Three years ago a few partners and I started a DVD rental company, much like the popular chain Redbox. Redbox was originally owned by McDonald's (MCD) and Coinstar (CSTR), but is now wholly owned by Coinstar. Our company functioned just like Redbox, but we owned it fully. Over two years the company produced decent returns, but nothing like Netflix's (NFLX).
Had we purchased Netflix shares the same day we started the company and sold them two years later, the same day we sold the company, our fortunes would have grown more than six-fold. Kudos to Netflix for its major growth.
But those days are long gone. Neflix is no longer the darling of investors that it once was. In fact, its stock dropped below the $85 mark after falling nearly 14% in Tuesday's trading, to finish just under the $88 mark. The stock posted Q1 revenues of $870 million and a $.08 per share loss compared to analyst estimates of $866 million in revenue and a $.27 per share loss. Analysts expected the loss as Netflix pushed to expand internationally, eyeing the European market. However, these better numbers still caused a strong drop in the stock as Wall Street questioned Netflix's growth forecast. For the astute investor, this drop provides a buying opportunity.
Investors seem to have forgotten that Netflix is not the next Blockbuster. Netflix, and particularly CEO Reed Hastings, has proved that it is capable of pivoting its business model when conditions make it necessary. While Blockbuster failed because it was trying to prolong its extinct business model, Netflix has thrived because it has shown an ability to adapt to what the market will want.
Right now the market has not realized that Netflix is preparing for the next wave of consumer taste, while still growing its existing business models.
Netflix did face a huge hiccup when it raised prices and split into two parts, separating the streaming business from the rental business (and doing it in one of the most ineffective ways - did they come up with "Quikster" by doing a quick office poll? Did they really think that people wouldn't mind creating a new account for Quikster?). These mistakes were the turning points that accelerated the stock's descent from its high above the $300 mark. However, despite its failure, the company is beginning to regain its bearings.
Currently the company is delving more deeply into streaming television shows. While the company lost its dirt-cheap, $30 million, four-year contract with Starz, which is owned by Liberty (LMCA) - even though Hastings was willing to pony up to $200 million for a new deal - the company is adding to its media library. Despite the loss of the Starz movies for its streaming collection, the company plans to continue to add television series, focusing on independent television shows.
I believe that consumers will be demanding more streamed television content in the future. College students, adults, and others who are busy want to continue watching their favorite programs, but at their own leisure. Further, with faster internet, slow college networks will not create a bottleneck for students wanting to consume this media.
What's more, the busier people become, the more they want to control their lives. Netflix has pivoted its business so that it will be in a perfect position when more consumers demand more of this type of control.
The 3 Who Can Ruin the Plan
Three groups can pose problems for Netflix. The first group consists of tech companies who want to steal away market share. Apple (AAPL), Amazon (AMZN), Google (GOOG), and DISH Network (DISH) are all companies that can harm Netflix.
Apple is well-positioned to offer a competing product with its strong user base of iPhones and iTunes. Amazon Prime users have access to content that competes with Netflix. Also, Google seems to be competing with almost everyone these days (even putting book stores out of business by giving free access to Google Books). Finally, DISH purchased Blockbuster and may decide to offer Blockbuster's content to its own subscriber base, eliminating the need for Netflix service.
Netflix should take all of these threats seriously. I believe that the company could respond by attempting a "land grab," adding to its 23.4 million users as quickly as possible, and then raising their switching costs so that customers face a fee or some other type of dilemma should they decide to drop the service.
Second, DVD kiosks pose a threat to Netflix's physical mailing and streaming business. After owning a DVD kiosk business, I realized a few very important details about the industry. Here is the most important-if you give the DVDs away for free, you can make more money than charging for them. How is this possible?
People forget to return them.
Our team realized that we made more money from people who forgot to return their DVDs to the kiosk. We ran specials where DVDs were free for 24 hours but then cost $1.49 for each day thereafter. If customers did not return the DVD within 5 days, they automatically purchased the movie.
Imagine the havoc that free DVDs would wreak on Netflix's physical media business. DVD rental companies would boost volume using the freemium model (Redbox already captures over 34% of the market), and they could improve profits in the process. In turn, Netflix's 7% 2011 year-end profit margin would be squeezed as customers fled to the free services.
While these two groups of competitors can cause quite a stir, the biggest threat to Netflix's business comes from its suppliers.
Hollywood poses a huge threat to Netflix as well. Investors are aware that Netflix depends on Hollywood for its content. But another threat has emerged.
Warner Brothers and Twentieth Century Fox have formed a joint venture with SanDisk and Western Digital that allows movies to be downloaded and stored on a thumb drive. This process is still in its early stages, but the move could cause Netflix to attempt yet another pivot in the near future as Hollywood aims to further protect its content.
In conclusion, Netflix is experiencing turmoil that provides a great buying opportunity for investors. The company is expanding into international markets, providing the company with improved revenue growth as well as volume growth. Also, the growth company's price to earnings ratio sits under 20.5, having fallen nearly 75% from its high of close to 80 in 2011.
Netflix is a good buy at current levels and a very strong buy if its price to earnings ratio would fall to 18, implying a price of $74.88. At this price, investors can make a profit by playing on Netflix's strong ability to grow and pivot its business.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.