Why NFLX is the new AOL
Whitney Tilson might have thrown in the towel but MKArch isn't ready to. At least in CAPS anyway. Personally I don't understand how nobody noticed the *ONLY* reason Q4 didn't miss expectations and earnings decline sequentially for the second straight quarter was due to slashing their marketing expense and a mysterious plunge in their tax rate q/q. Keep marketing and the tax rate the same q/q and they earn ~$0.66 a nickel miss and down sequentially.
I played with some numbers and I suppose if they keep adding 3M subs a quarter they will overcome the content cost increases that would have did in this quarter if Hastings hadn't manipulated the big beat. That's where the AOL comp comes in though. Intuitively I just can't believe the subs they are signing up in droves lately are going to be around long and I think I can explain why they won't be around long.
To understand NFLX fatal flaw you have to compare what they are paying for content to what the cable companies pay. It turns out that Comcast reports 23M video subscribers in their latest Q or just about the same as NFLX. If you annualize their programming costs it's about $7,200M for those 23M subs. NFLX reported ~$900M cost of subscriptions in 2009. I think ~$600M of that was for dvd's leaving ~$300M for content (the exact number isn't important). They have already signed two major new content deals in 2010 with Epix and Disney reportedly valued ~$200M/ year each and the Starz renewal this year is estimated to cost them another ~$200M or so per year. So add the new ~$600M to last years ~$300M and you get ~$900M or so in content costs for NFLX 23M subs vs. ~$7,000M for Comcasts same 23M subs.
Even though Comcast is the largest cable company they are still just one of many that can't afford to have NFLX stealing subs from them. If you follow NFLX you no doubt have heard the rumblings about them not paying enough for content. But they have 23M and rapidly growing subs so the content providers have to respect them right? This is the fatal flaw in the bulls argument IMHO. While NFLX did a great job catching the industry asleep at the wheel which enabled their meteoric rise I don't think their model is sustainable because the content providers can't afford to let them undercut their bread and butter Cable and TV stations.
Here's the basic problem. The cable companies are already telling the content providers they are not happy watching NFLX undercut them with the cheap as dirt content they got while everyone was napping and they will demand similar or better rates for themselves. The content providers can't let NFLX set a precedent that will devalue their content in negotiations with their bread and butter cable and tv stations customers. Ultimately NFLX is either going to have to settle for cheap content that consists of stuff no one really wants to watch or pay prices for good content that will force them to have to charge on par with the cable companies.
Starz is a great example. One of the best reasons given for NFLX success so far is you can get Starz content from NFLX for a fraction of what it costs to get it from your cable company. You don't have to be a rocket scientist to see the cable companies telling Starz to stick their content where the sun don't shine if they don't get the same or a better deal that NFLX got. So do the content providers give everyone else the NFLX rate or tell NFLX to open up the wallet? I don't think the biggest cable companies will be satisfied with just the same deal they'll demand better and will probably get it.
But let's switch gears for a minute and look at all of this from the subscribers perspective. Right now they think they've beat the system getting Starz content for less than they'd pay a cable company plus a hodgepodge of old movies and tv re-runs all for only $8.00/ month. Not only that but this is just the beginning NFLX is adding more content (which looks to be mostly tv re-runs). What happens when STARZ tells NFLX they have to pay a price that will force them to charge the same $10 or $15/ month that the cable companies are charging? If NFLX balks what do they have left to offer their subs? An odd assortment of ancient movies and tv re-runs? I don't see how this doesn't end up with either NFLX being forced to charge a lot more for their service on par or likely more than the cable companies are paying for the same content or they are left with cheap content that no one wants to watch. Or at least will get bored with after a year or two.
Sure they are signing tons of subs with their first mover caught the big boys napping advantage but how do they keep these subs for more than a year or two? Maybe that's why NFLX will no longer be issuing standard subscriber statistics after 2011? My guess is even though churn seems fairly low right now they are seeing large numbers of the earliest subs walking away. Since their numbers are being dwarfed by the avalanche of new subs lately the over all churn rate is low but when today's subs start anniversarying over the next year or two look out. AOL was a first mover with phenomenal growth so much so they conned Time Warner into merging with them and the Street lapped it all up. In the end their model was killed by the cable companies. Sound familiar?