Investors in Netflix (Nasdaq:NFLX), the streaming and mail order movie rental company, have realized tremendous gains, as the stock has surged over 500% in the past two years, with most of that growth coming in 2010. Even year-to-date, shares have risen by 35%. In 2010, Netflix surpassed the 20-million subscriber mark as 3.08 million additional users started using the convenient movie service. As Netflix continues to see growth in the domestic and international market, with Canadian operations becoming a significant part of the business, the stock keeps on defying market expectations and keeps setting new record highs.
However, concerns regarding the company's ability to sustain required levels of growth, and even issues with accounting practices regarding the amortization of its content library, have recently surfaced. With Amazon (Nasdaq:AMZN) expected to launch a free prime user service within the next couple of month, Netflix will be negatively affected in two main ways.

IN PICTURES: 10 Timeless Market Rules

Higher Expenses
First, there is practically no real competition for content streaming. Although other competitors, such as Apple (Nasdaq:AAPL), offer Apple TV, Netflix is able to offer movies for a much cheaper price. With Amazon entering the market as a direct competitor, a bidding war over premium content is likely to squeeze Netflix's margins. Even if Amazon remained out of the market, it seems highly unlikely that content providers such as Starz will renew contracts at the previously established low prices.

Estimates suggest that Netflix is paying Starz approximately $30 million a year for content rights. With this contract set to expire in 2011, Value Line predicts that the new agreement will be renegotiated for $250 million per year. Netflix would have to increase revenues by 13% to compensate for this price hike alone, ceteris paribus. Management released a forecast of future operating margins of around 14%, slightly better than the average annual operating margin of 13.1% in 2010. Based on increased competition for quality contracts and higher costs of international expansion, these forecasts seem overly optimistic.

Competition for Subscribers
Secondly, the obvious impact of Amazon's move service is that it will either hinder Netflix's growth, or might even attract their current customers. With a continuous quarterly Netflix churn rate of approximately 4%, there is obviously some dissatisfaction with the service which Amazon will be able to capitalize on. Prime members will have an automatic incentive to cancel their Netflix accounts since Amazon will be offering the service for free. Although Amazon will initially have a smaller library than that offered by Netflix, with nearly $4 billion in cash and strong brand recognition, Amazon has the necessary resources to grow the movie streaming business.

In addition to Amazon, other potential serious future competitors in this space may include Google (Nasdaq:GOOG), Comcast (Nasdaq:CMCSA), News Corp (Nasdaq:NWSA) and Time Warner Cable (NYSE:TWC).

Financial Performance
Netflix has also come under criticism for understating amortization. The company amortizes "licensed streaming content on a straight-line basis generally over the term of the related license agreements or the title's window of availability". Potentially, a more accurate method would be to amortize content on an accelerated basis, since newer material is more likely to be watched shortly following its release. Such a practice would likely decrease stated net income. Other concerns stem from the fact that, despite strong revenue and earnings growth, cash flow from operations declined by 15% in 2010 and Q4 was the first quarter in the past two years when Netflix did not perform any share buybacks.

The Bottom Line
The impact of these issues, including the threat of entrant into the market, will be determined in subsequent quarters. (Discover how to keep score of companies to increase your chances of choosing a winner. See What You Need To Know About Financial Statements.)

Related Articles
  1. Investing News

    What You Can Learn from Carl Icahn's Mistakes

    Carl Icahn has been a stellar performer in the investment world for decades, but following his lead these days could be dangerous.
  2. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  3. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  4. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  5. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  6. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  7. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  8. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  9. Investing News

    A 2016 Outlook: What January 2009 Can Teach Us

    January 2009 and January 2016 were similar from an investment standpoint, but from a forward-looking perspective, they were very different.
  10. Mutual Funds & ETFs

    3 Vanguard Equity Fund Underperformers

    Discover three funds from Vanguard Group that consistently underperform their indexes. Learn how consistent most Vanguard low-fee funds are at matching their indexes.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
Trading Center