revenue, and you can virtually guarantee yourself that there won’t be a one-stop online shop for film and TV content. It is simply not in the interest of content owners, and thus won’t happen.
This is bad news for Netflix as this is their ideal model. If they could , they would license every studio's content and then charge subscribers for access to their one-stop shop, potentially even tiering their pricing for more premium access. But again, this is not up to them. This fragmentation obstacle becomes an even bigger issue when you start to look at potential international expansion opportunities.
So, what will happen?
Over the last few months we have started to see two clear net strategies emerge.
- Pay for what you watch (rental or own) - The studios will continue to sell DVDs and allow retailers like Wal-Mart (WMT) and Best Buy (BBY) to sell digital copies of content on the same day that it is made available in stores. This preserves the window release model that the industry has been operating on when it comes to selling or renting DVDs despite the proliferation of the digital medium. Consumption is limited, but those that pay per view will get first crack at high quality content. Apple (AAPL) has now chosen this route as its preferred strategy by making its Apple TV nothing more than a gateway to rent first-run content from Disney (DIS) and Fox (NWS). Amazon (AMZN) is also competing on this front, and supposedly so will Google/YouTube (GOOG).
- Subscription services - Pay a monthly subscription fee for unlimited access to a content library. Netflix is pretty much the only game in town when it comes to this type of online service, though that is supposedly about to change. According to the WSJ, Amazon is entering the mix as it reportedly is in talks to launch its own subscription based service that will complement its rental service and also integrate its IMDB.com engine. Is Amazon willing to pay up to license a similar library within the type of window Netflix has targeted? Probably not, I wouldn’t be surprised to see them pay for non-exclusive access to a very vast library of older movies. Coinstar (CSTR) is also looking at integrating a kiosk/subscription model and is in negotiations with the studios. So, for at least a few more months, it would appear that Netflix is the only pure play internet movie subscription service in North America. (I am disregarding Hulu, which is owned by Fox, ABC and NBC. They are running a dual model that includes a free-advertising based streaming site as well as a plus version subscription site.)
If you ask me, I think the subscription based model is going to run into its fair share of challenges. It would appear that any company intending on running an exclusive on-line subscription model is going to be treated like a cable TV movie channel operator by the Hollywood studios. Basically, they will end up licensing content that will fall into a similar but separate viewing window as cable content, and they will compete purely as VOD version of such a channel.
The EPIX deal is a stop gap version of this and so was the previous Starz sub-licensing deal that Netflix signed. Going forward most cable channels have no incentive to enter into such stop gap revenue generating deals because they now view Netflix and any future subscription service as pure-play competition (sub-license to acquire a revenue stream but also risk eroding your pricing power and overall brand value???). And even those pay channels that are willing to sub-license are most likely going to need to negotiate those rights from the studios as future licensing agreements will contemplate such transactions.
This leaves online video subscription models like Netflix in the unenviable position of having to really pay up to license content libraries with very defined windows. The EPIX deal is an example of such a transaction. Netflix is supposedly paying about $200 million a year to license the content that EPIX, a subscription based pay TV channel, has access to. Under such a deal, Netflix users have access to all older EPIX content and also to newly released EPIX content after a 90 day window has elapsed. Since EPIX is a joint venture between MGM, Paramount, and Lions Gate (LGF), this deal provides access to quite a stable of high quality content.
But is the cost worth it?
Apple, Amazon, Best Buy, and Wal-Mart have focused on the old first run window that was Blockbuster and recently Netflix’s mail-in bread and butter. Netflix has instead chosen (or arguably been forced into) a strategy that has it going the route of the internet’s version of HBO or Showtime (without the original programming), which of course means it is going to be competing with cable channels on price, quality, and variety. EPIX is currently carried on Charter Communications (OTC:CHTRQ), Dish Network (DISH), Verizon Fios (VZ), Mediacom (MCCC), and Cox (CXR). So, why subscribe to Netflix? Why not just subscribe to EPIX or HBO for its movie library plus all its original programming and sports content?
Well, the obvious answer is that you can’t take your cable connection everywhere you go. Your iPhone or iPad on the road can’t quickly link up to your home cable subscription. Furthermore, your pay channels require you to buy a package of other basic programming that you might not want. So, Netflix is a more efficient and cost effective way to consume what you want on the go.
The problem is, this isn’t a mainstream model. Most people still like to watch major media on a large screen in either their living room or bedroom. They are more likely to retain such a service and seek internet duplication of it where available (and if practical), instead of trying to purely switch to an online medium simply for the fact that they can view some movies on their phone or portable device. Why? Well, you still want to be able to watch Bloomberg, CNBC, Comedy Central, ESPN, live TV, and the Food Network. Netflix doesn’t eliminate that. So, either all this content gets bundled into similar services, or the cable/iptv/satellite world eventually provides an on-the-go subscription that complements your home subscription.
Which do you think is more likely? The answer to this question is more of an infrastructure question. IPTV is already here it just requires a set top box. Why not move my entire cable subscription service to the net and then get the TV manufacturers to integrate the video and audio processing into my set (pure IPTV). That way I can take my home Comcast (CMCSA) or Time Warner (TWC) subscription anywhere I go on earth. That would be ideal!
Yes it would be, but regretfully we are not living in an ideal world. As I pointed out earlier, the era of the free net is quickly coming to a close. Why do you think net neutrality has all of sudden become a hot button issue? Companies that have invested heavily in building out the internet are not planning on sitting by and letting others continue to reap the rewards.
The cable nuisance/threat that a Netflix poses is just a small part of a much bigger problem. Content is not the only challenge facing a company like Netflix. They now also have to contend with carriers that want to recoup their significant infrastructure investments from the companies that are benefiting the most from them. As I discussed earlier, Netflix’s success is on the back of the free era of the net. An internet that doesn’t distinguish between the bandwidth being demanded by a company like Netflix that intends to stream hours of content to millions of users every single day, and that of an independent blogger with no more than a few hundred daily visitors.
The internet, up until now, has been NEUTRAL. Whether this lasts remains unclear, but current proposals are contemplating a shift for the mobile net that won’t include neutrality. This doesn’t bode well for a company like Netflix since the main driver behind the model is mobile digital video consumption. And even if such a shift doesn’t occur, the carriers and cable companies that control hard wired internet connections and rely on bundled service are bound to find ways to pass on costs to companies like Netflix. Subscription streaming services could experience the digital world's version of rising real estate costs.
And if this route is not chosen then you most likely are going to see these costs passed onto the consumer in the form of tiered pricing which will make the cost advantage of a service like Netflix a difficult sell. If Verizon, Comcast, and AT&T (T) want to recoup investments they are going to have to rely on bundled services. Bundled services that include TV, VOIP, and internet are how these carriers will recoup their investments. Bundling eliminates the arbitrage opportunity that some investors appear to think Netflix can exploit. If your basic package keeps climbing in price, then the advantage of a Netflix as a potential all encompassing content replacement package vaporizes.
Hopefully, this provides you with a decent glimpse into my thoughts on the industry. But what does this mean for the stock? And where could I be wrong?
At current prices, Netflix shares trade at roughly 60x 2009 reported earnings and 50x this year’s consensus estimates. It trades at over 40x p/b and carries an enterprise value of nearly 15x trailing 12month ebitda. By any rearview looking metric, the stock looks extremely expensive. However, when you consider that they grew eps by 40% yr/yr, the shares don’t look that expensive if you believe the company can keep growing earnings at 20% or more for the next five years.
That is where I disagree. At 15 million subscribers, Netflix currently has about 40% of the sub base of an HBO. At a much higher base, you would expect sub growth rates to start slowing down somewhat. That is not a shocker, but I think there is room for negative surprises in how quickly the rate slows over the next 12-18 months. The traditional rental customer is increasingly being afforded more options when it comes to digital online rentals which is not the Netflix model of the future. Up until now there have been few dependable sources providing cheap online rentals, and that has helped Netflix both by protecting its mail-in base that has access to new releases and providing a catalyst for sub addition via a limited streaming catalog.
Moving forward, I expect this to change. Netflix is bound to lose subscribers to point of sale digital sites as well as to other subscription services, all the while paying premium prices to reach critical mass in their content library. I expect that the next 8-12 months should prove to be the most challenging from a financial metric standpoint as Netflix continues to transition its model to a pure digital medium within the context of a much more competitive operating environment. Paying premium prices for limited window digital content is unlikely to add significantly to sub growth in the near term. In fact, one could argue that such acquisitions are necessary to maintain a loyal streaming sub base now that the novelty of the service has started to wear off. Since subs are not locked in and can cancel at anytime (at zero cost), there is a very good chance that churn could really pickup if on-line content quality/availability does not improve very quickly.
Consequently, I would expect gross margins, which have improved of late, to reverse course as content acquisitions costs rise sharply and sub growth rates stall. Whether or not you believe this argument against the long-term potential of the Netflix model, you probably would have to concede that the transition they are undertaking is bound to produce the type of volatility in financial metrics that don’t go well with aggressively priced stocks.
Where could I go wrong?
1) Netflix management could surprise me in some way.
To be clear, I have a very positive view of Netflix’s management. I think they are amazing, and was betting on them against Blockbuster five years ago. They are making all the right moves and have pretty much positioned the company to be a major player in the digital era. They seem to run the company with the view that everybody is trying to put them out of business. (Based on their first hand experience with Blockbuster you can’t fault them for being a little paranoid.) As a result, they have been quick to invest in a streaming model despite the fact that their mail-in business is still performing very well.
But this positive view on management doesn’t impact my view of the stock. The way I see it there is no way around the fact that Netflix will never be the online Blockbuster. It’s a content control problem that is further exacerbated by the current intermingled relationships between content owners and their cable networks. Cable and satellite companies already provide optimal distribution of content to the home. There is no mail-in convenience advantage to for Netflix to exploit. That’s a big problem when you consider the fact that for Netflix to grow into its valuation it needs to start replacing traditional consumption models instead of just offering a duplication alternative.
I do not see that happening. Yes, you can achieve tremendous cost savings if you cut your cable subscription to something barebones and just add a Netflix subscription to watch streamable movies, but what’s to stop HBO or other cable movie channels from competing on price or launching their own internet access subscription based service (already in the works for HBO) in the U.S. just to protect the value of their cable channel.
Furthermore, expansion outside of North America is a big problem. International content rights are licensed to a whole host of players all over the world. This obstacle is not going away anytime soon. Add rampant media piracy being the norm in many foreign countries, and you start to appreciate that international expansion is unlikely to provide a major organic growth driver for this stock.
2) A desperate goliath buys Netflix to gain a foothold in the digital media distribution market.
This has always been the biggest risk for those shorting this stock. There is not much you can do if a cash rich company is willing to drastically overpay to acquire a “new economy” presence. In Netflix’s case, despite the abundance of cheap capital, I think this risk no longer exists. As things currently stand, the Netflix digital model relies on third party cdn’s to host content, licensing of content from major studios and other content creators, and unfettered access for its subscribers to cost effective high speed internet connections. What they provide is a sub base and a very strong graphic user interface which customers typically find makes their mobile content consumption experience so user friendly. This is why you have not seen a single competitor buy this company over the past few years.
The consensus view is that everything that Netflix has been doing can be replicated when the time comes. It appears that time has come. In the last six months every single potential player you can think of when it comes to the digital world has entered the market or started to sharpen existing on-line media strategies. Amazon has been sitting on IMDB.com for years without tapping its full potential because DVD sales remained so lucrative (they also own a large stake in Lovefilm). Google bought YouTube.com and now is looking for ways to start monetizing the massive distribution network it has become. And Apple continues to pursue its own iTunes based tying all media to its devices approach.
All three of these giants have already invested in massive infrastructure to support their content marketplace goals, so bolting on more digital media offerings now that the device drivers are there is a no-brainer for them. And they all already have plenty of eyeballs so they would rather convert subscribers than buy them outright. The cable and satellite companies already have distribution and have been spending the last five years fretting over content so Netflix is a no-no for them, and most of them are now looking at direct distribution on the go alternatives to complement their traditional model.
The old school retailers are already pursuing their own separate non-subscription based strategies (Cinemanow and Vudu) which the studios have zero interest in abandoning as they complement blu-ray and other potential high margin early release window sales.
Then of course you need to rule out the desperate potential buyers like a Yahoo (YHOO) (out of their price range and also a bad idea with all the other scale players already involved) or Microsoft (not impossible but they have not pursued a control content distribution strategy which would be a major shift and significantly more expensive than going at it alone).
So, as you can see, a buy-out doesn’t really make sense for most suitors, and that’s before you factor in the current share price. Netflix’s stock is now its own worst enemy. It’s so overpriced that it actually reinforces the decisions of competitors or potential competitors to pursue what they already probably thought were more viable go it alone strategies.
What would I do if I was management?
I would go the AOL (AOL) - Time Warner (TWX) route. They should take advantage of a rich stock price (it’s not their fault the market is stupid) to acquire a studio and start offering direct sale early window releases as well as exclusive access to content. I would then consider starting or acquiring my own traditional pay-TV subscription channel so that a Netflix subscription could truly become unique, by existing alongside, and not in direct competition with traditional cable/satellite distribution (assuming I can get around the studio desired window restrictions). This way Netflix ensures long-term survival and can successfully pursue an HBO-esque global strategy. Start creating your own content to drive subscriber growth, which is what the cable channels have shown is how you make money, instead of hoping to dominate a marketplace that doesn’t want a dominant pure play digital distributor.
But make no mistake, no matter what route they choose the stock is likely to suffer. Either they overpay for Lions Gate or some other studio, acquire a Starz, or do nothing but sign licensing deals with studios for a ‘unique’ (and either “doomed” or growth “limited”) release window. Whatever course they pursue they can’t get around the shifting landscape and industry economics that are working against them.
For the record- If I had to be long an internet distribution play, I'd rather own a company like Open Table with an even higher p/e just because I am more convinced they can control their destiny. If they execute, Open Table could end up being the default (like Priceline.com, replacing and not just duplicating via the internet) way all restaurant reservations are made; I can't say the same for Netflix and movie watching.
Disclosure: Author is short NFLX and long LGF