ikkyu2 (99.46)

Netflix Investors Are Worried About the Wrong Things

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.