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When Netflix (NASDAQ:NFLX) recently announced a narrower quarterly loss than expected, the market punished the shares. The question for investors is whether the downdraft is a buying opportunity or is fully justified by the company's current prospects. This article examines how Netflix' business has evolved and what competitors it will face that weren't on the horizon when it went into business.

DVD By Mail

When Netflix launched, management dreamed of a world of streaming movies that just couldn't exist on then-available bandwidth. So the business started as a competitor to Blockbuster, with the upside that Netflix charged no late fees. This was sort of a backhanded way to admit that Netflix made more money the fewer times a user switched discs. By allowing unlimited duration borrowing, Netflix made sure nobody felt pressure to speed up another margins-eating DVD-swapping transaction.

The downside - that users could not switch discs on a same-day basis by dropping in at a bricks-and-mortar local store - was exploited by Blockbuster when it offered a by-mail service to its members, with in-store swap as a feature Netflix could not duplicate. But the bricks-and-mortar retail displays, and the need to stock and show customers at each retail location all the most demanded films, ultimately cost so much that price competition killed Blockbuster. Netflix was, hands down, the better way to rent DVDs.

DVD-by-mail is not the concept on which Netflix was founded, however - and is apparently not dear to management's heart. Last year, Netflix announced it would separate its DVD-by-Mail business into a subsidiary, apparently better to pursue its real passion unencumbered. Shareholders revolted: Netflix was the king of DVD-by-mail, and customers loved getting DVDs for the weekend. The simplicity of picking movies from one list, whether for delivery by DVD or for immediate viewing, seemed in jeopardy if Netflix jettisoned the business that had made it famous in the spin-off the reorganization appeared to promise.

Management backpedaled on the plan, but the damage was done: Did management really misunderstand so thoroughly what it was about its product that made it so loved? (Also, investors were worried that rate-hike defectors proved the company didn't have the pricing power or brand loyalty they'd hoped. But the dufus move of announcing a reorganization that confused customers about future services was definitely part of the problem.)

Streaming Content

By the time Netflix drove Blockbuster into a bankruptcy auction (in which Blockbuster was bought by DISH Network Corp. (NASDAQ:DISH)), Netflix and Blockbuster were both offering not just a DVD-by-Mail service but also streaming movies. The subscriber-side support for putting streaming movies onto the entertainment centers in which they had long enjoyed DVDs has improved over the last several years: Users can get Netflix content on their entertainment systems with a variety of third-party hardware from Microsoft's (NASDAQ:MSFT) game consoles down to Apple's (NASDAQ:AAPL) sub-$100 appliances. The highest grade of high-def video and digital surround sound are now easy to get to a home entertainment center, even without the relative complexity of stuffing a desktop computer into one's A/V cabinet.

Competition

The bandwidth growth to support on-demand high-def streaming isn't cost-free to users, but it's increasingly available alongside users' subscriptions to cable television subscriptions or Internet video services such as AT&T's (NYSE:T) U-Verse product. But therein lies the rub: To enjoy Netflix' service, customers frequently are driven to contract with Netflix competitors. Comcast (NASDAQ:CMCSA), AT&T, the private Cox Media Group, and other providers of video content to consumers have developed high-bandwidth data capability precisely because their products require it, and they intend selling their content to users - not allowing Netflix to take a cut to provide selected segments of the same content at the expense of their own offerings.

Netflix' competition for streaming goes beyond the old-school carriers. The back-end of Netflix' operation is the Amazon Web Services ("AWS"), which is an enterprise back-end product offered by Amazon (NASDAQ:AMZN). AWS supports virtualized server farms with massive and redundant pipelines to the Net. Netflix makes its money by streaming content through Amazon's rented back-end infrastructure at a lower cost than it collects from its operations to market subscriptions. This net includes paying Amazon fees for AWS at prices that allow Amazon to profit from the operation of AWS. This would be much more exciting, except that Amazon isn't simply a passive infrastructure vendor. In addition to selling DVDs (and virtually anything else users would want to buy), Amazon operates a streaming media service. Currently $79 per year, the Amazon Prime unlimited streaming service is cheaper than Netflix' (currently $7.99/month) streaming subscription, and Amazon Prime members get Amazon shipping discounts. Netflix' rate is more than 20% costlier than Amazon's, even ignoring applicable sales taxes. Since Netflix depends on someone else's back-end infrastructure, it will lack the margins of any competitor able to operate its own cloud.

The direct competition is worsening: To differentiate itself from the likes of Amazon, Netflix is creating original content. Not having seen Lilyhammer, the author can't speak to its effectiveness in attracting users but it's definitely been effective in making Netflix a direct competitor to content producers. Netflix has lost Starz, and with it such delights as Young Frankenstein. Recent additions of the Netflix streaming app to Sony hardware is no replacement for Sony's disappeared movie catalog. Disney (NYSE:DIS) content vanished with the Starz deal, but at least some of it returned under a separate deal also offered to Amazon Prime. How many times will kids want to re-watch episodes of Horseland? The solution to content is alternately paying more for material from widely-loved sources (Netflix as a replacement for channels people know) or Netflix offering content for which viewers will pay because it is unavailable elsewhere (Lilyhammer Season II and so on). Both have costs: Cash (licensing or production), marketing (educating customers what Netflix offers this year and why the changed lineup is worthwhile), customer comprehension of the meaning of Netflix (is it a cable substitute, or not?)

Conclusion

Netflix' 2011 rate-hike defections and product positioning fumbles have left questions about management's connection with customers. Current subscriber growth has been unimpressive, and the narrower-than-projected 1Q2012 loss leaves the company forecasting losses for 2012. Competition is heating up.

Netflix may be capable of surviving, but to what degree of success? Amazon's primary strength is in producing transactions at the lowest possible cost so that it can win price wars, suggesting that Netflix may be driving its business into the teeth of cut-throat commodity competition. The prospects for outstanding returns seem doubtful.

Matching Netflix against a more successful competitor may make an appropriate Long/Short investment. A competitor demonstrating both profit and growth is likely to make a successful long leg of a long/short in which Netflix' lackluster outlook offers protection from sector-wide movements unrelated to the competitive differences between the companies. Disney offers broadly-distributed media content through a variety of channels at high margin, and has grown its content-based earning capacity both through acquisition (Marvel, Pixar) and through internal improvements (films the quality of Bolt were not possible at Disney a decade ago; the Pixar acquisition seems to have improved corporate culture at Disney). Disney's monetization of content is hard to match, as it generates ongoing revenue from such characters as Tinkerbell and a host of cartoon princesses while raking in blockbuster profits from the likes of Iron Man. Netflix, in commodity competition to serve as a conduit to content, lacks a moat to protect any gains its content contracts may occasionally produce. It should be expected to perform relatively poorly in comparison either to a genuine content producer such as Disney, or a lower-cost streaming vendor such as Amazon. Investors interested in either Disney or Amazon might consider a long/short involving Netflix.

Source: The Future Of Netflix