There are dozens of ideas being bandied about dealing with how Netflix (NFLX) should address increasing competition and rebuild a loyal following. That includes partnering with cable providers, which could bode well for the entertainment video giant that has long been seen as overvalued by investors.
When Netflix came onto the scene in 1997, it was a darling in the eyes of consumers and investors alike. It was rewarded with a fast-growing subscriber base, as also eager investors, that drove the stock above $300. However, as quickly as it rose, it fell, and now it is trying to redefine its self to its customers and to investors. To help it with these goals, Netflix should consider partnering with cable companies, according to a report released this week by Moody's Investors Service.
As Moody's correctly points out, such a partnership could open another sales channel that could lead to an increase in subscribers. I believe that Netflix is in dire need of having as many avenues as possible to deliver its service so a partnership can help it tap into a market of potential customers that it had not previously been able to access. This is imperative if it wants to increase its membership numbers. Netflix's huge misstep last year with regards to running up its charges on subscribers resulted in a significant loss of customers.
The company increased subscription rates by as much as 60%, and simultaneously set the stage for the exodus of almost 1 million customers.
I was one of the customers who jumped ship in protest of the rate increase. I knew that there were other companies that I could take my business to, and as Netlix's drop in membership shows, many others though alike. I believe investors must keep in mind that Netflix's revenues are largely derived from its subscriptions. So to have such a sharp decline in subscribers was indeed impactful.
Netflix's 52-week trading high in 2011 of more than $300 a share was way too high in my opinion. My sentiment directly relates to the many challenges the company still faces, despite clarifying its price structure to be more palatable to current and future subscribers. That main challenge relates to it having to compete with satellite and cable providers, not to mention others that offer streaming services, such as Amazon (AMZN).
For whatever reason, including its competition seeing it as a viable threat, Netflix has been dealt some blows over the past year. For example, this year the company lost a major source provider of movies to stream when Starz Entertainment announced it would not renew its contract with Netflix. Starz cited its "strategy to protect the premium nature of our brand…" I saw this as potentially crippling to Netflix because this was its main source to current and new release movies. Its streaming library was only a go-to point for me when I felt nostalgic and in the mood for a decade old, or older, movies. Shareholders should monitor such movie offerings because they directly relate to whether people will choose Netflix over its competitors.
The ratings agency also notes that a partnership with a cable company would limit competition from the cable industry. Considering cable companies are one of Netflix's biggest threats, in terms of subscribers, I think it becomes a case of if you can't beat them, join them. However, I don't know how willing cable companies would be to partner with Netflix. I think it would be in their best interests to position themselves to continue to take advantage of Netflix's weaknesses, such as the company's lack of resources to make its own shows for streaming.
Netflix was trading around $110 when this article was written, which was far below its $304.79, 52-week high. Its valuation problems mounted during the middle of last year when it announced a dramatically higher and altered cost structure. Outraged customers fled and investors sold, bringing the stock down to a more reasonable price.
However, even at $110, I think Netflix is still overvalued. It faces several challenges, including competing with satellite and cable providers, not to mention others that offer streaming services, such as Amazon.
Partnering with a cable company may leave Netflix in the same kind of predicament. I think it may be a challenge to find a partner willing to enter into an agreement. If one, or more, is found, Netflix may have to deal with an exorbitant amount of fees. I believe the reason goes back to the advantages cable companies have over Netflix. I think that one of Netflix's best moves will come from having shows that it produces. It's clear that its reliance on others, especially its competitors, is not at all reliable, and the Starz pullout is an example.
One of the cable companies highlighted by Moody's as being a possible good partner is Comcast (CMCSA). With an $80 billion market, Comcast does seem like a plausible partner that would benefit Netflix. However, the question becomes, would the cable giant want to partner with Netflix. I can think of many reasons why it would not, and again they all boil down to competition. Comcast already has a customer base; it doesn't need Netflix to stream its movies. Comcast would be in the driver's seat in a partnership with Netflix, and able to charge whatever it pleases. It has nothing to lose, while Netflix has everything to gain.
Netflix CEO Reed Hastings has reportedly been meeting with potential cable partners, although no formal agreements have been announced. I admire the tenacity the company seems to have to partner with a cable provider. Investors should take this as the company being willing to explore all avenues to grow its business.
Losing Starz left Netflix subscribers, who were already complaining about the lack of movie selection, in even more of a lurch. Since the rate increase debacle of 2011, Netflix has taken steps to shore up its offerings to customers and calm investors fears. This includes inking an agreement to create its own content through a partnership Twentieth Century Fox. It will produce new episodes of "Arrested Development" for Netflix. Also, Netflix has launched its first original series called "Lillyhammer."
CBS has indicated it may produce shows for Netflix. In what could be a major boon, Netflix has partnered with Apple (AAPL) to allow AppleTV customers to purchase a Netflix subscription through their iTunes accounts.
Netflix also stands to benefit from the many different tablets that are on, or that are coming to, the market that play streaming videos. Apple's new iPad, which debuts in mid-March will be able to play Netflix movies.
These types of efforts, if successful, may help Netflix decrease its reliance on others in the industry for its content. That could help it improve its gross and operating margins, which are 36.34% and 12.02%, respectively.
Those margins are in line with Amazon's, which is Netflix's main, publicly-traded competitor. Amazon was trading around $182 a share at the time of writing. Its earnings per share are $1.37, compared to Netflix's EPS of $4.16.
Amazon's market capitalization of roughly $83 billion dwarfs Netflix's roughly $6 billion cap, which I think significantly poises it to pick up any of the pieces that Netflix may fumble and drop.
Of note is Amazon's operating margin, which is very low at 1.79%. I think the company's free shipping offer seems to be the culprit behind the low margin. It is eating away at the company's operating income, and its operating margin. Amazon's strong revenues are partly the result of the free shipping offer that has enticed customers, and therefore increased revenues. I'm sure that doing away with the offer for the sake of stabilizing shrinking margins will be key for the company's valuation.
Shipping is an area that Netflix doesn't have to worry about. Its margin challenges relate to subscribers, even by its own admission. I think that the company's attempt last year to separate its DVD shipping business from its streaming business reflect its effort to get away from mailing movies. Netflix's allure when it came on the scene partly stemmed from it covering the costs of shipping and receiving movies. I think the company's focus last year to encourage companies to use its streaming service over having DVDs mailed was smart. It was a way for the company to rid itself of a major expense - postage fees.
If it is able to continue to grow the number of subscribers, Netflix can generate more revenue to license more content. It can also generate to increase its spending on research development.
All of these "ifs" play a major role with regards to the future of Netflix's stock - a target price between $85 and $90 is more reflective of its value. For now, the stock is a hold.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.