Is Netflix Built to Last?

After a 200% rise over the past 12 months, Netflix (Nasdaq: NFLX  ) has certainly rewarded investors. But does the company have a wide enough moat to keep competitors at bay for the long haul?

The stuff moats are made of
Warren Buffett coined the term "economic moat" to describe the strength of a company's competitive advantages. Many factors confer short-term competitive advantages, but in his excellent The Little Book That Builds Wealth, Morningstar's Pat Dorsey convincingly argues that only four factors create an enduring economic moat. Let's use Dorsey's criteria to see what Netflix's moat is made of and just how sustainable it is.

1. Intellectual property rights
Moat-building intellectual property includes intangible assets such as patents, licenses, and brands. Any company can have a brand, but truly moat-widening brands must increase a consumer's willingness to pay for a product.

Moat source: no
Sure, consumers like the Netflix brand, but they aren't willing to pay more for a movie just because it comes in a cute red envelope. When rival Blockbuster lowered the price of its DVD subscription plans back in 2007, Netflix quickly followed suit. That's not how a company with a wide-moat brand would respond.

2. Customer switching costs
Products that are tightly integrated with a customer's business or lifestyle make it difficult for that customer to switch to a competitor's product.

Moat source: slight
Coinstar's (Nasdaq: CSTR  ) Redbox and the joint venture Hulu can tempt Netflix's subscribers with cheaper movies, but these low-cost competitors can't hope to duplicate Netflix's powerful movie recommendation engine or personalized movie queues. These unique features will make subscribers think twice before jumping ship.

3. The network effect
The value of some services increases in direct proportion to the number of people using them. For example, Facebook offers a much richer experience with 500 million users than it did with a handful of undergraduate dorm mates.

Moat source: no
While it's true that each new Netflix member could incrementally improve the recommendation engine and movie review database, I don't think that's sufficient to support a sustainable economic moat. The average member's Netflix experience is not meaningfully improved by each incoming member.

4. Cost advantages
Finally, lower costs can create lasting competitive advantages. The benefits of operational efficiencies and smart processes inevitably erode over time. A truly sustainable cost advantage, like economies of scale or a superior geographic location, simply can't be copied.

Moat Source: yes (for now)
Netflix's greatest competitive advantage -- its uber-efficient DVD delivery system -- is the biggest factor keeping competitors at bay today. Unfortunately for the company, this advantage is steadily eroding as digital delivery becomes more common.

Netflix's distribution centers and information systems enable the company to deliver physical DVDs within one business day to 97% of its member base. Potential competitors would have to invest multiple years and hundreds of millions of dollars to replicate this capability. However, the playing field for distributing movies digitally is much more level. Netflix has the first-mover advantage in digital delivery and has signed a number of shrewd partnerships to embed its technology in consumer devices such as the Xbox 360, PlayStation 3, and Wii, but competitors' barriers to entry will be much lower in the future than they are today.

Numbers don't lie
To determine whether a company enjoys a sustainable competitive advantage, examine its return on invested capital over time. Returns consistently exceeding a company's cost of capital suggest that it possesses a nice moat. Here's how Netflix's ROIC stacks up next to Blockbuster:

Company

FY2007

FY2008

FY2009

Netflix

12%

17.8%

28.8%

Blockbuster

(1.6%)

7.4%

2.8%

Source: Capital IQ, a division of Standard & Poor's.

Survey says: narrow moat!
As you can see, Netflix currently enjoys phenomenal returns on invested capital, thanks in large part to its prowess in delivering physical DVDs. But the competitive landscape is shifting by the minute -- and not in Netflix's favor. With $1-a-day rentals and plenty of new releases, Coinstar is chewing up the low end of the market, while companies such as Apple (Nasdaq: AAPL  ) and Amazon.com (Nasdaq: AMZN  ) are trying to capture the per-rental (rather than subscription) market. And we can't overlook the threat posed by on-demand offerings from cable companies Time Warner Cable (NYSE: TWC  ) and Comcast (Nasdaq: CMCSA  ) , or the movie studios themselves, who surely would like to get a slice of the action.

Ready to buy?
Not so fast, my Foolish friends! Even if you believe that Netflix can widen its narrow moat and fend off the coming competition, that doesn't automatically make it a smart buy. While competitive advantage is critical, it's also essential for investors to have a strong understanding of a company's management, finances, and valuation -- and to always buy at a significant margin of safety.

That's the strategy our team at Motley Fool Inside Value employs. You can read all of the team's research reports and see their best buys for new money now, with a 30-day free trial.

Rich Greifner does not own shares of any company mentioned in this article. Apple, Amazon.com, and Netflix are Motley Fool Stock Advisor selections. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 18, 2010, at 11:00 AM, BioBat wrote:

    Netflix currently has a huge cost advantage for customers on digital delivery over its rivals that doesn't seem to be included in your analysis.

  • Report this Comment On August 18, 2010, at 12:16 PM, morrisjd wrote:

    The moat argument: By the same token you would argue that Google has a very narrow moat, as the internet is open to all comers concerning search engines. Yet only Google dominates the field. WHY?

    Another thing. Competitors (those with network and internet access) are hamstrung by unintended collusive connections. For example a media giant able to compete against Netflix has ties to a cable company conglomerate that prevents this from happening.

    In a fashion similar to Google, I think Netflix will dominate the streaming field because they have the lead, they have the infrastructure (and customer critical mass) and they don't have any "business ties" that would constrain or reduce their focus or their ability to expand.

    The new TVs and Blu-rays with Netflix compatibility says it all.

  • Report this Comment On August 18, 2010, at 12:23 PM, TMFTenacious wrote:

    @1GR8DAD,

    As you can easily see from the disclosures above, neither I nor The Motley Fool own shares of Netflix.

    Thanks for reading,

    Rich

  • Report this Comment On August 18, 2010, at 12:28 PM, TMFTenacious wrote:

    @morrisjd,

    Actually, I'd say Google has a wide moat, based on its superior search algorithm. That's an advantage that even the most competent competitors have been unable to erode.

    Netflix had a strong moat in physical DVD distribution, but as I mentioned in the article, I feel the barriers to entry for digital distribution are much lower. Netflix certainly has the first mover advantage, and I love the strategy of partnering up with the device makers, but I don't believe the company's moat will be as wide in the digital era.

    Thanks for reading,

    Rich

  • Report this Comment On August 18, 2010, at 12:57 PM, morrisjd wrote:

    If we were to roll back the clock to Google's early days, it could be argued that, because their algorithm was in the public domain, it was open to competition from all the major players such as Yahoo and Microsoft. These major players (with huge moats) had huge resources (capital and technical expertise) to combat Google.

    So I would conclude that Google started out with a tiny moat. They succeeded by being first to roll it out and thus gain market dominance. Maybe their moat is big now, but that is because they were there with the excavation equipment to enlarge it.

    Netflix has the game boxes, blu -ray devices, new HDTV sets and Wi-Fi as its excavation equipment.

    Jack

  • Report this Comment On August 18, 2010, at 1:04 PM, BioBat wrote:

    If Netflix digital distribution moat is so small, how come no other company in the last 5-10 years (when internet enabled video has started to take off) has come anywhere where near being able to reproduce or replicate at even a fraction of success (both and gaining and retaining subscribers and at delivering quality video over the internet) what Netflix can through its service? This includes on demand streaming by cable companies, what once were freebies (Hulu) and those that still are (youtube). Nobody comes close yet they've all been in the game just as long and some longer.

  • Report this Comment On August 18, 2010, at 1:22 PM, TMFTenacious wrote:

    @morrisjd,

    If first mover advantage was the key to success in this space, then we'd still be using Lycos and Webcrawler. Google captured market share (and maintained it) because its search alogrithm produced more relevant results than its competitors. I'd only invest in Netflix if you believe the company can consistently provide a "more valuable" video watching service than its competitors.

    -Rich

  • Report this Comment On August 18, 2010, at 1:29 PM, TMFTenacious wrote:

    @BioBat,

    This industry is still in its infancy. I think Netflix began offering downloadable content in the 2007/8 timeframe? Do you believe Netflix's competitive position will still be as strong in five years' time? That's the key question, IMO.

    -Rich

  • Report this Comment On August 18, 2010, at 2:25 PM, marine1129 wrote:

    Google's moat also has an order of magnitude number of server farms and data centers over their competition, which includes Microsoft and Yahoo. And they are building more every day. Their competition can't catch up unless Google stops the server farm/data center effort which isn't going to happen.

    TechnologyBill

  • Report this Comment On August 18, 2010, at 4:30 PM, BioBat wrote:

    TMFTenacious,

    Video over internet has been around a long time. I knew many people who were watching streaming content on their computers over the internet pre-1998 (it wasn't a great viewing experience mind you) but in over a decade nobody but Netflix has figured out how to deliver it well. It's not just a licensing issue, which Netflix has no advantage over anyone else - it's a technology advantage that nobody else has figured out. They may in time but given Netflix' ability to adapt rapidly and jump into new target areas faster than any other company I've seen in a long, I think they'll retain a significant competitive advantage in 5 years.

  • Report this Comment On August 18, 2010, at 7:06 PM, mattack2 wrote:

    NONE of the competitors have an "all you can eat" model, especially for digital distribution.

    (I say that as someone who has barely done any streaming -- mostly playing with it for a few minutes... and who probably has paid MORE per movie than if I had rented each one separately.. but I still far prefer paying for as many-as-I-want-to-watch.)

  • Report this Comment On August 18, 2010, at 8:00 PM, TMFTomGardner wrote:

    One of my favorite things about evaluating competitive advantages is that it naturally leads to a big debate -- and I love debate!

    Netflix definitely has a major brand advantage at this point, which can act as a moat. I also think it's audience size and financial strength have opened the door on some very effective wheeling and dealing to increase their streaming library. The company's culture is a huge competitive advantage; I recommend reading their HR deck if you haven't:

    http://techcrunch.com/2009/08/05/other-companies-should-have...

    And finally, I'd cite Reed Hastings and his experience as an entrepreneur, his long-term committment to this business, and his ability to inspire others as a core competitive advantage.

    The textbooks and Michael Porter can give you some good tools on how to define competitive advantage. But I also think the standard tools don't take into account the genuine complexity of business. Finally, I love that we can disagree and then agree to disagree.

    Netflix is a multi-rec in Stock Advisor. And from my standpoint, the future remains very bright -- because of some of the advantages mentioned above and because of their passion for the future.

    Foolishly, Tom Gardner

  • Report this Comment On August 19, 2010, at 1:01 PM, TMFOpie wrote:

    The one area in which Netflix has a competitive advantage and IP lead is in its movie recommendation engine. No other provider that I know of -- Comcast, Apple, Hulu, TimeWarner -- has the recommendation power that Netflix does. They even hosted that $1 million challenge for tech teams around the globe to improve the engine (and two finally teamed up to win). I've long contended that there is true shareholder value tied up in that IP and that some other distribution company would love to tap into it or re-create it. So far they have done neither. Netflix will take that IP to digital distribution but right now because the library is much smaller its not quite as valuable. But there are valuable network effects with the rec engine itself as more people add more votes.

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