Netflix Is Facebook's Predecessor

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Includes: FB, GOOG, MCD, NFLX, OUTR, ZNGA
by: Spencer Knight

It is hard to believe that less than one year ago Netflix (NASDAQ:NFLX) was soaring higher with no ceiling in sight. Unfortunately, this all came crashing down last July. The stock fell off a cliff during the second half of July all the way through November. To be fair, part of this free fall can be attributed to a systematic decline in equities. But for the most part, Netflix has struggled to maintain the same strength it once had.

Click to enlarge image.Click to enlarge

Source: StockCharts.com.

Netflix's story can be applied to Facebook (NASDAQ:FB). Facebook is scheduled to have its initial public offering sometime in the second quarter. Initial estimates stated Facebook will join the secondary market in May, but it may end up being pushed back to June. It is all speculation as of now.

More importantly, it is essential to note that Facebook will end up in the same boat as Netflix. This boat was once filled with gold and other treasures, but it has sprung a leak and is slowly sinking. Netflix was once the king of the movie rental industry, providing customers with on-demand access to almost any movie or television series imaginable. Similarly, Facebook is the leader of the social networking industry. But as Netflix has proven, there is only one way to go when you are at the top of an easily copied market.

Facebook will begin trading with a valuation around $100 billion, which, by the way, is more than McDonald's (NYSE:MCD). It is hard to imagine Facebook can be compared to McDonald's, but the underwriters seem to think so. Nevertheless, there are several kinks in Facebook's cogwheel. It is undeniable that Facebook is improving on the revenue side. It is also undeniable that Facebook's costs are increasing substantially as well. Facebook's costs are up 97% year over year, while revenue is up 44.7%. This is staggering.

On the other hand, it is important to note that young companies usually have higher costs because there is a tendency to invest in their future -- and this takes money. The problem with this is that Facebook was launched eight years ago. Therefore, the question is whether or not Facebook can be considered a young startup. If it is classified as a young startup, then the increased costs should be welcomed because they will ultimately pay off in the future. However, in my opinion, Facebook is not a startup. In this case, increased costs will continue to drain income and put pressure on the company to deliver higher and higher revenue.

Similarly, Netflix has continued to increase revenue year over year. But one major red flag on its income statement is an uncharacteristic increase in operating costs and negative income. The biggest issue with Netflix has been its inability to keep customers knocking at the door. Coinstar's (NASDAQ:CSTR) Redbox is the major reason for this. While Netflix has been seeing current customers cancel left and right, as well as a much slower increase in new customers, Redbox has been thriving -- even after a slight price increase due mainly to the hotly debated Durbin Amendment, which created higher debit interchange fees that businesses must pay when a debit transaction occurs. Nevertheless, Redbox has been bringing in nothing but good news for Coinstar. In fact, Coinstar raised the firm's 2012 guidance earlier due to Redbox's success.

This is important for Facebook because, as you can see, the once unstoppable Netflix has hit a wall. Netflix will need to create a pay-per-view service similar to Redbox. In this scenario, consumers will not need to pay a monthly subscription fee. They will simply only pay for each movie or television program that they watch. Unfortunately, for a business such as Netflix this will be difficult to do without stepping on Redbox's patents -- but not impossible.

Facebook, on the other hand, has faced similar problems. Even though Google+ (NASDAQ:GOOG) has more or less struggled to compete with Facebook, there are plenty of other social websites springing up almost weekly. Any of these can potentially be to Facebook what Redbox is to Netflix.

Facebook's biggest problem is ad revenues. It appears as if Facebook is struggling to capture ad revenues that are needed to keep moving the company forward. One reason for this is because the majority of Facebook users are in the younger age brackets and, frankly, do not care about ads.

Nonetheless, Facebook's stock will likely start high and trickle down, similar to Netflix over the past nine months and to other social media stocks. During this time Netflix's ship will continue to sink. I expect to see a plethora of Netflix bulls come to the rescue, stating that the firm is just going through a soft patch and will eventually move past this. Even if this is the case, the fact is that Netflix was not a profitable company in the first quarter of 2012. And while one quarter of unprofitability should not be concerning over the long term, if Netflix's business model does not change, then this unprofitability will be a long-term problem.

Expectations are high for Netflix and Facebook. Netflix has gone from producing $1.26 per share to a loss of eight cents. Netflix has also seen an incredible amount of subscribers cancel their service. To add insult to injury, these customers are likely using Redbox as a no-strings-attached alternative. Facebook, on the other hand, has seen ad revenues slow to about 37% growth on a year-over-year basis. This is concerning because it will be difficult for Facebook to improve on this growth rate.

Netflix and Facebook are not unique services. In fact, Facebook is simply a service. Facebook should not be regarded as a high-income platform because, quite frankly, without membership fees Facebook will not provide investors with enough income to sustain even a $10 billion valuation. Perhaps an outright purchase of Zynga (NASDAQ:ZNGA) could help create more income. Netflix, on the other hand, is being beat by financially aware consumers. Instead of promising a certain amount of income to Netflix per month, consumers are simply renting movies from Redbox. And unless a person rents seven or more movies per month every month, then Redbox is a much better option.

The bottom line is that Netflix's stock will continue to move lower because Netflix will struggle to bring in new subscribers at a rate that will please investors. Another reason for this downfall is because the movie and television suppliers are sticking high fees on their products. Therefore, Netflix must pay a substantial amount to keep their movie and television library filled.

Facebook bulls should take note as well. Facebook is similar to Netflix in that they are not in unique markets with difficult entry points. Keep in mind that Facebook is simply a social site. The system is used for socializing with friends. Facebook is the epitome of a service that everybody could easily do without. But since it's free, why not spend every hour on Facebook? Unfortunately for Facebook, those hours are not spent clicking on ads, which is Facebook's key source of income.

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