Defying the Naysayers

About six months ago, Netflix (Nasdaq: NFLX  ) was a story everyone wanted to hear. Today, the Wise can't get enough of ridiculing its valuation, business model, and competitive position. Conventional wisdom suggests that Netflix is an overvalued Internet wunderkind that will be tag-teamed by Wal-Mart (NYSE: WMT  ) , Blockbuster (NYSE: BBI  ) , and video on demand (VOD). Don't bet on it.

Call me a fool
But I still believe. If I've taken away one thing from my experience with Hidden Gems investing, it's that jewels are hidden for any number of reasons. Netflix -- though it's still up more than 200% in a year -- is a gem simply because it's fallen from favor. What makes me so sure it's not just some run-of-the-mill flameout? More than I can tell you in one column!

But in a sentence, the market severely underestimates the depth and breadth of this company's moat. What about Wal-Mart, Blockbuster, and VOD? They don't worry me in the least. In my opinion, Netflix has sustainable competitive advantages investors have discounted too heavily. Warren Buffett would probably choke if he heard me say that a company with a forward P/E of 60 can be a value play, but if the market believed what I believe, then this company would be valued much more highly.

But let's sidestep valuation for a moment and get back to the story. It's a tale of the Internet, DVD economics, and movies. I think it ends nicely -- and with Wal-Mart, Blockbuster, and VOD looking elsewhere for an easy meal.

Internet brands
When you want to buy cheap books online, where do you go? Chances are, you click on Amazon.com (Nasdaq: AMZN  ) . Which engine do you typically use for your searches? Probably Google. Auctions? eBay (Nasdaq: EBAY  ) . Financial news? Yahoo! (Nasdaq: YHOO  ) .

When people think about the Internet, they typically associate one or, at most, two sites with a particular service. People are creatures of habit, whether they're using the same brand of shampoo for much of their lives or getting their online sports news from ESPN.com. People develop Web-browsing habits that change infrequently over time, making it very difficult for an upstart to supplant an established Internet brand.

How does an Internet site reach this position of dominance? Typically, the first movers in the space grab the most mindshare and keep it, even in the face of heated and competent competition. Take, for example, Amazon and barnesandnoble.com. Barnes and Noble (NYSE: BKS  ) built an online service that compared favorably to Amazon on price, convenience, and distribution. Yet people continued to shop at Amazon for their books and CDs. By the time Barnes and Noble launched its website, people had already come to associate Amazon with buying cheap online.

The old same place
An established bricks-and-mortar store base can be more liability than asset for an online property. People think of bookstores when they think of Barnes and Noble, not its website. Successful branding in retail rarely transfers to the Internet space and can sometimes be an impediment to attracting online traffic. The most significant competitive advantage is mindshare. Anyone with enough financial resources and operational expertise can compete on price, convenience, and distribution. It is very difficult to steal mindshare.

An understanding of the Internet space helps explain why competition from Wal-Mart's and Blockbuster's online offerings have been ineffective and laughable, respectively. Netflix has already grabbed significant mindshare in this space, and its position will only grow stronger with time. Management has said time and again that it welcomes competition on its turf because it only draws more attention to the best service for online DVD rentals -- Netflix.

Thus far, Wal-Mart and Blockbuster have made only half-hearted attempts at competing against Netflix on turnaround time and selection. If and when they do take these issues as seriously as customers do, it will be too late. The Netflix brand will already be entrenched in the minds of American consumers.

The economics of DVDs
DVDs are not going anywhere soon. Historically, media formats like the LP and VHS have enjoyed life cycles of about 20 years. Even with acceleration in technological development, these cycles have not shortened because technology is not the most important factor in determining the length of these cycles.

Clearly, there is a certain amount of inertia when it comes to abandoning old formats. It takes time for hardware like record players, VCRs, and DVD players to penetrate American households. DVDs have been around for almost a decade, and only now are the players becoming ubiquitous in American homes. It seems unlikely that we will be quick to replace our relatively new DVD players with a superior format. For now, most Americans are perfectly content with the capabilities of the DVD format. And besides, most people are still smarting from having to pack away their VHS collection of movies.

In VOD?
Even VOD will have a difficult time overcoming this inertia. Yes, VOD has the potential to revolutionize the way people watch movies. At the same time, it will take at least five or even 10 years for VOD to become mainstream. The selection on VOD is limited to a few hundred titles at most, and I don't see this changing anytime soon. Studios release movies first on the big screen, then on DVD, and finally on VOD. They have enormous economic incentives to keep it that way.

Consider that a DVD sale nets about $17 to the studio per family, while VOD and downloading nets about $2 per family. Because DVDs are so much more profitable, studios will milk the DVD cash cow before giving in to VOD. This is comparable to publishers distributing books in expensive hardcover editions and then in paperback. They will never release hardcover and paperbacks simultaneously. Likewise, studios will protect new-release DVD sales from VOD and downloading.

I don't deny that VOD is a very compelling proposition for customers. Why wait for DVDs in the mail when you can watch a movie at the press of a button? The few people I know who have cable VOD have given nothing but rave reviews for the service. But even if VOD were to become mainstream much earlier than expected, and even if VOD were to relegate Netflix to a niche market (in other words, even if the worst-case scenario were to develop), our investment in Netflix would still be successful.

Say what?
Consider that there are about 60 million cable subscribers in this country, a number that is not growing very quickly. Assume that all 60 million use VOD (not very likely, but I like to be conservative with my worst-case scenarios). That still leaves about 40 million households that will rely on DVDs as their primary medium for home movies. Netflix need capture only 5 million of those to become an extremely successful investment.

If Netflix happens to become a multibillion-dollar online media company, as management believes it can, then even better. But we are not depending on success of this magnitude for our investment in Netflix to do well. That's why I'm so cavalier about cable VOD. There is more than enough space for both VOD and DVD-by-mail, and Netflix has demonstrated beyond a reasonable doubt that it is on track to dominate the latter market.

Bottom line
DVDs are here to stay -- at least for a good, long while -- and as long as they are around, people will continue to rent them. VOD won't, in my view, pose a competitive threat for at least five to 10 years. When it finally does, Netflix will be positioned to compete effectively with its own VOD offering. But again, success in VOD isn't critical to my thesis. So, let's wrap here and pick up with more on Blockbuster, valuation, and at what prices I'd be picking up shares of Netfix in my next column.

Looking for the next Netflix or even a fallen angel set to get its wings back. Click on the link to learn more about Tom Gardner'sMotley Fool Hidden Gems and to sign up for a free trial if you like what you hear.

Fool contributor Daniel Hong owns shares of Netflix. The Motley Fool isinvestors writing for investors.


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