Why Whitney Tilson Is Wrong About Netflix

Jan.21.11 | About: Netflix, Inc. (NFLX)

I'd like to start out this article by saying I wouldn't touch Netflix (NASDAQ:NFLX) stock with a 10 foot pole. That being said, I believe much of the "bear" case against NFLX simply doesn't hold up. As to Mr. Tilson, he may not be entirely wrong, but I strongly believe he frames his analysis in a way that doesn't tell the whole story. (Netflix CEO Reed Hastings responds here).

Of course their DVD by mail business relied on a more traditional economies of scale advantage. Surely their online streaming business is a largely uncharted territory for the company with significant amounts of diminishing barriers to entry.

However, the way the bears describe it, anybody could open up shop as a streaming business tomorrow and mirror the success of Netflix (of course they don't explicitly say this, but again, I think the issue is more complex than they frame it to be). I don't believe many of the bears' claims are completely true and would argue that there are actually significant barriers to entry to the streaming business. I've listed the following in order of complexity/difficulty to overcome:

1) The major studios and networks hate the trend to streaming consumption. It has destroyed their single most profitable revenue windows - DVD sales and cable subscriptions.

That said, the writing on the wall is crystal clear at this point - consumers are demanding it and they'll give up reasonably complicated tech workarounds to get it. The studios and networks know they have to play ball, and right now Netflix has a massive head start on the tricky and trying negotiations with the big license holders. Those rights holders don't like outsiders and it's taken Netflix a very long time just to get a seat at the kids table in their club. No other outsider is going to get in easily, if at all.

So, why don't the studios and networks just get together and form their own streaming business? Frankly, it's because they are direct competitors and getting in bed with each other is unnatural (as seen by the significant, yet largely unreported troubles at Hulu with different studios pulling shows or implementing restrictions such as air-delays).

Now, Hulu has had some success, but not all the networks and cable providers have signed on. Additionally, they aren't making enough money. They can't get an advertising based model to work online, and the subscription service hasn't really caught on (see YouTube: although the company has all the media and the right platform, they simply haven't found a way to make it profitable).

As for movie studios, the biggest group was EPIX, a joint venture between Viacom (VIA.B), MGM (NYSE:MGM) and Lionsgate (NYSE:LGF). On a shockingly fast timeline, EPIX signed the biggest licensing agreement in Netflix's history, giving them semi-exclusive window to stream 3,500+ late release films. This was a massive win for Netflix, and proves the studios are not interested in, or unable to, replicate Netflix's distribution model.

2) You need a lot of hardware partners to do this effectively.

A web browser and a smartphone application is just not going to cut it. You need access to the most entrenched set top boxes in order to really argue an attractive value proposition to consumers. Netflix owns the Playstation 3, Xbox 360, Wii, Apple TV, TiVo, Roku, scores of Blu-Ray players and TV manufacturers.

In short, they've negotiated prime real estate via an OEM to software model that these hardware creators will not give to other parties - the space is too valuable.

3) Their algorithm.

Netflix lives and dies by their online recommendation engine, powered by their famous algorithmic method of deciding. The company cares so much about this piece of their puzzle that they hosted a yearly competition in which budding quants could win up to $1 Million for improving their algorithm just a few percentage points.

What other online companies come to mind when one thinks about reliance on algorithmic recommendations - Google (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN). Pretty good companies if you ask me. Again, due to their dominance of input (lots of users) and mathematical tinkering, this will be a challenging advantage to overcome.

4) Consumer loyalty.

Yes, it's fickle and yes it can be bought, but Netflix has an extremely populist brand. They are "of the people" and "sticking it to the man". They have a trademark on the word "queue" and people are literally starting to ask for "Netflix recommendations" rather than "movie recommendations."

People have put a lot of effort into ranking, rating and otherwise fleshing out their online Netflix profiles - they will be reticent to do all this over again with another partner (See Pandora: the sites users have spent so much effort into personalizing their profiles and tastes that although superior products come out such as GrooveShark, its a tough sell to get members to switch).

In all, I still think that NFLX stock is overpriced, but many bears and short-sellers may not have as good of a case as they believe.

Whether Mr. Tilson or the NFLX bulls are correct I am not sure. However, one thing is certain. The truth most likely lies somewhere in between, with neither side telling exactly how it really is. Feel free to post your thoughts below in the comments section.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.