Netflix (NFLX) has been on the cover of all financial websites for the past few days as pundits analyze its decision to separate the high-growth streaming business from the cash-cow DVD business. Personally, I believe it is a good, savvy idea that makes sense for the long term (although very poorly implemented and communicated) because it allows for Netflix to fund its growth while leaving the door open to sell the DVD business completely without further diluting its brand equity. So no, the number one reason to sell Netflix immediately is not its poor management, although that might be a close second.
The primary reason why you should not invest in Netflix is the reason why I have never bought the stock in the first place: lack of barriers to entry. ‘Barriers to entry’ is one of Porter's Five Forces along with Threat of Substitutes, Buyer Power, Supplier Power, and Degree of Internal Competition. Porter’s Five Forces is an analytical framework created by Michael Porter of the Harvard Business School. This methodology is extremely useful for identifying companies in profitable industries with strong business fundamentals. In essence, ‘barriers to entry’ asks the question 'how easy would it be for competitors to enter the market and succeed'? If barriers to entry are low then the company will have difficulty thriving in the long term as the product/service offering risks becoming commoditized.
My favorite example of superb barriers to entry involves Apple (AAPL). Anyone who uses an iOS device and has an iTunes account has a very strong incentive to stay in Apple's ecosystem; this is because switching will necessitate a significant investment for new applications. When you factor in the brand identity, cost advantages, economies of scale, and access to inputs you have a company with a very low threat of new competitors. Such strong barriers keep competitors from even trying, thus saving the dominant company from even financing a defensive effort. These are exactly the type of hurdles that you like to see from one of the most profitable companies in the world.
Now contrast this with Netflix. If you choose to stream from another provider you might be slightly inconvenienced for a day or two but it is quite a minor change. It is not difficult for me to imagine Apple, Google (GOOG), Amazon (AMZN), or even a group of content providers such as News Corp (NWS) /Disney (DIS) joining forces and then offering a superior service at a competitive price - thereby effectively cutting Netflix out of the market. With Netflix extremely vulnerable now I fully expect to see a figurative shot fired across Netflix’s bow before the end of the year. Even the diminutive Blockbuster (BLOAQ.PK) is directly trying to solicit customers from Netflix. When even your weakest competitors are challenging you there are problems. TheStreet has a good rundown of the likely candidates to take “Netflix’s crown”.
I am not even addressing the exorbitant P/E or shaky fundamentals of the company because the business model just does not work for me. In closing, fellow contributor Rocco Pendola wrote an excellent article that helps dispel the myth that Netflix is a value stock after its recent tumble. Nothing is worse than trying to catch a falling knife. I am generally a contrarian, but it appears that the market got it correct in this case. I still do not believe that Netflix will face a doomsday scenario in 2011 or even 2012, but the business model is so shaky that it is only a matter of time before a more robust competitor enters the market and eats Netflix’s lunch.
Furthermore, in the past quarter, Neflix has dropped almost fifty percent and there are signs that the bleeding could continue. Shorting the stock could be dangerous, but with so much downward pressure on Netflix, such a strategy could make sense. The more conservative approach that I would consider is to buy NFLX Jan 2012 LEAP Puts currently trading around $15. This provides significant maturity so that you can avoid a short squeeze on a positive spike while limiting your losses to $15 per contract versus potentially unlimited losses with a short.
- Netflix has a business model that is difficult to defend from competitors.
- Lack of management direction will cause unnecessary volatility.
- Consider purchasing LEAP put against NFLX to profit from future declines.
Disclosure: Author is long AAPL and GOOG; short AAPL October 22 415 Calls.