Netflix (NASDAQ:NFLX) and IMAX are probably the two most controversial media stock plays these days. I've outlined my bearish IMAX scenarios in past articles. IMAX has a great product; I just don't think the revenue model is ultimately sustainable unless the company reinvents itself.
Netflix provides plenty of fodder for bulls and bears alike. Like many products, Netflix disrupted the home video delivery market and reaped the rewards of its vision. However, the world of content delivery is rapidly evolving, and as streaming becomes increasingly utilizied, I think Netflix has trouble brewing.
I want to stress that I like Netflix's product, I love its selection, and its rating and information system has always been valuable to me. I am a subscriber to both the DVD and streaming products. But the stock may have seen its historical highs.
Business Model Past and Present
The company's core business model is to buy a DVD once and then rent it as often as possible. It's why timeshares are so profitable: Build a building and sell the units in it 52 times. There is no paying for libraries of content beyond individual DVDs. If streaming had never been invented, Netflix would likely remain the biggest DVD renter, although it's facing increasing competition from Coinstar's (CSTR), with Blockbuster now in bankruptcy and Movie Gallery gone altogether.
However, Netflix's move into streaming, which initially seems like a brilliant, first-mover strategy, isn't an arena where it has a competitive, technological, or financial advantage. Streaming technology is, or will soon become, a commodity just like home entertainment equipment. Every competitor will have the same technology.
Unlike DVDs, streaming rights cost money -- big money. Netflix reportedly put up a billion dollars for the EPIX rights (Paramount, owned by Viacom (NASDAQ:VIA), is part of the content, along with Lionsgate's (NYSE:LGF) and MGM's extensive libraries). Now, any company with deep enough pockets can jockey for position on having rights to streaming content.
Who has the deepest pockets of the possible competitors? Amazon.com (NASDAQ:AMZN) has $6.3 billion in cash and $1.8 billion in TTM free cash flow. Google (NASDAQ:GOOG) has $34 billion in cash and $6.9 billion TTM FCF. Apple (NASDAQ:AAPL) has $28 billion in cash and $29 billion in TTM FCF. Netflix has $350 million in cash and $270 million TTM FCF.
Netflix has a brand name, yes, but so do all of these companies. The brand name may not yet be in streaming, but all of these companies are extremely well -managed. Amazon is already streaming some content. Apple already has a platform with iTunes. Google is, well, Google.
This doesn't even speak to other possible competitors, which includes all of the content producers themselves. If they can make more money with a pay-per-view proprietary streaming concept than licensing the rights, they will. So add Viacom, News Corp (NASDAQ:NWS), Time Warner (NYSE:TWX), Comcast (NASDAQ:CMCSA) and Disney (NYSE:DIS) to the mix.
Content Is King
In my bearish argument for IMAX, my many years in the entertainment industry have taught me several things, chief among them that audiences can and do discriminate between good and bad content. IMAX is held hostage by content it cannot control. Netflix is in a similar situation; the best content costs more to get streaming rights for. Hedge fund manager Whitney Tilson has pointed out that Netflix has three choices:
- It can have a weak library and maintain low prices.
- It can license better content and pass the cost along to its customers, which would crimp growth.
- It can license better content and eat the cost, which would hurt margins.
Choice #1 will ruin Netflix's brand name, in my opinion. Choice #2 is playing out right now, and we've seen the outrage many customers are expressing with Netflix's big price hike. This price increase was, to me, inevitable. In order to maintain quality content, Netflix has already been paying big money (it also dropped $100 million on an exclusive original TV series starring and produced by Kevin Spacey). I just didn't expect the price increase so soon. Choice #3 may be the next step -- possibly inevitable if subscriber growth slows and churn increases.
Tilson also points out that the Epix, Disney, and Starz deals would cost $420-625 million annually. Now go back and look at the financial information above. Netflix had to increase prices.
Netflix isn't going to go out of business unless its competitors literally corner the market by bidding up the price of content so high that it cannot compete. The company is trading at 57 times this year's earnings. I'd be willing to offer a premium P/E on a company that had a lock on its market, great management, great balance sheet, and clear skies ahead. But Netflix has a lot of struggles coming down the pike. I do not see this valuation as sustainable. I have opened a small short position and set a stop about 10% above present prices. I will add to the short if the stock falls below its 200-day EMA at $225.
Disclosure: I am short NFLX.