Battle Of The Serial Disrupters: The Long Case For Netflix

| About: Netflix, Inc. (NFLX)
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The 6.2% surge in Netflix (NASDAQ:NFLX) shares on Monday, which raised its market cap by $740 million, seems overdone. The surge came after the company announced a new multi-year exclusive subscription video-on-demand agreement with Twentieth Century Fox Television for "New Girl," a breakout Golden Globe-nominated sitcom hit.

Netflix has a long history of disruptive innovation. With its innovative flat monthly subscription fee-based unlimited DVD rental service without due dates and late fees, NFLX can be credited with playing a large part in the eventual demise of movie rental chains such as Blockbuster, Hollywood Video, and Movie Gallery. Now, however, as the company strives to protect its top-dog position in the online on-demand media streaming business, it is facing online retailing giant Amazon (NASDAQ:AMZN) -- a formidable competitor with its own history of disruptive innovation. AMZN made its name by disintermediation first of bookstores, which led to the eventual demise of Borders Group and other small bookstore chains, and later expanding to include most product categories and becoming the world's largest online retailer.

Netflix has a formidable lead in content acquisition and, according to recent research analysis by Piper Jaffray, it is still the king of online media streaming. It offers 33% of the top 75 TV shows and 14% of the top 50 movies available for streaming, compared with 7% and 11%, respectively, for Amazon (see Table 1). Hulu, another competitor in the space -- resulting from a joint venture between NBCUniversal Television Group, Fox Broadcasting Corp. (NASDAQ:FOX) and Disney-ABC Television Group (NYSE:DIS) -- has a lead in top TV shows, with 44% of the top 75 TV shows but has none of the top 50 movies. Redbox, a subsidiary of Coinstar (NASDAQ:CSTR), offers 10% of the top 50 movies but none of the top 75 TV shows. Other top contenders in the space include Wal-Mart (NYSE:WMT), via its Vudu subsidiary, as well as Comcast (NASDAQ:CMCSA), DISH Network (NASDAQ:DISH), and TimeWarner (NYSE:TWX) via its HBO subsidiary.

Click to enlarge images.

Table 1: Availability of Top Movies and TV Shows on Leading Online Streaming Sites

Netflix as a company is doing well. In the latest March quarter, it reported that domestic online subscriptions were up 5.76 million, or 25%, year over year to 29.17 million, while international subscriptions were up even more strongly, by 4.07 million, or 132%, to 7.14 million. Its online on-demand media streaming is available currently in North and South America, the Caribbean, the U.K., Ireland, Sweden, Denmark, Norway, and Finland, while its flat-rate DVD-by-mail service is available only in the U.S. Key to this strong subscriber growth has been the company's leadership in acquiring content for distribution from Hollywood's big production houses, including deals with Disney, DreamWorks Animation, Pixar, Lucasfilm, Marvel Studios, and many others. Besides, the company also has been putting out original content, including the critically acclaimed "House of Cards" American political drama series.

All of this bodes well for its competitive position and the company is holding well against well-capitalized rival Amazon, which has a market cap of $130 billion, including $7.9 billion in cash and investments, compared to Netflix's market cap of just $12.6 billion. The company still has a largely untapped domestic market for subscription to its online on-demand streaming media service, which the company estimates to be in the 60-90 million range, and it is just in the first or second innings of its international expansion. Going forward, analysts estimate strong revenue and earnings growth, with revenue expected to rise 17% to $5.07 billion and earnings up even more strongly by 122% to $3.07 in FY 2014. Our problem, however, is with its valuation and its long-term competitive position vs. Amazon, and figuring out how long investors at current price levels will have to wait before realizing a meaningful return on their investment.

While Amazon was a late entrant into the online media streaming its business, its growth has been even more spectacular than Netflix. Furthermore, it has driven up the content acquisition costs, so that gross margins at NFLX were down in FY 2012 to 27.2% from 37.2% in 2010. Amazon has far deeper pockets than Netflix and has $7.9 billion in cash and investments, far exceeding the $1.0 billion held by Netflix. It can easily weather any potential increase in content acquisition costs resulting from a bidding war between Netflix, Amazon and others. Furthermore, its online media streaming business is just a small part of its online retail empire that it can afford to operate at a loss for a while, if need be.

Amazon has also bundled the online media streaming service with its Amazon Prime subscription, with which members get two days of shipping on unlimited items and a Kindle book to borrow each month with no due date. At $79 annually, this premium service is cheaper than Amazon's $7.99 per month service; that comes to almost $96 annually. It is inevitable that Amazon's competitive position will get stronger as it continues its aggressive subscriber growth and content acquisition. Netflix has limited options here, as it does not have other business lines that can subsidize the online media streaming business. Its high-margin DVD rental business is already beginning to show strains as its total subscriber base was down 22% year over year in the March quarter to 7.9 million. Furthermore, we are doubtful that it can increase prices, as prior attempts to do that -- such as the Qwikster debacle in 2011 -- has led to a loss of subscribers. In that event, the only options left for the company to remain competitive in subscriber growth and content acquisition would be to offer more shares or to increase debt.

Amid this uncertainty, Netflix shares trade at an astronomical 330 times current TTM (trailing 12 months) earnings and 73 times earnings in FY 2014, compared to averages of 171 and 33, respectively, for its peers in the e-commerce group (based on data from Also, its shares trade at 14.8 times book compared to the average of 6.4 for its peers. Furthermore, shares are up to over fourfold from the lows just nine to 10 months ago. We believe that these multiples are too optimistic, and the recent fourfold surge is overdue for at least for a technical correction. While we are optimistic about the company going forward, the current high multiples for the stock just do not factor any of the competitive threats mentioned above. Given that, we believe that the risk is more to the downside in the short to intermediate term, and interested longs could possibly acquire shares later at much lower prices -- possibly if and when shares dip toward the 200-day moving average in the $150 range.

Besides competitive and valuation analysis, we also analyze a stock based on how attractive it is to leading fund managers, based on their latest available public filings. Based on our analysis (see Table 2), we find that these leading fund managers were very bullish on the stock in the latest available March quarter. Specifically, 79 legendary or guru fund managers collectively or in consensus added 32.9% (or 1.90 million shares) to their 5.78 million share prior quarter holdings, 57 billionaires and billionaire fund managers in consensus added 17.8% (or 1.03 million shares) to their 5.81 million share prior quarter holdings, and 18 consumer sector-focused fund managers in consensus added 11.7% (or 0.15 million shares) to their 1.28 million share prior quarter holdings. Also, 27 of the world's largest or mega fund managers, with over $30 trillion in assets under management, cut a minor 0.9% or 0.23 million shares from their 26.47 million share prior quarter holdings in the company.

Guru, sector-focused and billionaire fund managers also heavily accumulated NFLX shares in Q4 2012, when its shares traded in the $50-$100 range, adding 3.62 million, 66,471 and 3.28 million shares, respectively. Also, there have been no additional 13D/G 5% ownership or other filings by these leading fund managers on NFLX since the end of the March quarter, so the numbers in the table represent the latest known information on their investing activity in NFLX. Based on this activity, we interpret that NFLX shares were an attractive buy to these fund managers in the $150-$200 range, supporting our earlier thesis that the shares should be bought if they dip toward the $150 range. However, we should also remember that most of these fund managers have multi-year horizons, and whether or not shares temporarily drop toward the $150 range, their heavy consensus buying over the last two quarters speaks of their bullishness about the long-term performance of NFLX shares.

We would be buyers of NFLX shares once the gap from April was filled in the $175 range, adding more as prices dropped toward the 200-day moving average in the $150 range.

Note: Fundamental data in this article were based on SEC filings, Zacks Investment Research, Thomson Reuters, and The information and data is believed to be accurate, but no guarantees or representations are made.

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

Business relationship disclosure: The article has been written by the Hedge and Mutual Fund Analyst at is not receiving compensation for it (other than from Seeking Alpha). has no business relationship with any company whose stock is mentioned in this article.

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