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Netflix Investors Are Worried About the Wrong Things

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September 19, 2011 – Comments (3) | RELATED TICKERS: NFLX

I recently read JakilaTheHun's blog entry.  He called it "Netflix's Management Has Learned the Wrong Lesson."

The CW right now is that the old Qwest ad, "Every movie ever made, on demand" will never occur; just as the conventional wisdom 45 years ago was that a pocket-sized communicator, that would let you speak to anyone anywhere on the planet at any time, was a fantasy of StarTrekian proportions.

Well, right now there's an iPhone in my pocket and it can probably play 10% of all the movies ever made on demand.

Jakila's point was that splitting off the mail-order DVD service, which has access to 90% of all the movies ever made; from the Netflix streaming service, is a problem because it destroys value.  There is a synergy, he argues, between the DVD service and the massive availability it has; and the streaming service with its convenience and lack of postage. 

To some extent this is true but this is a very short-term view.  Whenever I evaluate a business - now Jakila's laughing, if he's reading this - I am looking for a durable competitive advantage.  He's laughing because this is a tired old saw and most people who preach about a DCA wouldn't know it if it bit them on the hindquarters.  But I think it's the right way to analyze NFLX c. 2011.

The DVD service actually had a DCA when it started because it could deliver, first 4, then 7 GB in 48 hours.  As a method of bit delivery it totally trumped what broadband access there was at the time, especially given that so many households lacked broadband but owned a DVD player.

Now the DVD service has a Proctor and Gamble - like DCA: a giant inventory of DVDs, a set of contracts with the major content rights owners, and a fairly impressive affiliation with the USPS to distribute and return DVDs with barely any human input.

Problem is, streaming is a better method of bit delivery, and there's no durable competitive advantage; in fact, NFLX must rely on others to do its distribution, and those others - cable companies and other wirelines Internet providers - want a piece of that market.  And the content owners, some of whom are last-mile Internet broadband providers too, have rightly balked at letting NFLX or any player assemble a batch of contracts.

I don't think streaming video of ever movie ever made is a viable business, apart the impossible business model of acquiring the rights to every movie ever made in perpetuity.  (It'd be a good business model if the world's largest cash pile could do it, but I do not believe AAPL's $75B would suffice and I do not believe most of the rightsholders would sell at any price.  DOJ would also block it.)

Rather, I think this market niche - streaming video - will continue on a long term basis to be fragmented, and I think the way it works now is the way it will continue to work: an established company with an established business model will piggyback some content and derive fractional profits at the margins from doing so.  Apple is doing this with the iTMS and the AppleTV; Amazon has started bundling streaming video with its Prime free-shipping service; and at the moment I am a dissatisfied consumer who is paying for all three of these services in various ways and trying to convince his wife to let me turn one of them off.

That one is NFLX.  Because, looking long-term, it doesn't offer anything the others don't, can't or won't.  Meanwhile ad-supported video will continue to exist as yet another target for consumers' ever-diminishing leisure eye time.

I am not *short* NFLX because I do not have a *short*-term catalyst in mind for a downward price movement - and looking for something like that is not the way I trade.  But I am long-term extremely negative on the stock.  I think if you are looking with a 10, 20 or 30 year eye, its intrinsic value is very nearly zero.

3 Comments – Post Your Own

#1) On September 19, 2011 at 2:10 PM, davejh23 (< 20) wrote:

"I am not *short* NFLX because I do not have a *short*-term catalyst in mind for a downward price movement - and looking for something like that is not the way I trade. But I am long-term extremely negative on the stock. I think if you are looking with a 10, 20 or 30 year eye, its intrinsic value is very nearly zero."

I agree.  In response to Jakila's post, I stated that I believe the stock easily has 30-50% downside potential if earnings start coming in flat, as analysts are still expecting 70% earnings growth for next year.  If they lose subscribers over coming quarters, there is no justification for the near-40 P/E multiple...10x might be more appropriate for a company with a shrinking customer base, which could mean 80%+ downside.  I, of course, don't know what is going to happen with the stock.  However, if I had to put money into any stock, right now, and not look at it for the next 10+ years, NFLX would be the last stock I would consider.

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#2) On September 19, 2011 at 2:30 PM, JakilaTheHun (99.94) wrote:

I don't understand how you're even disagreeing with me, ikkyu2. 

My rationale is that NFLX's main competitive advantage is a monopoly on DVD-by-mail service.  Even though the future is streaming, the DVD segment is the company's bridge to cross over into that market.  And it's a very well built bridge.  It gives them an advantage in attracting more customers to streaming, which then gives them economies of scale, and more bargainning leverage in the future. 

By abandoning their bridge (the DVDs), they are essentially making themselves less distinguisable from the rest of the market, thereby forcing themselves into a small niche market.  I think they can continue to do well within that small niche; but it's going to hurt the company's earnings over the long-run.

Even if they continued bundling their services, I've argued that their moat would shrink with streaming, but at least they would be able to claim a large loyal customer base that competitors would have difficulty replicating.  It wouldn't be an insurmountable advantage, but it would help.  But splitting DVD off ruins this.

But I still don't understand how your analysis goes against anything I've said. 

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#3) On September 19, 2011 at 3:37 PM, ikkyu2 (99.32) wrote:

Well, I think we 99% agree, Jakila.

I think that you disagree with Reed Hastings about the decision to spin off the DVD business, but I think Reed is righter than you, because Reed thinks the DVD business is basically irrelevant.

A TMF Rule Breaker would state that there is no point in having a durable competitive advantage in a market that has been disrupted by a disruptor technology, and I think that's basically where we are with Qwikster today.

I have been watching you operate on CAPS for a few years, by the way, and I think my conclusion is that I wish my real life portfolio was managed by you instead of me.  I'd be wealthier today.  So I hope  today's entry didn't read too much like a potshot.

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