Will Netflix Continue To Grow, Or Repeat Its Devastating 2011 Results?

| About: Netflix, Inc. (NFLX)

The recent bounce back in Netflix's stock price is surprising and deserves another look. Although they are regaining subscribers (they announced recently that they added 2 million more in their latest quarter, which is approximately a 7% domestic growth rate) at a healthy quarterly rate, will that last? They are also running a low 0.65% profit margin, so the cost of getting these subscribers is large and most of the profits are spent to retain and gain content. Right now the Netflix P/E ratio is over 500, which is astronomical, but if their targets come to fruition their forward P/E is 68. But when buying a stock it is always good to look at their competitors and their forward P/E ratios, which a couple of them are Time Warner (NYSE:TWX) at 14.2 and DirecTV (DTV) which has a forward P/E of 9.69.

Some consumers buy stable blue chip companies due to their dividends, like Time Warner which offers a 1.9% dividend, Comcast (NASDAQ:CMCSA) who pays a 1.9% dividend and even News Corp. (NASDAQ:NWS) which owns Fox and part of Hulu offers a 0.5% dividend. However, Netflix does not have dividend yet as most of their money is going to content and growing globally. The competition is also running very high profit margins unlike NFLX at 0.65%:

TWX: 11%

DTV: 9.92%

CMCSA: 9.91%

NWS: 11.65%

DISH: 4.46%

CSTR: 5.39%

The profit margins show that the competition is diversified and offers products that generate better margins. The competition also seems to be doing a better job running their business more efficiently, which is helping out their bottom line. Also unlike Comcast (14.85B) and DirecTV (5.63B), Netflix is at a -8.51M operating cash flow, so when contracts come up on the auction block, who is going to be the favorite to scoop them up?

But with the larger more established companies having more impressive key statistics, the Netflix bulls have growth potential. The Netflix bull case can be summarized in this Fool.com video. The major factors that can propel Netflix back to $300 is massive potential sales growth overseas, a buyout from a bigger firm which Carl Icahn alluded to in his disclosure of ownership and using their large subscriber base effectively. They also have a big international potential with over a 100 million households with an internet connection in Europe, South Latin America and parts of Asia according to this Trefis.com article. But with this potential they are still only slowly gaining subscribers and are still losing money due to those operations according to this Techcrunch.com article. However, they have recently added another 1.8 million international subscribers, which represents a 42% growth rate. In addition to revenue, the larger subscriber rate brings in negotiating power. The larger the viewership, the more leverage Netflix has to let the movie studios know that it could lift their DVD sales and promotes any upcoming sequels to their content. They can also get contracts cheaper or sell viewership data to studios and other companies who study viewer data to analyze what is popular. Lastly, although Netflix is more than 10 years old and should be considered an established company, it is only at an 11 Billion market cap and has room to growth. This sets up the last possibility for the bulls, a buyout. The aforementioned companies all have market caps that are much larger and cash on hand that can buyout Netflix. This would give a company like Comcast or DirecTV instant access millions of subscribers and the ability to bundle the Netflix service and offer it to their millions of existing companies. They would also be able to give Netflix more content and offer even more value to subscribers.

So now that the bull case has been stated here are a list of some things that might hinder subscriber growth and thus revenue growth going forward. One major question is can Netflix renegotiate their content contracts with the studios to keep all of their content and possibly add more? Sure, but these are expensive agreements and the other aforementioned competitors will also be bidding. This recent Christian Science Monitor article shows how they can lose thousands of titles in a day when contracts are renewed. Once those contracts go on the open market there are dozens of competitors bidding on them. This business is cutthroat and lives off of content, which in turn drives down margins as movie studios play each company against the other for bigger contract money. Netflix is not blind to this and is trying to do original programming like House of Cards and Arrested Development, which brought in a lot of new domestic subscribers. But as those actors go in to renegotiate their contracts they are going to want a lot more money and if they don't get it and the show ends, how many subscribers will they lose again?

They can also lose subscribers if they try to restrict sharing, like this Bloomberg article points out. When they decided to raise their prices in 2011 they lost 800,000 customers, so how many will they lose when they tell people they can't share their accounts with family members and now they have to pay to have separate accounts. They will go to Amazon or Hulu or HBO who have cheaper options. Also how long will it take Dish Network to get Blockbuster's streaming service up and running with just as much content as Netflix? Take a look at the Dish Network's financial profile, they have 2B in operating cash flow and thus have a lot of money to start building up the Blockbuster library.

Another obstacle for this business model is online piracy. Most youth and younger adults know how to use torrent technology, newsgroups and peer to peer networks to download shows and movies without paying for them. They are also smart enough to hide their activities online as this Ispreview article points out. A statistic on this web site claims 70% of all 18-29 year olds have downloaded illegal content. Online piracy being on the rise leads to two big negatives for Netflix. The first is that their growth will inevitably plateau and might even decrease since their market is mainly older consumers and they might never convince the younger generations to pay for content that they are getting for free. The other negative is that movie studios continue to lose money to this pirating and they will try to make up the difference by charging Netflix and its competitors more for their content.

Another obstacle for Netflix is bandwidth. As Netflix expands it will continue to deal with bandwidth issues like this WorldTVPC article points out and which might further drive down their margins. Also the consumers have to upgrade their internet or get frustrated with load times, which is another cost they have to add in to their monthly budget versus on demand from Comcast or DirectTv. Netflix will also start streaming 3D movies so ISP's may see their bandwidth being crippled and pass the cost down to Netflix to increase bandwidth. This can result in many lawsuits and even the government having to step in. All of this uncertainty should be weighed in on how it will affect subscription growth and margin rate. This Fox News article points out the uncertainty about who will pick up this growing cost and if it turns out that the consumers will be charged in the end, that will cause a revolt against Netflix.

In conclusion, Netflix's outlook hinges on whether or not they can overcome industry obstacles to keep their subscriber growth high. Netflix will never be able to run away from having to deal with new contract negotiations costing them more money and competitors stealing their contracts, but maybe a buyout can help? This article also did not go into two competitors who are always changing the media and internet landscape and might cripple Netflix in the future, Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG). Although market growth has been healthy in the past quarter, the fact that they have slowed entry into new markets should caution the investor. But as the past has show, they should have used some time to think before raising their prices in 2011, so we will see if this cautious approach will pay of in the form of continued global growth in the future.

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

Additional disclosure: All views are my own speculations and are not meant to influence the stock price

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