Netflix: Beset With New Challenges

May.11.11 | About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX) has had one of the best runs of any stocks in the market over the last two years. It has increased 800% in price over the previous 24 months as it has rapidly added subscribers and dispatched its main competitor, Blockbuster (BLOAQ.PK). However, the market is changing rapidly with new competitors emerging seemingly by the day. It also is starting to face some significant operational challenges. Given these headwinds, which I will outline below, I think Netflix’s rapid growth and stock price could be negatively impacted in the near future.

New Competitors
Google (NASDAQ:GOOG) is the latest entrant into the streaming video market. It is making 3,000 movies available to consumers through its YouTube property. The company just signed a deal with major studios including Warner Bros, Sony Pictures, Universal Picture's and Lions Gate Entertainment. Most of the streaming movies will be made available at the same time as the DVD release. Movies will be available for 99 cents to $3.99. Although not (yet) a subscription service, given Google’s deep pockets I could see this as a formidable competitor at least on the margins. Additionally, Google will rent movies through its Android Mobile Marketplace. It also will be another factor in driving up content costs.
Amazon (NASDAQ:AMZN) is looking to make inroads into this space. The company already offers free streaming of 5,000 movies and TV shows as part of its Amazon Prime service. Given Amazon’s expertise in cloud computing, logistics, and algorithmic prowess anticipating what a customer wants based on previous purchases, this could turn out to be a major competitor in this space.
HBO just created an iPad app that is going bonkers with 1mm downloads in its first week. HBO is the gold standard of original video and this is another way to distribute this content to users. In addition to these competitors, Netflix also faces competition from the Dish Network (NASDAQ:DISH), Wal-Mart (NYSE:WMT), Best Buy (NYSE:BBY), Apple (NASDAQ:AAPL) and Redbox.
Operational Challenges
All of this new competition is going to do a couple of things. First and foremost, it is going to drive up the cost of content. Michael Pachter, with Wedbush Securities in Los Angeles, said the exponential rise in Netflix’s license fees revolve around recent benchmark content deals completed with pay-TV channel Epix and The Walt Disney Co. (NYSE:DIS). Netflix’s license fees are projected to go to $500mm this year from $180mm in 2010. It will also impact operating margins, which are already challenged. Its total operating margin is already less than Comcast (NASDAQ:CMCSA) and it is likely to spend heavily to penetrate international markets in Latin America. Finally, Netflix’s operating cash flow generation is abysmal. Despite nearly doubling its net income from Fiscal year 2,008 to 2010, NFLX’s operating cash flow actually went down during that time period.
Prognosis: At around 54 times this year’s projected earnings and over 5 times trailing revenues, NFLX’s valuation is stretched given all the new competition and operational challenges it faces. NFLX sells at the very top of its five year range of valuation based on P/E, P/S, and P/CF. AVOID.

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