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The Stream Of Netflix: Many Obstacles In Its Course

|Includes: Netflix, Inc. (NFLX)

The stream of Netflix: Many obstacles in its course

Netflix, headquartered in Los Gatos, California, is among the pioneers in online streaming of movies and television programs.

The company, besides offering the internet video streaming service in which most of its revenue comes from, also rents out DVDs by post.

The key to Netflix's business model lies in offering its subscribers television programs and movies at much lower prices than traditional television services. An average Netflix subscription costs around $8.2. However the problem lies in this business model itself. Netflix gets its content by entering into licensing deals with producers or other broadcasters of content. These licensing deals are based either on fixed fee or revenue sharing. However, once a program starts streaming through the internet via Netflix it cannibalizes the television revenues of the broadcasters or producers. This has led to many broadcasters and producers asking for much higher licensing fees or refusing to share content with Netflix.

The higher licensing fees for its content means that the comparative advantage of Netflix, is being eroded. The company has responded accordingly by entering into its own production of content and/or buying exclusive rights to movies and television programs.

House of cards is a big budget political drama starring two time Academy Award winner Kevin Spacey in the leading role. The budget of its first 30 episodes is approximately $100 million. The first season of House of Cards premiered exclusively on Netflix in February this year and was very successful. Producing such programs or buying exclusive rights to them is a riskier and costlier strategy for the company that started with the vision of offering content at cheaper rates.

Competition in the segment is also catching up. Amazon is expanding the scope of its online streaming service. HBO Go and Vudu are other major competitors. Many channels and broadcasters are setting up their own video streaming services; broadcasters will have an advantage because of their competency in producing screen content. As more online distributors populate the cyberspace, things may become more challenging for Netflix.

In the fourth quarter of 2012, ending in September, Netflix was able to add 2.05 million new subscribers. In the entire year it added 5.4 million new subscribers. Its earnings per share in the four quarter stood at 14 cents per share. From its revenue of $945.24 million, it was able to post profits of only $7.90 million in the quarter - a net profit margin of just 0.84 %.

Netflix urgently needs to control costs and improve profitability. On a year-on-year basis, profits were reduced by 77.5 % in the fourth quarter of 2012, in comparison to the fourth quarter of 2011; revenues went up marginally only by 7.95 % in the quarter.

Netflix's shares closed on Nasdaq on March 5th, 2013 at $ 181.73 per share. This is 626 times its earnings per share in 2012 ($ .29). The high P/E ratio that it is trading has little to do with investors' expectations about a miraculous turnaround in its profitability and EPS in the near term. At the current P/E ratio, the shares of Netflix are trading on irrational and unexplained exuberance.

Netflix is expanding internationally and has lately started services in countries such as Denmark, Finland and Sweden. International expansion will add to its subscription base and revenue. It may be able to benefit from economies of scale and this may be reflected by an improvement in profitability.

Additionally, it has a non-exclusive content sharing agreement with movie studios such as Paramount Pictures and Metro-Goldwyn- Mayer. It signed an exclusive contract with Walt Disney to be the exclusive broadcaster of all new Walt Disney releases from 2016 onwards. The price that Netflix has paid for this deal has not been disclosed, but those in the know say that the company paid dearly.

To compensate for losing its comparative advantage, it is trying to create a differentiation advantage through content exclusivity. Chief content officer, Ted Sarandos says that Netflix's differentiation comes from its ability to let customers watch "what they want, when they want it", unlike the case with television.

However, trying to compete with television may be the wrong strategy for the company. It should perhaps try and focus on the customer segment that prefers to watch television programs and movies on the internet and focus on producing high quality content.

It should sign exclusivity deals with caution and not pay excessively for them. Its customers are price sensitive - past experience has shown this. When it raised the price of its subscription in 2011, many chose to leave. So there is little scope for covering costly content deals with higher subscription prices. Market penetration is the right course in this scenario. It should also enter international markets where American programs and movies are popular. The economies of scale that it will realize from this international expansion can be the driver of profitability in the medium and long term.

Most importantly Netflix should start focusing more on profitability rather than on revenues. Cost control, and not revenue growth, should be made the top priority for the near term. The company's business model is one that has long term strategic value - it may even be acquired by larger internet companies like Google and Yahoo in the medium and long term. Long term investors in the company are likely to generate huge gains in that particular scenario. However for those looking to invest in the shares of Netflix with a short term perspective, the P/E ratio of 626 could be considered too high - the bubble is likely to burst sooner than later and it is likely that the fundamentals of the company cannot sustain such a high price.

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