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Is the Picture Flickering At Netflix?

 February 07, 2011 09:10 AM


(By Michael Corty, CFA) Netflix (NFLX) is a powerful entertainment aggregator that has used the Internet to build a compelling value proposition to over 20 million subscribers. Over the past several decades, movie distribution has expanded from theaters to television licensing, VHS, DVD, and now online distribution, as broadband speeds have increased to handle digital delivery. Netflix is a well-managed company with strong growth prospects. However, we believe the shares are overvalued at over $220 per share. We think the game changes for Netflix as streaming content replaces DVD delivery.

CEO Reed Hastings and the Netflix management team have done an outstanding job of using the first sale doctrine to carve out a dominant DVD rental franchise to the detriment of its brick and mortar competitors, as well as movie studios selling DVDs at $20 a pop. The first sale doctrine allows rental companies to purchase DVDs, and then rent them to customers with no additional per-use costs, a crucial benefit to the rental business since the VHS days of the 1980s. In a nutshell, anyone who buys a DVD is free to sell, exchange, rent, or lend it to others. Therefore, rental companies like Netflix and Redbox can buy DVDs from the cheapest source, and rent them as many times as they desire. However, the studios work with Netflix directly, and negotiate either revenue-sharing or fixed price deals that usually prohibit Netflix from selling the DVDs after their rental cycle.

Consumers have been watching ad-supported video content over the Internet for several years, usually broadcast television shows on websites owned by content owners, or partially owned, in the case of Hulu. In its latest earnings conference call, Netflix stated that over one third of its new subscribers are signing up for its $8 per month streaming-only plan (one DVD at a time, and streaming cost $10 per month). Clearly, consumers are looking for streaming content. However, we believe the transition to streaming levels the playing field for Netflix's competitors, especially as television content becomes a more crucial part of Netflix's offering.

Several companies that already sell or rent digital content such as Apple (AAPL), Amazon (AMZN), Hulu, and Vudu (owned by Wal-Mart (WMT)) could emerge as strong competitors to Netflix. We believe Amazon is a likely competitor, with its huge customer base and desire to make up for lost physical media sales, including DVDs. Amazon already sells digital video content, and is more than capable of opening a streaming rental storefront as well.

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