The Netflix Long Term Business Plan May Actually Work

Mar.19.12 | About: Netflix, Inc. (NFLX)

The recently -- and widely distributed -- Bullish analysis on Netflix (NASDAQ:NFLX) from Citigroup analyst Mark Mahaney pushed me to take a closer look at this stock. The Citi buy rating and $130 target price were based on an in-house survey measuring customer satisfaction with the Netflix service. The Citi analysts also estimated semi-fixed 2012 expenses of $1.8 billion for content and $300 million in promotional costs. The theory is that as new subscribers are added -- one million estimated for the year -- the extra revenue would drop right to the bottom line, an extra $90 million of profit for 2012. A quick look at the 2011 income statement shows net profit for the year of $226 million, so a $90 million gain looks pretty good.

However, my first though was that Netflix would not be able to drop the full subscription fees of a million net new subscribers all the way to the bottom line, so the profit growth would reach the levels the Citi analyst expect. So I approached my research into Netflix with a dose of skepticism.

The bearish arguments against Netflix continuing to grow the business are persuasive. The company even discusses the challenges it faces in recent earnings releases. Here are the major knocks against the Netflix business:

  • The Netflix service of streaming movies and older TV episodes will be overrun by the TV Everywhere offerings from the content providers. The best example is the HBO GO product from Time Warner's (NYSE:TWX) HBO networks. HBO cable channel subscribers can stream all of the HBO created content ever produced plus a wide choice of movies, at no additional cost. Netflix management expects most of the major networks to offer similar services.
  • Netflix cannot afford, or the content providers will not sell, enough current, in-demand content to Netflix to keep customers engaged enough to retain their subscriptions. The Achilles heel of the Netflix streaming business model is the company's position as a middle-man between content producers and end viewers.

In spite of the tremendous challenges faced by Netflix, I think there is a good probability the company will remain as a major and growing player in the over-the-top video streaming space. Here are my reasons.

Netflix has a major head start in the video streaming game. The company started streaming movies in 2007 and should have a significant knowledge base of what it takes to succeed. What Netflix provides is a service that is widely known, provides an easy to use service at a very affordable price and the company does buy enough content to keep customers happy. With these attributes, Netflix will hold its own in the U.S. market, adding customers and increasing the profit contribution from domestic streaming. There will be no best source of streaming video content, pulling customers away from all other providers. The majority of consumers will go with or stay with a name with which they are familiar and comfortable.

The company has cash and profit reserves to fight off competition. For the 2011 fourth quarter, domestic streaming accounted produces an 11 percent profit margin and contributed 21 percent of what the company calls contribution profit. The DVD rental business is still the cash cow of the company, producing a 52 percent contribution profit margin and the other 79 percent of contribution profits.

The growth potential for Netflix lies in the company's international expansion efforts. The push internationally was initiated in the second half of 2010 and focuses on Canada, the UK and Ireland and Latin America. Canada should work out fine for the company, with results similar to the U.S. Latin America has the greatest potential. The region has a large population base, growing availability of fast broadband Internet and little competition. The main competitors are the stores selling bootleg DVD's on the corner. DirectTV (DTV) has done very well offering service in Latin America and Netflix has similar potential. The tough international market will be the UK and Ireland where Sky GO and the BBC iPlayer have built audiences in over-the-top video services and Netflix must go in and compete against established players. If the company can do well in that market, it would be a very good sign for long-term growth.

Netflix management made a serious judgement error in 2011 with the announcement to split up the company. The positive of that misstep was to bring the share valuation down from stratospheric growth expectations. Any investment in Netflix should be viewed as a speculative holding. That said. there is a good possibility this stock will do very well for investors over the next few years, fueled by stable growth in the U.S. and stronger growth internationally.

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