Money Matters - Simplified

A Netflix Bear Emerges From Hibernation

 After a torrid run, the bearish argument is building against Netflix (Nasdaq: NFLX). Hudson Square Research analyst Daniel Ernst went on CNBC yesterday to explain his pessimistic view on the video-rental giant.

 
 Ernst claims that four things will put an end to Netflix's earnings growth and its buoyant share price. The stock has more than tripled this year -- with a good chunk of that growth coming after Hudson Square issued a "sell" rating on the stock back in June. Given that he's been on the wrong end of this trade for several months, Ernst may feel even more urgent about the likelihood of an upcoming tumble for the shares.

Unfortunately, he only managed to go over three of his four horsemen of Netflix's apocalypse. Still, they're points that any investor -- long or short -- should consider before approaching the company.

1. Content costs are growing sharply
In an effort to build as thick a moat as possible, Netflix is striking a ton of licensing deals with major studios for streaming content. The company's efforts to expand its digital catalog helped Netflix's content acquisition costs soar 142% year over year in its latest quarter, according to Ernst. Revenue only grew by 31% in that time.

With Netflix's costs for snapping up discs and inking streaming deals skyrocketing, one would expect margins to implode. That hasn't really happened so far; earnings climbed 26% during the quarter, or 35% on a per share basis, thanks to the company's penchant for share buybacks over the past year.

2. Average revenue per user will continue to fall
Ernst argued that consumers will be paying much less for Netflix in the future. Average revenue per user clocked in at $12.12 a month during Netflix's latest quarter. Ernst pointed to the new $7.99 "streaming only" monthly plan, suggesting that prices may drop by a third.

He's wrong about that. Dead wrong. Netflix would probably love it if everyone checked down to the $7.99 a month plan. It would free the company from buying optical discs that age quickly, covering round-trip mailing costs, and manning dozens of regional distribution centers.

The closest thing to Netflix's new $7.99 plan is the $8.99 plan that includes unlimited streaming and a single DVD out at a time. That rate is going up to $9.99 a month next month, with plans allowing for more than one or two discs out at a time going up by at least $3 a month. It's Netflix's first price increase in six years, and couch potatoes who fully appreciate the escalating content costs Ernst pointed out earlier will understand the hike.

True, Netflix subscribers have been gravitating toward lower-priced plans. Average revenue per paying subscriber has shrunk from $13.30 to $12.12 a month. That trend will continue, but next month's pricing increase -- coupled with folks who still want optical discs for the tens of thousands of titles not available through Netflix streaming -- likely won't cause any ridiculous deterioration in ARPU.

Again, if it happens, Netflix should be so lucky.

3. The competition is coming
I can't argue with Ernst's final point. Real competition is on its way. Instead of the leveraged dinosaurs of Blockbuster and Movie Gallery, we're talking about cash-rich Amazon.com(Nasdaq: AMZN)Apple (Nasdaq: AAPL), and Google (Nasdaq: GOOG), all of which that know a thing or two about digital delivery.

Unfortunately, they're not necessarily in tune with what couch-bound viewers want most. Remember when Apple TV and Google TV were supposed to be the hot holiday gadgets? Are you telling me that the same Google that has struggled to get television studios to play along with its hardware will become a major player here? Apple TV has been around for years. Its latest model overcomes many of its earlier shortcomings, but Apple's been doing too well with its a-la-carte downloads and rentals to make a serious push into digital smorgasbords. If Apple hasn't followed Napster, Rhapsody, and Microsoft's (Nasdaq: MSFT) Zune Pass in offering streaming subscriptions for music, why confuse iTunes users with a Netflix-esque video model now?

Amazon is the more viable threat. Coinstar's (Nasdaq: CSTR) Redbox is rumored to be basing its upcoming digital strategy on a Redbox-branded service fulfilled by Amazon. Perhaps even more model-altering is a reported plan by the leading online retailer to include streaming as a bundled bonus for its Amazon Prime shopping memberships.

The bear's fatal flaw
The problem with Ernst's argument is that some of these threats are mutually exclusive.

When Netflix began inking digital licensing deals more than two years ago, studios weren't asking for much. Online streaming was a niche offering. Who wants to see a two-hour flick on their PC? Netflix changed the stakes by partnering with Blu-ray players, console makers, and even TiVo (Nasdaq: TIVO) to deliver seamless streaming into the living room.

Studios won't make the same mistake in their next go-round. They will demand stiff licensing fees from Netflix, and they're not going to give Amazon, Google, or Apple a discount because they're substantially smaller. In other words, Ernst's first threat silences the third threat -- or the other way around. And if the second point is true, and Netflix users do indeed gravitate toward lower-priced plans, you can also expect the cheapness of Netflix's offerings to keep competition at bay.

In the meantime, the waiting game only makes Netflix stronger. It closed out the third quarter with 16.9 million subscribers. More than 11 million of them are streaming. By the end of this month, we'll be looking at nearly 20 million subscribers, with more than 13 million of those accounts actively streaming.

How much larger will Netflix get before any of its otherwise brilliant dot-com rivals wake up? How quickly can they scale their digital catalogs to compete with Netflix's 20,000-plus titles? How fast can they ramp up their memberships to afford the costly content deals, and at what money-losing price point will they have to compete at in order to gnaw at Netflix's base? How much can they afford to lose in a race where, at best, they can only place a distant second?

Bears believe that bulls aren't discounting Netflix's competitive future. I argue that those bears aren't baking in the cruel reality that the first digital giant to take a shot at Netflix will fail. And when it does, my crystal ball tells me that those cash-rich giants will do what they do best: spark a bidding war to buy Netflix at a premium next year.

© 2010 UCLICK L.L.C.