Netflix: Why I'm Staying Short

| About: Netflix, Inc. (NFLX)

Starzs (LSTZA) decision to end contract renewal talks with Netflix (NASDAQ:NFLX) is certainly bad news for stockholders of Netflix—the stock dropped close to 9 percent in the after hours trading.

This development couldnt have come at a worse time, as Thursday Netflixs higher subscription price went into effect. Why should subscribers decide to stay with the company that may end up providing less contentment at a higher price, especially when offers from competitors like (AMZN), Apple Computer (NASDAQ:AAPL), and Google (GOOG) are offering better value?

As we wrote in a previous piece, Netflix, together with Open Table (OPEN), have been the poster children of web-based businesses that captured and captivated the minds and the wallets of the momentum crowd that chased after their stocks. For more than a year, the stocks of both companies reached for heaven but couldn’t get there. The problem, however, is that neither of the two companies have a sustainable competitive advantage, because they have no barriers of entry to protect their businesses from competition and because they don’t have bargaining power to get favorable prices for the stuff they buy from suppliers, as today's developments confirm for Netflix.

Netflix’s plan to expand overseas does not look that promising either. Selling movies online in a diverse world environment, where not everyone has access to fast broadband, and not everyone is interested in American movies, will be a tough task. A business model that works in America may not work overseas—that’s the lesson from Dell (NASDAQ:DELL).

In the 1990s, Dell Computer’s direct-made-to-order distribution model drove out of business scores of US computer retailers. Sales grew by leaps and bounds and profit margins soared, rewarding the company founders and the herd of investors who fell in love with the stock. But Dell Computer’s startling performance and stock run didn’t last forever, as the company failed to replicate its model beyond its home market (the US) overseas, due to diverse market conditions that require expensive localization of the company’s model.

In the last three years, Netflix’s direct movie distribution over the internet drove out of business scores of movie rental outlets, including Blockbuster. Netflix sales and profit margins and stock performance have followed similar partners. But as Netflix’s US subscriber base is approaching saturation, the company must look outside the US for growth, where it will have the same fate as Dell for several reasons:

1. Internet infrastructure. Netflix’s model relies on fast and inexpensive access to the Internet. However, internet speed is slower and costs are higher in most countries around the world, especially in counties where the “last mile” bandwidth has yet to be built, like Africa, Southeast Asia and parts of Latin America.

2. Language and culture. Netflix’s contentment consists mostly of English language movies; and English isn’t the only language spoken around the world. Each country has its own movies. India, for instance, produces scores of movies daily that require separate licensing. The same is true for European countries like France and Germany that produce their own movies. And even if such a market for English language movies does exist, Netflix’s pricing power will be quite limited.

3. Intellectual property right protection. In most countries around the world, intellectual property rights are hard to enforce. The probability of getting caught and sanctioned is quite low. This is especially the case in the world’s two most populated countries, China and India, where intellectual property is considered a social good--why pay for Netflix when you can download movies for free?

4. Competing distribution channels. Each country has its own movie distribution channels. In countries like Greece, for instance, older movies are distributed for free by major newspapers—why would someone pay Netflix?

The bottom line: Netflix's business model isn't working. Its stock was, is, and will be a good short, as long as there is a momentum crowd ignoring basic economic principles.

Disclosure: I am short NFLX.