Netflix (NFLX) CEO and founder Reed Hasting has every right to be proud of what he has accomplished. He identified a fatal flaw in the business model of then-dominant video rental king Blockbuster (OTC:BLOAQ), and over the next 15 years proceeded to catalyze a revolution in consumer viewing habits.
The company now has the look of a dominant player. Netflix has an enormous subscriber base; at approximately 26 million, the company's subscriber base is on a par with that of Time Warner (TWX) cable channel behemoth HBO. The problem with Netflix is that this combination of early innovation and current scale has not resulted in much profitability.
Following a run of success, management wildly misread its customer base in the summer of 2011. By announcing the splitting of the company into two: Qwikster, which would focus on the legacy DVD mailing operations, and Netflix, which would focus on the high-growth streaming operations, Netflix management lost sight of the key factor that powered the company's success: Focus on what customers want.
The unforced error of this announcement revealed a potentially disastrous divergence between what the company is and what management wants the company to be. The cold, hard reality is both simple and disconcerting: Netflix is a dominant player in a niche facing rapid change, and in pursuing growth it must leave behind a niche with high barriers to entry and expose itself to competition in an arena in which it is, in some cases, actually at a disadvantage. In short, this is a company moving from an area of strength to an area of weakness, and it remains to be seen just how it will survive.
The challenge now is what, exactly, management can do about it. Domestic subscriber growth appears to be tapped out, or at least approaching that point. It is hard to believe that there are a large number of U.S. households comprised of potential Netflix subscribers; among U.S. consumers at least, it is likely that everyone with an interest in Netflix is already a subscriber. Content costs, either for licensing the content of others or the development of propriety content, are spiraling higher and have already reached unsustainable levels.
Streaming is an area rife with competitors, many of whom have considerable advantages over Netflix:
Time Warner properties HBO and Showtime have both developed products allowing their subscribers a Netflix-like viewing experience. Additionally, video on demand (VOD) services from competitors EchoStar (SATS), AT&T (T) and Verizon (VZ) threaten to further undercut Netflix's streaming offerings.
The Prime Video offering of Amazon (AMZN) raises the specter of a competitor with a superior infrastructure and deeper customer relationships duplicating Netflix's streaming offerings while also beating the company on price.
Hulu, though it suffers from fractured ownership with competing agendas, remains a threat with its Hulu Plus offering. Owners Comcast (CMCSA), Disney (DIS) and News Corp. (NWS) all have a strong incentive in keeping pressure on Netflix and maintaining a thriving market for their content.
Additionally, Netflix is under attack in its area of strength, with Coinstar's (CSTR) Redbox kiosks skimming customers looking for a smaller selection and same-day access to physical DVDs.
One of the biggest challenges Netflix faces is that with each of the competitors listed above it simply does not have the financial firepower to compete. True, each views their competition with Netflix with a differing level of priority, but nonetheless that is an uncomfortable position for any company to be in.
Time Warner: Market Cap of $41 billion, TTM EBITDA of $6.9 billion
EchoStar: Market Cap of $2.8 billion, TTM EBITDA of $619 million
AT&T: Market Cap of $198 billion, TTM EBITDA of $35.2 billion
Verizon: Market Cap of $128 billion, TTM EBITDA of $31.7 billion
Amazon: Market Cap of $108 billion, TTM EBITDA of $2.15 billion
Netflix has brought a knife to a gun fight.
A review of Netflix's most recent annual report is illustrative:
Sales: From 2007 to 2011 sales increased substantially, rising from $1.2 billion to $3.2 billion over the period.
Profitability: Gross margins have trended upward, increasing 1.5 percentage points over the past five years (to 36.3% from 34.8%). Operating margin has done even better, rising over 4 percentage points in the past five years (11.7% from 7.6%).
Cash Flow: While operating cash flow has remained strongly positive over the past five years, it has not increased as much as might have been expected. Operating cash flow in 2011 was $317.7 million, up only 14.5% from the $277.4 million level achieved in 2007. This moderate rise in operating cash flow during a period when sales increased 165.9% and operating income increased 309.8% suggests considerable limits to the operating leverage in Netflix's model. Technology and Development spending has increased substantially, reaching $259 million in 2011 from $114 .5 million in 2009.
Streaming Content Obligations: The company currently has at least $3.9 billion of streaming content obligations not reflected on the balance sheet. Of these obligations, nearly $3.2 billion are due within the next three years.
Thesis: It is difficult to look at Netflix and see an attractive investment opportunity. Despite a 15% decline this year, the company remains aggressively priced at 23.6x TTM EBITDA. Additionally, low return on equity (8%) and the large off balance sheet streaming content obligations suggest that further declines would be justified based on fundamentals.
Recommendation: Netflix is in a strategic bind, and shareholders may have no good way out. Competition in the streaming business is driving up content costs, Redbox is chipping away at the DVD business, and the company is so highly priced that improved fundamentals could very well result in no price movement at all. It is hard to see upside here. Investors would be well advised to wait for a pullback to around $60 before buying.