Dueling Fools: Netflix Bear

People tend to care most about three things when it comes to renting movies:

  • Cost.
  • Selection.
  • Convenience.

For serious movie aficionados, I'll gladly concede that Netflix (Nasdaq: NFLX  ) is winning the race in all three categories. After all, the cost of any given monthly subscription plan is the same whether you watch one flick or 30. That's a tremendous deal for the most die-hard fans. And who can argue with 60,000 unique movie titles, or a service that you reach over the Web and delivers the goods straight to your mailbox?

In fact, I've recently gone so far as to point out that Netflix is one of the primary reasons why Blockbuster (NYSE: BBI  ) may not be long for this world. It's largely because Netflix so easily wins on the key elements of cost, selection, and convenience that Blockbuster is feeling so much pain.

All glory is fleeting
Given that Netflix is clearly both a category killer and the strongest player in its industry, you may be asking why I'm not out buying its stock. The reason is simple. Netflix has a great transitional business model, but it has absolutely no long-run moat. At its core, it is a distribution company. As such, its business is more akin to YRC Worldwide (Nasdaq: YRCW  ) than it would like you to believe. Anybody with a truck can start a trucking company. While YRC is among the biggest and best-run of the bunch, its ability to charge higher prices is severely limited by the ease of entry from potential competitors.

Netflix profits because people's Internet connections are fast enough to browse a video catalog but not quite good enough to watch a high-quality movie in real time. As soon as fiber optic connectivity to the home becomes commonplace, Netflix's model is doomed. And such next-generation connectivity is closer than you might believe. Verizon's (NYSE: VZ  ) FiOS service was among the first to launch. Utah's Utopia project is another effort well underway to provide ultra-fast networking to people's doorsteps.

Once the network stops being the bottleneck, movie downloads will be as easy as music downloads are today. That spells trouble for Netflix and its current position in the movie-rental business. Remember that Apple's (Nasdaq: AAPL  ) iPod and iTunes platform launched the company from nowhere to the top of the legal music-download business. Likewise, the company that will successfully commercialize movie downloads probably won't be one that's on anybody's radar today. When network speeds increase enough so that physical distribution of movies is no longer needed, the competition will get fierce, and the download price for movies will plummet.

Cracks in the foundation
In addition to the future threats facing Netflix, its business model seems to already be peaking. Take a look at a couple of charts gleaned from its annual SEC filings:

Year

Revenues

Y/Y Change

2001

$74,255,000

N/A

2002

$150,818,000

103.11%

2003

$270,410,000

79.30%

2004

$500,611,000

85.13%

2005

$682,213,000

36.28%



Year

Subscr.

Gross Adds

Cancelled
Scrips

CF*

2001

456,000

566,000

402,000

137.67%

2002

857,000

1,140,000

739,000

162.06%

2003

1,487,000

1,571,000

941,000

109.80%

2004

2,610,000

2,716,000

1,593,000

107.13%

2005

4,179,000

3,729,000

2,160,000

82.76%

*CF: Cancellation fraction of prior year's subscriber count.

The first chart shows that Netflix's most rapid ascension is behind it. Its revenue growth rate is clearly slowing. The second chart indicates that Netflix already has significant trouble keeping its customers for the long term, even without any fiber-optic-based competition fully up to speed. From the looks of that high cancellation rate, customers don't tend to stick around for very long -- around a year or less on average, it seems. For a company that makes its money based on monthly subscription fees, that's a giant red flag.

The big picture
Netflix has slowing revenue growth, an outrageously high churn rate, and a moat that's destined to collapse. Yet it trades at about 36 times its trailing earnings per diluted share. With the path ahead looking so much rockier, that's a premium price to be paying for a risky stock. The market simply offers far better deals elsewhere for me to bother thinking about buying Netflix.

Netflix is aMotley Fool Stock Advisorrecommendation. For more of Tom and David Gardner's picks, try out Stock Advisor free for 30 days.

There's more to this Duel! Check out the other three arguments, and then vote for a winner.

At the time of publication, Fool contributor andInside Valueteam member Chuck Saletta had no ownership stake in any of the companies mentioned in this article. The Motley Fool has a disclosure policy.


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