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Summary

  • Netflix's investment in content will cost more and take longer than anticipated.
  • The net neutrality rulings do not appear to be leaning in Netflix's favor.
  • Buying TWC or CBS just for their subscription based channels offers greater value then Netflix.

Netflix:

Netflix (NASDAQ:NFLX) the product is terrific. I am a subscriber and most people I know are subscribers. There is no disputing Netflix's popularity and that's why their subscriber count continues to grow. Management is sound and has done a great job of driving growth.

Netflix the stock is a different story. Through no fault of management, it has become grossly overvalued even with the recent pullback. At over 133x earnings and over 67x 2015 earnings, investors are clearly paying a premium for the anticipated growth.

Netflix is counting on international growth to realize that high valuation and at this point to me, it appears as though the challenges they are facing means that investors are going to be waiting quite a while. Even in the subscription based programming segment, there are better values that also offer increased diversity.

Content is king:

If you listened to the recent earnings interview, have a Netflix subscription, or take in any forms of entertainment - you know that content is king. Without quality content, no one subscribes. Netflix also knows this and reiterated it throughout the entire call. It is good that management understands this and with their recent successes, the Disney deal, etc. they clearly have a grip on what type of content its current subscribers want and they are ready to invest heavily in it. That is fantastic and will be imperative in retaining and acquiring new customers in already existing markets. The downside of this strategy is that it is very expensive - especially with increasing competition every day.

Mature markets:

Lets look first at what impact this content strategy will have to existing subscribers in mature markets as I actually believe this may work out well for Netflix in this area. Margins are currently at 27.1% in mature markets with Netflix targeting 30% as the limit. Anything beyond that, it appears that the plan is to put that additional funding into more content. I feel as Netflix increases their original, must see programming it will not only attract more customers in these markets but also decrease churn. If subscribers had a show that they needed to see being released every month or every other month, it would seem likely that fewer households would leave and come back. Again though, this is very expensive and I anticipate another rate hike would be required to do this and achieve the desired 30% margin. However, in these established markets I believe Netflix has the room to increase prices without a significant impact on subscribers so this strategy appears to be sound in these markets.

The headwinds in these markets however are quite substantial. Net neutrality and competition being the chief among those. Reed Hastings appeared to minimize Netflix's concern about net neutrality and they feel as though their argument is the correct one. I wont go too deeply into what the net neutrality arguments are however I will highlight the ISPs case in its simplest terms: Netflix is a content provider, just as they are. However, the ISPs have invested in the infrastructure and established the channel that Netflix uses to distribute their content. I wont make an argument of who is right or wrong in this instance but I want to point out that the legislators making these decisions stand to lose a lot by weighing on the side of Netflix. Here is a look at some of the biggest ISPs in the United States and their election contributions and lobbyist spending from OpenSecrets.org:

Comcast (NASDAQ:CMCSA):

Time Warner (NYSE:TWC):

Cox:

Netflix:

I know this isn't an exact science but it does give a small snapshot of just how intimately government and these companies are intertwined. How much weight that information carries to you may vary but it is worth mentioning and is part of the reason I believe Netflix will stand to lose in the net neutrality debate which will result in a larger expense than Netflix is letting on.

The second is the ever increasing competition. In the online streaming space; Amazon (NASDAQ:AMZN), Hulu, Yahoo (NASDAQ:YHOO), and Microsoft (NASDAQ:MSFT) all offer some version of original, on demand content. In the premium programming space, HBO and Showtime (NYSE:CBS) both offer great content and are also seeing increasing growth. On their recent call, Netflix was quick to say that they do not necessarily compete directly with these companies but are competing for a piece of the consumer's entertainment budget - that they are just another channel for subscribers to purchase. While that may be true, what they are leaving out is that they are directly competing with these companies for much of the premium, original content that is the focus of their strategy going forward. This again, will drive costs up even higher as it seems many companies with very deep pockets are attempting to get into this space.

International Growth:

There are a couple potential problems with Netflix's plan for international growth that they seem to be downplaying. As it stands, outside of the United States, only 20% of the content available to Netflix subscribers is local. While that may work in Canada and the U.K., will that same strategy work in Germany or France? Also, going back to the content strategy, how much impact will it have that some of these countries have already seen programming that is Netflix exclusive here in the United States, but airing via a different medium in another country that doesn't have Netflix. Chief Content Officer Ted Sarandos indicated that they would attempt to secure first run rights on all of their originals in the future but again, that sounds like an expensive proposition.

It is my belief that creating international content will be much more difficult and expensive than Netflix is giving credit for. For some countries, it may even be cost prohibitive versus the number of potential subscribers that are available in that area - leading Netflix to opt out of creating original content for that region and thus lowering their potential pool of subscribers. See the below chart from Variety.com:

(click to enlarge)

Would it be worth it to Netflix to create enough premium content that is culturally relevant in Poland, Spain, and Italy to potentially secure 3 million or so subscribers? France and Germany will be the major test for Netflix. I'm anticipating slower adoption and the need for more original, French and German programming than is currently factored into Netflix's stock price.

Summary:

I do believe that Netflix has plenty of room to grow. I think they are well run and will eventually be a household name in Europe but I do not believe it will be nearly as inexpensive or easy as the stock price would indicate and that investors may be waiting a while and in for a rough time if the net neutrality rulings and deeper European expansion go as I suspect.

If investors are really looking to invest into the subscription based, premium programming space, HBO and Showtime both offer great content and expanding international growth at a better value with the safety of diversity. Based solely off of the income generated just by HBO and CBS cable networks(includes Showtime and CBS sports), and applying that to the stock prices of their parent companies - Time Warner Cable and CBS , respectively - both have substantially lower P/E ratios.

 

Netflix

HBO

Showtime*

 

2Q 2014

Revenue

1340

1417

516

Operating Income

129

548

213

EPS

3.33

2.47

0.9

P/E

133.9

58.99

65.81

HBO in particular offers similar international growth prospects at a much lower valuation and is tied to Time Warner Cable which by itself appears to be moving in the correct direction and understands the value it has in HBO.

If Netflix can seamlessly transition these next 6 markets into an instant success, I would need to change my stance but I think the ride will be much more turbulent than Reed Hastings and crew are preparing investors for. That's not to say it can never be done, just that it may take some time and any hiccups that result in missed earnings will have a substantially negative impact on this stock, at these valuations.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Netflix's Headwinds Are Greater Than It Would Have Us Believe