As Competition Grows, Netflix Looks Worse Than Ever

| About: Netflix, Inc. (NFLX)

After running to over $300 last spring, shares of Netflix (NASDAQ:NFLX) have turned in an awful performance over the past year and a half, dropping more than 80% to a recent trading range between $55 and $60. Investors who were expecting rapid earnings growth have instead seen revenue growth taper off, while profit has plummeted due to heavy investments in content and international expansion. Unfortunately, the outlook for Netflix is equally gloomy. In spite of the modest profitability of the video streaming business model, competition is increasing. As a result, Netflix will have difficulty generating the strong profit growth necessary to support its current share price.

Last quarter, Netflix released a decidedly mixed earnings report. While management touted continued subscriber growth both domestically and internationally, the decline of the DVD business is putting increasing pressure on Netflix's earnings. Thus, total domestic contribution to profit of $217 million was only 2% above the prior year result. While international revenue is growing rapidly, thus far this has only served to widen losses. Netflix believes it can eventually become profitable if it becomes the "first streaming service to reach scale" in each market. However, there is no guarantee that Netflix can achieve this goal, as it has limited cash flow to invest in adding content and subscribers. In other words, the prospective returns for Netflix's heavy international investments are very uncertain.

Moreover, I expect competing services to become a much more serious threat in the next year or two. Since announcing its Prime Instant Video service early in 2011, (NASDAQ:AMZN) has rapidly added content in order to grow its membership base. Although Amazon's library of 25,000 titles does not yet match up to Netflix's offerings, Netflix has been cutting some titles recently while the Prime Instant Video library is growing by leaps and bounds. Furthermore, Amazon Prime includes other important benefits such as free 2-day shipping and access to the Kindle Lending Library. All of this costs only $79/year at Amazon, vs. $96 for a full year of Netflix streaming-only access. Furthermore, Amazon offers a massive amount of additional streaming content on a pay-per-view basis, whereas Netflix's business is purely subscription-based.

Netflix will be gaining some additional competition soon. Verizon (NYSE:VZ) and Coinstar (NASDAQ:CSTR) recently announced that their joint venture, Redbox Instant by Verizon, will start up later this year. The service will focus on newer movie titles, and Redbox Instant (like Amazon) will offer additional titles on an a-la-carte basis. It is clear that Verizon and Coinstar are aiming for quality rather than quantity in the Redbox Instant content library. The service will offer very few titles compared to Netflix, but may nevertheless do better at offering the movies customers want most.

Netflix's biggest long-term challenge is that its competitors are better financed and highly motivated to gain share in streaming video. Furthermore, Verizon and Amazon have other businesses that produce significant cash flows, which can support heavy investments in content. I think that Amazon presents the bigger long-term threat, because its strategy revolves around driving Prime adoption. I expect Amazon to continue to invest in Prime Instant Video as a loss leader, as management believes that this will lock customers into the Amazon ecosystem and drive sales of other products. While I am skeptical that this strategy will work for Amazon, it is certain to hurt Netflix. By the end of next year, Prime Instant Video will probably have more content than Netflix, and Prime membership will still be cheaper than Netflix membership, while offering more benefits.

There is simply no way that Netflix can match Amazon when the latter views video streaming as an advertising tool more than a business for profit. Verizon and Coinstar may apply additional pressure with a lower price structure for Redbox Instant. As a result, Netflix is likely to see the domestic streaming subscriber count plateau over the next year, while the more profitable DVD subscriber base continues to shrink. Once this happens, Netflix will face a vicious cycle where declining domestic profitability forces cutbacks in strategic investments and compromises international growth.

Today, Netflix possesses no clear competitive advantage. While the stock has fallen hard already, it still trades at roughly 60X 2013 analyst estimates. Of course, it is possible that Netflix will find a way to stay one step ahead of the competition, through its own innovation or competitors' blunders. However, given Netflix's recent earnings weakness and the emergence of more competition, shares seem substantially overvalued today. To justify the current share price, Netflix would need to demonstrate (at a minimum) that it can restart domestic earnings growth. I thus rate Netflix as a sell or short.

Disclosure: I am short AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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