Time Warner Could Put Netflix Out Of Business Tomorrow

| About: Time Warner (TWX)
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I cannot drive this point home enough: For Hastings to contend that Netflix can put together an original programming powerhouse that even resembles HBO in relative short order is an insult to the people at Time Warner. If Netflix mattered much, folks at TWX might actually be offended. I don't think they are.

From "Netflix Stock Up Again: More 'Irrational Exuberance?" March 21, 2012

Netflix (NFLX) longs really need to beware of a sobering reality: Reed Hastings is playing with fire. He initiated a game of chicken with CEOs and companies that could chew both him and Netflix up and spit them out. It would take very little effort - just a meeting, a memo, a press release and several million in advertising dollars - for any number of old guard media members to snuff Netflix out.

Ironically, the fact that Netflix is such an unmitigated disaster allows it to continue to live and breathe another day. There's really no reason for the old guard to alter plans or change desired course to put Netflix out of business. That's because Netflix dictates nothing. If it were not for the company's own hype and Hastings' masterful rhetoric, larger numbers of investors would come to realize just how insignificant Netflix actually is.

In this article, I use Time Warner (TWX) to illustrate just how fragile the situation at Netflix is. Netflix is living on borrowed time.

Time Warner's HBO GO

HBO GO might be the best example of a streaming video service out there. You cannot access the product, however, unless you subscribe to HBO via traditional cable or satellite. And, according to HBO brass, don't expect that to ever change. As far as I know, the stance of HBO co-President Eric Kessler has not shifted since late last year:

Kessler said that, despite the success of HBO GO ("It's HBO Anywhere"), the company has no plans to offer the new mobile offering to a broad audience ...

HBO's decision to remain tightly wedded to the cable industry makes it something of an outlier in this age of aggregation. The rationale, according to Kessler, is that services like Netflix and Hulu are competitors and that HBO's bread and butter is content, not licensing ...

Kessler is undaunted, saying HBO regards cord cutting as a temporary phenomenon that will go away once the larger economy improves. He also says that HBO will flourish under its current model thanks to its star power (its latest coup is getting The Social Network's Aaron Sorkin to pen a series) and because its partnership with cable companies allow it to avoid transaction costs like billing.

Sounds a bit stodgy and old guard, but it's actually brilliant. And it brings to the forefront the Fantasyland Reed Hastings lives in. If he really thinks Netflix can become the next HBO in an instant, let alone over the next decade or three, they should be waiting for him at Bellevue with their oxygen masks.

When I make my bull case for Canada's Rogers (RCI) and Bell (BCE), I do it in part because the two companies continue to take control of key "appointment viewing." That is premium content that simply does not work as well in an on-demand format. For the most part, that's limited to the sporting events the two media and telecommunications giants own and/or air.

You no longer need to make sure you're in front of your television at 8:00 p.m. on Thursday night to catch your favorite sitcom. You can either DVR it or watch it later on-demand. As Hastings likes to point out, that phenomenon will only continue to take hold until on-demand becomes the default way of consuming video entertainment.

HBO remains one of the last bastions of non-sporting event, non-Oscars, non-special event appointment viewing. It's programming is so good that people pay a premium to subscribe to cable or satellite to see it. If Netflix, all of a sudden, became as expensive and seemingly "exclusive" as HBO, what do you think would happen to its subscriber numbers, even if it upped the quality of its presently meager (and rented) content? That's a rhetorical question that, admittedly, fails to live up to the rhetorical bar of hype Hastings has set.

Whereas Hastings has to backtrack on decisions multiple times, HBO (and Time Warner) can do what it wants. Whereas Hastings has to consider changing Netflix's business model several times per quarter (hey, we should be an a la carte option on cable as well!), HBO (and Time Warner) can do what it has always done. Whereas cable companies like Comcast (CMCSA) can rebuke Netflix's overtures, they stand at attention when HBO calls.

Time Warner Holds The Cards

For one reason or another, investors have allowed TWX to be one of the most undervalued stocks in America. I do not pay much attention to P/E ratios, but they matter here. As of this writing, TWX sports a P/E of 13.21 and a forward P/E of 9.84. This is a company that not only should do more than $30 billion in revenue next year, but, maybe more importantly, it holds the cards from a content control standpoint.

Here's a link to the "Business" section of TWX's annual report. Carve some time into your schedule to scroll through it. It will take a while. Time Warner is so much more than HBO and HBO GO. If it ever decided to offer HBO GO to cable and satellite non-subscribers, it would ratchet the Netflix death spiral up to hyper-speed from its present slow and agonizing clip. Taking it a step further, if Time Warner opened up most or all of its content using a TV Everywhere model, we would see Reed Hastings emerge from his Mercedes on the 101 in Gilroy on his way from Santa Cruz to Los Gatos waving a white flag.

Time Warner, for obvious reasons (it's protecting cable and satellite), refuses to go to an all-out TV Everywhere model. What should buoy investors, however, is that, while it could literally take control of the streaming game if it did, it absolutely does not have to make such a concession. At some point down the line, the time might be right to switch directions, but the brass at TWX will make that call. TWX CEO Jeff Bewkes might be the most powerful and sharpest media head you've never heard of.

With one simple, yet presently unnecessary strategic salvo, Bewkes renders Netflix extinct.

How To Play It

While another Netflix implosion is likely in 2012, the safer and more prudent route for long-term investors might just be to go long TWX. I am long the stock, adding to my position on a weekly- to bi-weekly basis. I intend to complement that stake with a long position in TWX January 2014 ATM calls sometime between now and the end of May. I might sell closer-to-expiration ATM puts to help finance that transaction. Selling puts could help me add to my long position in the stock on a pullback. In any scenario, it generates income to offset part of the long call purchase.

Disclosure: I am long BCE, RCI, TWX.

Additional disclosure: I am long NFLX June $40 put options.