Question: Can Netflix Hit $100 Again?
Netflix (Nasdaq:NFLX) CEO Reed Hastings announced July 3 that its subscribers watched 1 billion hours of video in June, the equivalent of more than one hour per subscriber each day. Hastings was sending a message to investors that its business model is working - subscribers are watching less live TV and more Netflix content. Currently trading around $83, many see a stock that's cheap. I don't share this sentiment. If it does hit $100, it's only going to be short-lived. Here's why.
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It's heating up. Amazon (Nasdaq:AMZN) Prime Instant Video just signed a three-year agreement July 10 with Paramount Pictures that will give its streaming service several thousand additional movies and TV episodes for customers to watch. While its 17,000 titles pales in comparison with 60,000 for Netflix, the fact it charges $16 less on an annual basis should be enough to shake loose some customers. In addition to Amazon, you have Hulu, Apple's (Nasdaq:AAPL) iTunes, Google's (Nasdaq:GOOG) Play, as well as several other streaming services from cable companies. The marketplace is only going to get more crowded and content more expensive. Profits will be hard to come by.
SEE: Top 5 Ways To Legally Cut Out Cable
I live in Canada and heard rumors that the Canadian version of Netflix wasn't nearly as good as the U.S. version, but I kept an open mind as my wife and I sat down to select our first movie. The choices were slim. I like "Uncle Buck" as much as anybody, especially since the lead is fellow Canadian John Candy, but there were many other movies that I would have rather seen.
How can the company survive long-term if it can't deliver the same service to every customer? Steve Swasey, vice president of corporate communications at Netflix, attributes the problem to licensing, suggesting licensing restrictions are regional in nature. That's bad news for Netflix shareholders as Toronto is the third largest movie market in North America behind only Los Angeles and New York. Netflix is losing serious business north of the border by short-changing its customers.
SEE: Effects Of The New Canada-U.S. Border Deal
It's tempting to want to capture more than one market at a time in order to speed the expansion process. Unfortunately, doing so creates capital expenditures and higher spending, which reduces profits. Analysts believe that Netflix should continue to take market share in the U.S. where it already holds a commanding lead and broadband accessibility isn't an issue. Normally I'm not one to agree with them, but in this situation it's hard to argue with their logic.
In addition, after royally messing up its plan to split the DVD and streaming services, it needs to get back the customers it lost as a result. To date, it's retrieved one-third of those customers and likely will generate less than its projected seven million net new subscribers in 2012. Running off to the U.K. and elsewhere will only divert management's attention. Instead of entering other markets, fix Canada and the U.S. before heading elsewhere.
Forbes recently highlighted accounting rules that allow Netflix to hide future streaming content obligations totaling close to $3.7 billion. They aren't on the balance sheet mind you. They're in the footnotes - item 8 to be exact. Within the next three years it will have $3.1 billion in streaming content to pay for in addition to $400 million in debt. Its balance sheet is a land mine waiting to explode.
In the first quarter of 2012, its cost to acquire content increased 42.4% to $623.9 million, resulting in a significant reduction in its gross margin. Much like Pandora (NYSE:P), Netflix faces a catch-22 in that the more subscribers it gets, the more its content acquisition costs increase. It's a hamster running on a hamster wheel in that it's getting nowhere fast.
SEE: What's Next For Netflix?
Getting a Free Ride
Cable and telecom companies will introduce tiered pricing on the use of data so Netflix won't be able to get a free ride on their pipe. I know this to be true because once I got Apple TV, I was suddenly getting emails telling me I was using an unusual amount of data and should buy more. This comes after being upgraded by BCE (NYSE:BCE) to a supposedly superior service. I'm no fan of Bell or Rogers Communications (NYSE:RCI), which have both been using their monopoly-like situation to fleece Canadians for years.
However, in this instance, I'm led to believe that Netflix could pay the cable guys a wholesale fee per subscriber so I wouldn't have to buy more data, but they inexplicably refuse to do so. Ultimately, the telcos and cable companies will start their own video streaming services and slowly chip away at Netflix's commanding lead. Comcast's (Nasdaq:CMCSA) Xfinity is just one example of what's already out there.
The Bottom Line
Content is king in the streaming business, which means Netflix is going to have to keep paying more to acquire shows like Arrested Development, Mad Men and all the other cable programs we like. If they don't, somebody else will. Long-term, I just don't see how it can earn enough to justify a P/E ratio north of 30, which is what it needs in order to get to $100 and beyond.
At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.
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