Why Netflix Is A Buy

Jan.11.12 | About: Netflix, Inc. (NFLX)

Netflix is one of those names I have had a special sort of bead on, having recommended it last January with valuation target met soon after, and warning people out of it formally in September, before much of its devaluation. The stock chart speaks for itself, so you might want to pay attention now. Read through the two aforementioned reports for background on the Netflix story. This report will focus on the company’s outlook, its current options and the stock opportunity. We also offer some free consulting advice to the Netflix team from a seasoned Wall Street warrior. They followed our last recommendation to kill the brand diluting Qwikster game plan, so who knows, perhaps there is hope and coinciding opportunity in NFLX.

Netflix (Nasdaq: NFLX) shares jumped 11.4% last Wednesday on a comment by Piper Jaffray’s (NYSE: PJC) Gene Munster, who said that the new CEO of Yahoo (Nasdaq: YHOO) might like the idea of bringing Netflix’s skill set under the Internet giant’s media umbrella. The stock kept going from there, but yesterday received a downgrade to “underperform” from “neutral” at Bank of America (NYSE: BAC). I started writing this article last Wednesday, and so I apologize for not publishing sooner, given the shares’ movement since. But where do we go from here?

After Netflix’s nightmarish year in 2011, giving up 61% of its value, this new light shed upon it has revealed something to me with regard to a shift in capital sentiment about the stock. Indeed, the simple analyst’s statement may even inspire other Internet names to take a serious look at Netflix as a tool to draw recurring traffic and to drive growth. Perhaps there might be some synergistic opportunity for such a combination. It was not too long ago that AOL (NYSE: AOL) set out on this sort of mission, after all, and Netflix does have broad appeal. More importantly to shareholders and prospective investors, the idea may have helped to put support in a floor for NFLX shares that already seems to be somewhat established anyway.

2011 was a nightmare for Netflix. The company’s management team (some might say dictatorship) was guilty of over-thinking things last year, and messing with a good thing while trying to stay relevant and on the cutting edge. You can do that, though, when you are the visionary who reinvented the way things get done in your field. However, it can get expensive making mistakes like these, which is the lesson of last year.

The company which is known for liberating movie renters from late fees, limited film options, and more expensive home film viewing costs, suddenly raised its pricing scheme. The company’s customer base, made up largely of cash-strapped, though tech-savvy pioneering types, was deeply insulted and knew exactly what to do about it. Social networking sites, message boards and YouTube channels caught fire with their expression of intense distaste and a vow to protest Netflix. Given the development of competition, via Redbox and the revived Blockbuster, now run by DISH Network (Nasdaq: DISH), outlets existed for effective venting. Or, perhaps the pricing change was simply not a good idea.

Furthermore, investors took note that the environment could get more competitive, with Amazon.com (Nasdaq: AMZN), Apple (Nasdaq: AAPL), Walmart (NYSE: WMT), Google (Nasdaq: GOOG), Comcast (Nasdaq: CMSCA), Time Warner Cable (NYSE: TWC), Yahoo (Nasdaq: YHOO), AOL (NYSE: AOL) and every major movie house capable of entering the game. Perhaps my first mention of this fact last year even inspired more active research into the idea.

Netflix has a more immediate problem though. Its streaming business has a high break-even point due to the cost of securing early access to hit films. Thus, even as the subscriber count has grown, it’s become unclear whether this delivery channel the company has placed so much emphasis on would hit profitability targets. As a result, its streaming film portfolio is limited, and given that it costs the subscriber extra to get access to the vast inventory of films delivered via regular mail, investor interest softened. That said, the nascent stock action is telling us capital sentiment is changing and there’s a solid floor in place.

Here’s why I believe Netflix still has great opportunity, as does the streaming business generally. It’s because of what I see developing for television. While it’s been long talked about – I remember Bill Gates discussing it in a Microsoft (Nasdaq: MSFT) video report at least a decade ago – Apple (Nasdaq: AAPL), Google (Nasdaq: GOOG) and others are about to revolutionize television. The evolution of the television has been undeniable over the last decade, but its focus has remained on quality of picture development and size reduction. However, the day is coming for more interactive television sets through connection to and usage of bandwidth. What that will do for Netflix and others is allow for more easy streaming of video content into more American homes than the company reaches today. It will make it easier for less tech savvy Americans to use the service and therefore expand the audience. Today you can use your TV, with the aid of your Microsoft Xbox, Sony PlayStation (NYSE: SNE) or Nintendo Wii (OTC: NTDOY.PK) gaming console. to stream movies. Tomorrow, America’s baby boomers will be able to stream films too, but more simply through their smart TV.

As I thought about this, I considered the risk of a flattening of the film distribution process. Perhaps that will occur eventually as competition is increasingly reaching across levels of distribution, but I don’t think it will happen immediately. That’s because of the economic value of the process of gradual release, squeezing the maximum profit at each point of distribution. Those who control the distribution of films are not about to kill economic value, if they can preserve it. So Netflix might find it has broader reach, without finding itself competing more with the likes of every cable company in the nation, at least not initially. And, as a result, it may offer acquisition appeal to one of those providers. Of course, if broadband is widely accessible through the television, then the Internet players like Yahoo and Google become potential suitors or competitors. There is opportunity, but also risk; we cannot assume to know how this suddenly dynamic industry will shape out in the end.

The evolution of streaming leads one to consider where Netflix might add value in its physical DVD distribution channel as well. This is where we suggested we may offer a consulting value add to our friends at Netflix. And if they’re listening, I’ll gladly take a complimentary subscription in exchange for a good idea, if not a few shares or warrants.

It is my view that the revival of Blockbuster, via DISH Network’s kiosk offering employing the acquired Blockbuster brand has proven effective. It’s also my view that Netflix is losing market share where it once stole it all, to Redbox and Blockbuster and others. I expect that many renters of films via the kiosk find it easier to do than through the mail, and not at higher cost in many cases. Yet, it’s very clear that Netflix is looking past the hard copy business to the future, which certainly is streaming. You cannot even figure out how to get hard copy films from Netflix’s website, until you begin the process of subscribing to streaming. It’s a mistake in my view, and is neglecting the strong core business the company still dominates at this point.

The problem is that the physical rental business is likely to die off more slowly than Netflix is betting on, in my view. The Netflix brand value would compete in kiosks on day one versus the Blockbuster brand, and there’s a readymade acquisition opportunity in the Redbox business. Let’s face it, all “Redbox” is, is a play on the red marketing package so familiar to Netflix subscribers, and that makes it almost perfectly engineered to fit in as an acquisition, in my view. This probably sounds like a crazy idea to the Netflix team, due to their emphasis on streaming and pioneering of mail distribution, but I see it as an opportunity to extend the brand to a significant portion of the market for film rentals. And I bet Redbox is itching to sell out to Netflix at this point, if not engineered for it from the start.

The significant changes that have occurred to EPS estimates over the recent past reflect the extreme difficulty in predicting the evolution of this market and its competitive aspects. There’s probably also a bit of penalty for management’s recent missteps. But, Netflix has established itself quite speedily as a brand to be reckoned with, and soon will offer people another channel option for film viewing with the help of TV developers. Its offering is competitively priced and will offer films at will to subscribers through the TV, versus a shorter list from the HBO types. I expect it will appeal to many.

Mark my words, when the smart TV is commonplace, the game expands exponentially for Netflix. Therefore, I view the risk/reward ratio here worthwhile, especially after the discounting of the stock in 2011. The analyst community is divided, evidenced by the great variance in EPS estimates from a high of $0.96 to a low of a loss of $0.75 for 2012. However, stock sentiment is solid now, as NFLX barely nudged lower today on the downgrade. Given that tax loss selling is over, the stock has even further support. Therefore, this is a stock to watch for aggressive portfolios.

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