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Peter "Pej" Hamidi is a well known trader on Wall Street and Founder of InvestmentCapitalist.com. He is presently a Quantitative Proprietary Trader running a global macro portfolio. By presenting a unique global macro perspective of financial markets, technology and the geo-political landscape... More
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  • Netflix And Managing Short-Term Profits From A Long Term Core Holding 0 comments
    Feb 13, 2012 3:49 AM | about stocks: NFLX

    In late December, early January, there was widespread talk about the potential earnings hit Netflix (NFLX) was destined to take as they prepared to enrage their customers by implementing two huge changes. The first was an across the board membership price increase, which didn't include streaming-only memberships, and the second had to do with the breaking off of negotiations with Starz, which wanted an almost 10-fold increase in royalties in order to allow Netflix to continue streaming media from Starz's vast catalog. What many analysts said would be a major faux pas, we strongly disagreed with then and still do. Netflix has proven to be nimble and strong at the negotiating table such that they've made Starz look like business fools to walk away from the pile of money Netflix was about to give them. Starz played the hand as if Netflix would lose a chunk of revenue from membership cancellations when in fact, Starz made up only 8% of the company's streaming content. And since they have been quick to replace that 8%, it's been rather quiet as far as customer complaints go. Losing Starz was certainly not the end of the world for a company that generates tremendous free cash flow. Moreover, Netflix made the right decision to walk away because it saved them from eating into their growing hoard of cash, which they can use to acquire other content from various sources. More importantly, with SOPA hanging over media streaming, even if it appears to be dead in the water, the recent shutdown of Megaupload has pushed a lot of web media viewers towards legitimate sources of content which they don't have to pay per view. In other words, rather than the "iTunes" model, where you buy the music and can only play it on your iPod, Netflix's subscription model for streaming media allows members to view whatever is available whenever they want and however many times they want. This keeps their pricing model simple, members know exactly how much they're going to pay each month and it becomes a "sunk cost" to the consumer. And at $8/month for streaming only, it's an incredibly small slice of every family's entertainment budget, which in fact appears to be a recession proof model as more family's turn towards stay-at-home entertainment rather than spending $100 for a family of 4 to go to the movies on a weekend.

    Since they're paying for the subscription, family's will watch enough content to "feel" satisfied for the price they're paying. Moreover, it's not just about accessing Netflix through your Samsung SmartHub function. Anyone can access the streaming media using their computer's, so while mom and dad watch a boring romance flick, the teenage son can watch a horror flick with his girlfriend and the younger sister can watch a teen-bop flick with her friends during a sleep over. The flexibility is what gives Netflix a tremendous competitive advantage over other media options, and what's more is the Fed's won't come knocking for torrenting copyrighted material and breaking anti-piracy laws. For all that, what's $7.99 when it gives you access to an enormous pool of streaming content which continues to grow by the day? The move to raise prices for subscriptions involving DVD rentals was apparently designed as a pre-emptive strike to eventually condition customers to move over into a streaming-only subscription package as that would dramatically reduce Netflix's fixed overhead and widen already fat gross margins.

    Perhaps in five years, we'll see tiered pricing like today's cable television, which charges more for premium channels. Netflix is ideally positioned to benefit from the Tsunami effect after Congress implements some version of anti-piracy laws being discussed on Capital Hill. Although the metrics aren't broken down in detail for us, sources inside the company alluded to the closing of Megaupload and voluntary shut-down of sights like btjunkie and FileSonic as having a marginally positive impact on new subscriptions. However, it's difficult to say because the company is consistently adding subscribers faster than its attrition rate, but all evidence points to an immediate spike in streaming memberships after the wave of voluntary and involuntary closures of some of the biggest torrenting and direct download sights.

    What the movie industry needs is similar to what the music industry has with the RIAA, a central depository for royalty payments that distributors can work to streamline payments via a single source. Netflix has the mass, the eyeballs and an entrenched customer base to allow them to move towards a more copyright friendly model in partnership with all the major studios, perhaps even competing with the cable company's "pay per view" and "on demand" offerings. If Hollywood is considering releasing new movies in the theatres simultaneously with on-demand via cable and satellite, why not through Netflix? The latter has a much wider reach and a single point of negotiation rather than the fragmented cable industry. Netflix comes standard on most internet enabled Blu Ray players as well as HD and 3D television sets with internet functionality, whether wireless or wired. Now that we're able to stream media wirelessly from any handheld or mobile device to a "WIDI", or Wireless Display enabled TV, the opportunities and imagination can run wild. Everything falls together in a way so perfectly ideal for Netflix that the stock is worth a fraction today of what it will be worth in 7-10 years time.

    As much as the bears hate what we've been saying, Netflix is rapidly becoming ubiquitous in almost every home with internet enabled, HD/3D T.V.s. Furthermore, as Apple is showing, their new Apple TV is taking off as well as the new Google TV. Both are merely app's designed to push revenue towards these two giants, but at the end of the day, Netflix was the first and prime mover and therefore holds an enormous lead against its competitors. The company's subscription based business model and a mostly fixed cost structure creates scalable profit margins that are already fairly wide. That's an amazing business opportunity and appears Netflix may be at the dawn of a golden era, especially as broadband becomes faster, more accessible and expands to mobile devices opening up an entirely new market mass consumer market. This is also why the stock didn't stick around in the low $70's too long, blasting to the mid $120 level almost a week after we began picking some up as long term core investments.

    The Netflix long recommendation made in early January on Seeking Alpha and covered in extensive detail on Investment Capitalist produced windfall gains in less than a month. As previously instructed, when a windfall gain manifests in a short time-frame, most believe they've begun a marathon whereas an intermediate term trader positioned for the move when it happened feels a little closer to the finish line. The first major target is $150, but as I've always stressed, it's crucial to trade around your core position. Expect some backing and filling over the next few sessions while the stock gathers the strength to punch through $125. Consolidation for another push will happen only after weak, fast money traders sell to smart money buyers with longer time horizons. Their purchases will reduce the available float and allow the stock to enter into another mark-up phase. Keep a close eye on Investment Capitalist for real time stock market commentary and consider signing up for real-time alerts via Twitter (@macrotrading).

    Disclosure: I am long NFLX.

    Stocks: NFLX
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