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Netflix (NFLX) shares lost a considerable amount of value over the last three months. The main causes of this loss include reduced subscriber guidance due to price increases and the potential loss of premium content from Liberty Starz Group (LSTZA). Netflix followed this up by segregating the DVD by mail and streaming services into two distinct entities. The question now must be raised as to whether these strategies are good ideas, bad ideas, or instabilities forced upon an unsustainable business model.

On December, 2010, Reed Hastings wrote on Seeking Alpha that Whitney Tilson of T2 should cover his short position against Netflix. In Mr. Hastings’ letter, he commented that “there is no specific content that we ‘must have’ at nearly any cost,” later adding that “if content costs rose faster than we expected, then in practice we’d have less content...” Mr. Hastings explained that in an effort to maintain high profit margins, Netflix would accept “less subscriber growth than we wanted from a not-as-good-as-it-would-otherwise-be service.” Flashing forward, Mr, Hastings has apparently kept to his word.

The business model Mr. Hastings has described appears to require a product whose quality and/or value must deteriorate over time. Generally, companies strive to improve quality and value, or at least maintain them. Cable operators are generally reluctant to lose desirable stations, whose content is important to the customer. The loss of the content provided by Starz (LSTZA) may not be wholly analogous to the loss of a local sports team’s cable station from a cable company’s roster or pepper from the colonel’s herbs and spices, but it does represent a significant reduction to the total quality of content offered through the Netflix streaming service.

This price for the right to stream premium video content, such as wide-release Hollywood movies has increased considerably since Netflix inked that deal with Starz, largely due to value recognized from the deal. As a Netfliz subscriber, I very regularly see the Starz intro when I stream a movie through Netflix and believe that the Starz content is fairly core to the Netflix streaming library. Starz apparently believes its content is considerably more valuable than it did previously, as it is believed the company turned down a ten-fold increase in licensing fees versus the expiring deal.

If other content producers and owners continue to play hardball with Netflix on licensing fees, and Netflix stands by Mr. Hastings’ not-as-good-as-it-would-otherwise-be service model, then the quality of Netflix service should be expected to only further deteriorate over time and/or continue to institute price increases. For example, CBS and Disney (NYSE:DIS) television content deals will also soon require renegotiation, and others will follow. Netflix will have to, again, decide whether to let that content go, creating even-worse-yet service or implement further price increases in order to maintain margins.

Apparently, Netflix was aware that something may alter growth. In 2011, the company stopped providing as extensive of guidance as it had previously, limiting subscription and revenue projections to the following quarter rather than the full year. Netflix then announced an increase to the cost of services shortly after the second quarter ended and shortly before Starz negotiations fell apart, as most believed they would. But can Netflix continue to grow its subscriber base now that it has told both current and prospective customers that their service will likely either continue to worsen or increase in cost, if not both?

Given the letter Mr. Hastings wrote in late December, it appears Netflix insiders may have then already known that price increases and/or content decreases were forthcoming within 2011. Netflix insiders have been prolific sellers of shares over the last year, while simultaneously instituting a stock buyback plan that largely purchased shares at a price $100 north of where it now trades. In the second quarter, Netflix bought its stock at an average price of $238 dollars, and it funded this program with bonds that pay 8.5% interest.

Essentially, insiders may have profited from withholding significant upcoming service changes from shareholders and customers, while also using a stock buyback plan to conceal the siphoning of equity through insider sales. Mr. Hastings, by the way, has options to buy Netflix stock for $1.50 per share and an automatic program to sell 5,000 shares per week.

One major issue that could be hurting Netflix here is that many content owners appear more interested in licensing per user and not per use. Essentially, if forced to pay for streaming content per subscriber regardless of their rate of use, then Netflix would end up having to pay such licenses for customers that may only, in practice, use the DVD service.

The inevitability, here, appears to be that streaming premium content pricing will increase in cost, and that if Netflix cannot accept a lower margin of profit that the owners of that content will find another website that will. In the meantime, Netflix is being forced to split the DVD by mail service in order to shield itself from excessive streaming costs it may incur due to those old fashioned DVD only users. Eventually, the streaming Netflix model will probably have to become more like a premium cable station or an On Demand services that are coupled into the cable/internet systems that most Netflix users need to stream content anyway. In short, the Netflix model was unsustainable.

Can Shareholders Sue Netflix or Its Board For Any of This?

There are two types of shareholder lawsuits, both with fairly similar starting requirements: (1) Direct suits, brought by the shareholder in their name, arising from an injury to the shareholder; and (2) Derivative suits, brought by a shareholder on the corporation’s behalf, arising from an injury to the corp. Both generally require that you first request that the board take action on their own, but suits can also attempt to justify why such a request would be futile. Statutes usually require that the shareholder post a bond, but this rule is eroding over time. The Model Business Corporation Act (“MBCA”) requires that the suing shareholder was a holder at the time of the alleged wrongdoing and at the commencement of the suit, with some jurisdictions adding that they must remain a shareholder until judgment.

Corporate boards have a strong defense to these types of lawsuits through what is known as the business judgment rule. Essentially, this rule presumes that corporate decisions have a legitimate business rationale behind them, and that the burden falls on the accuser to prove that directors breached their fiduciary duty (of good faith, loyalty, and due care). Failing to prove such a breach, the suit should fail. The primary exception to this is where the disputed action constitutes waste such that no business person of ordinary, sound judgment could conclude that the corporation received adequate consideration.

This hurdle is difficult, because courts will not second guess a business decision simply because an investor can offer of wiser hypothetical courses of action. Moreover, Netflix is a particularly dynamic and technologically advanced business that cannot be expected to evolve according to a traditional business model. Generally, pricing determinations are protected under the business judgment rule.

While it may appear highly unorthodox for a company to announce its intentions to offer deteriorating services in order to maintain its margins, and while this may also arguably not be a good long-term strategy, the desire to protect the corporation’s profit margins is a legitimate business objective. Moreover, Neflix cannot be expected to control that which is out of their control, such as the availability of content at a reasonable price.

One argument that could be made, in theory, is that buying of company stock during the second quarter constituted a waste, but the test for such waste is essentially whether the action was so one-sided that it was irrational. This plan is likely to have some accepted rational basis, given that corporate buybacks are common and that the purchases within the second quarter, though at far higher than present prices, represent a relatively small portion of the total company. Nonetheless, this does appear to be the strongest particular action upon which a shareholder could theoretically gripe.

If any shareholders are interested in discussing potential claims at greater detail, including information not discussed here, please feel free to email me directly.

Could the Feds/SEC Sue?

Beyond shareholders, some followers of this recent Netflix drama have alleged that the considerable insider selling that has occurred within 2011 was premised upon insider knowledge as to upcoming price, structure and content quality changes that were likely to hurt share value. Federal securities laws are primarily designed to ensure full and credible disclosure by public companies.

SEC Rule 10b-5 governs fraud in the purchase and/or sale of securities, and states that “a corporate insider must abstain from trading in the shares of his corporation unless he has first disclosed all material inside information known to him.” There are exclusions to falling under the purview of this rule, though, such as where those insider transactions are not actively made by the insider based upon information available at that point in time, but instead made pursuant to an automatic sale plan.

The SEC's goal in creating such automatic plans was to allow executives to sell shares without triggering insider trading charges. Requirements include setting up the plan when the insider does not know of any significant nonpublic information, and that they provide dates or prices at which trades should be made, then giving up control of those pending trades to a broker.

For example, I earlier noted that Mr. Hastings has an automatic program in place to sell 5,000 shares per week. In fact, Mr. Hastings has had such an automatic program in place for several years, including what would amount to millions of dollars worth of sales at prices significantly below $100 per share. Therefore, it would be difficult to prove a case against at least this one insider for recent sales prior to these recent announcements, as it appears he would have sold the exact same amount at nearly any price (and he will be making a profit so long as the sales are above his $1.50 stock option cost to purchase).

Conclusion

Whether or not Netflix has opened the door for lawsuits is one thing, but the real issue for Netflix is now whether the door has been opened for big money competitors to take away their unhappy customers. With every DVD Netflix mails me and every movie I now stream, the remaining pool of content is worth less and less, yet costing me more and more. If Netflix cannot continue to acquire premium content, sooner or later Netflix will not seem like such a deal.

Netflix essentially offers a pipeline for content owned by other corporations that have long histories of dealing with cable companies. These cable companies could use this period of instability to establish competing products that are integrated into their services, essentially expanding the cost and quality of On Demand services.

Beyond traditional video content providers, several wealthy technology companies could benefit from competing with a weakened Netflix. For example, both Amazon.com (NASDAQ:AMZN) and Wal-Mart (NYSE:WMT) are believed interested in competing with Netflix in terms of both cost and quality. Further, Apple (NASDAQ:AAPL) could attempt to expand its iTunes program to include a subscription rental option that it could seamlessly integrate into its popular products. Additionally, websites such as Hulu may become more competitive, relatively speaking. Hulu already has support from content owners in hand, being a joint venture of News Corp (NASDAQ:NWSA), Disney and NBC/Universal, among others.

Though Netflix is currently the dominant video rental service, most of these potential competitors have more cash on hand than the total market value of Netflix. A refusal to lower margins appears likely to result in competitors that are willing to accept a lower margins entering the business. If Netflix does not realize this threat, Netflix streaming may soon end up referring to customers switching to a new service that puts quality first.

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

Source: Has Netflix Opened The Door To Lawsuits And Competitors?