Netflix Gets the Last Laugh

Oh, if only Whitney Tilson had listened to Netflix (Nasdaq: NFLX  ) CEO Reed Hastings sooner.

"Shorting a market leading firm as it is driving a huge new market is a very gutsy call," Hastings wrote in an open letter to the publicly short and fellow charter-school donor Tilson. "On balance, I would rather have my co-philanthropists on the long side of this particular bet."

Netflix's stock has gone on to soar nearly 30% since Hastings' mid-December advice. Tilson and his fellow shorts were already smarting plenty before that. Netflix's stock has been a 10-bagger over the past four years.

In other words, it eats shorts for breakfast.

The stock's gains since early last week won't be stinging Tilson anymore. He has now covered his short position.

Bear essentials
"We have closed out our position because we are no longer confident that our

investment thesis is correct," Tilson wrote on Wednesday.

He had actually met with Hastings a few days earlier, but the company's blowout holiday quarter and a favorable customer satisfaction survey also helped sway the once-vocal bear.

It was hard to poke too many holes in Netflix's fourth-quarter report. Gross margins slipped, but net and operating profit margins widened sequentially. The company was also able to tack on a record 3.1 million subscribers during the quarter, mollifying concerns that Netflix wouldn't be able to beef up its streaming content without sacrificing either marketing or margins.

This doesn't mean that all critics have been appeased.

"I think they're playing accounting games here," Brecken Capital's head Leonard Brecken said on CNBC on Friday. He feels that Netflix isn't appropriately amortizing its streaming costs, ultimately leading to a share price that will fall to well under $70.

Earning its keep
Brecken isn't the only one who feels that Netflix is overvalued.

Hastings himself agreed with Tilson back in mid-December that his stock's valuation was "substantial." Shares are obviously even more expensive now.

However, Hastings was advising Tilson to cover his short because it's hard to make money betting against a company that has a bigger moat than cynics may think.

There are plenty of companies beginning to cash in on the smorgasbord model.

  • Comcast (Nasdaq: CMCSA  ) is now letting its subscribers access streaming content on channels that they are already paying for through its Xfinity service. It's at the heart of the TV Everywhere movement that Comcast and Time Warner (NYSE: TWX  ) have been trying to get off the ground for nearly two years.
  • Amazon.com (Nasdaq: AMZN  ) is rumored to be adding a streaming service to its Prime shoppers who pay $79 a year for subsidized shipping at no additional cost. It already leaked an inadvertent preview earlier this month.
  • Now that Apple TV is gaining traction, it wouldn't be a surprise to see Apple (Nasdaq: AAPL  ) go from piecemeal digital rentals and purchases to adding an "all you can stream" option. It hasn't taken this approach with digital music, but there's no premium cloud-based music service that is making a dent in its iTunes stronghold.
  • Coinstar's (Nasdaq: CSTR  ) Redbox has been talking up a digital strategy since last year.  

The rub, of course, is that none of them are close to competing with Netflix now. Xfinity is just Comcast's way to keep the cord-cutting in check. Its cable bills are several times over Netflix's monthly rate. Coinstar is a brand associated with cheap DVD rentals. It will have an uphill battle if it wants to take on Netflix in streaming instead of cashing in on the gradual closing of Blockbuster stores.

Amazon and Apple are the two that should be taken seriously, but they're missing a major component.

I'm not talking about the existing base of 20 million subscribers at Netflix, though that's huge given that content licensing deals are inked for fixed sums. A content provider will be missing out on a big chunk of the audience if it plays hardball with Netflix.

The scary truth is that Netflix doesn't need the studios to play along. As long as Netflix clings to its DVD distribution centers, it can still offer any title on the market. No one else can do that. Blockbuster and Redbox have local access to new releases, but Netflix has it all. Apple and Amazon will never be able to compete.

This doesn't mean that Netflix has a birthright to the stratosphere. Investors have to realistically asses what this market is worth. The playing field will be more level internationally, where Netflix is in for cutthroat competition as an exclusive streaming service.

However, predicting that Netflix will falter because of competition that doesn't exist or amortization accusations has been painful for shorts in the past. Why should the future be any different?

Is Netflix overvalued? Share your thoughts in the comment box below.

Apple, Amazon.com, and Netflix are Motley Fool Stock Advisor recommendations. The Fool has written puts on Apple. The Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Longtime Fool contributor Rick Munarriz has been a Netflix shareholder -- and subscriber -- since 2002. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (7)

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 February 14, 2011, at 8:16 PM, websterphreaky wrote:

    I seriously believe that the Netflix "party" is on the short path to hell and here's the reason why.

    A recent report from the major ISP's showed that Netflix is EATING UP 85% of the Internet's Bandwidth in the evening from 7PM till 2AM. That leaves 15% for the rest of EVERYONE to use for EVERYTHING WE NEED TO DO!!

    Trust me, the major broadband providers like AT&T, Verizon, etc. are not going to put up with that chit for very much longer. They go after Netflix for fees (or bottleneck them) or they will shut YOU down for excessive bandwidth use.

    Either way, Netflix will lose. They have no "Right" to eat up all that bandwidth. It's no damn wonder that anything I try to watch on Boxee, or other services, is constantly Cashing!!

    Tell ya, I wouldn't bet Long on Netflix.

  • Report this Comment On February 14, 2011, at 8:56 PM, MKArch wrote:

    How about gross profit was actually DOWN sequentially and net profit ONLY beat analyst estimates and was not down sequentially because they slashed their marketing expenses and their tax rate plummeted from ~42% to ~37% sequentially for a hole? If not for those two levers they earn ~$0.66 and miss estimates by a nickel and earnings are down for the second straight quarter.

    Here's a little math to demonstrate why the content providers don't need NFLX and their 20M almost non paying subs. Comcast has about the same number of subs as NFLX with MRQ video revenues of $4,881 and cost of content at $1,846 or cost of content was about 38% of video revenues. I checked and saw Comcast offering a 6 month special on Starz for $10.00/ month. I'll guesstimate it's regularly $15.00/ month. Assuming cost of Starz is ~38% this works out to ~$6.00/ sub.

    Lets see what happens to NFLX model and growth if they pay $6.00 per sub for Starz. Starz managment already gave everyone a hint about how they will deal with NFLX el cheapo business model. "if NFLX wants cheap content they'll just get less of it". Right now NFLX subs think they've beat the system getting Starz content for a fraction of what it costs to get it from their cable company. Not only that but they think NFLX is going to keep adding content. What happens after NFLX renegotiates and gets the bottom of the Starz barrel of content and still has to pay big bucks for it?

    This story isn't over yet. Hastings knows this that's why you won't be getting standard subscriber metrics after 2011. I'd be willing to bet one reason is because a large percentage of early streaming subs have seen everything they want to see are not renewing. Because their numbers are small and new sub numbers are large they are not causing large churn right now but look out when the current class of subs start anniversarying over the next year or two. Particularly when the renegotiation's with Starz results in less content not more content.

    AOL had massive growth and wall street ate their story up. So much so that they were able to acquire Time Warner even though their model was unsustainable. NFLX model is also unsustainable because the content providers will not allow them to set a precedent that will allow their bread and butter cable customers to demand content at a fraction of what they are paying now. You've got it bassackwards that the content companies need NFLX and their almost non paying subs. They can't afford to let NFLX devalue their content. They're even telling anyone who will listen NFLX model is unsustainable but nobody wants to listen. Maybe they'll finally get it when NFLX negotiates less Starz content for orders of magnitude more money. If anyone listened they already told you this is coming.

  • Report this Comment On February 14, 2011, at 9:59 PM, MKArch wrote:

    Just thought of another way to see how insignificant NFLX is to the content providers. If you annualize Comcast's $1,846 content costs it comes to ~$7,400. Even though Comcast is the largest cable company they are still just one of many that are paying top dollar for content.

    Last year NFLX subscription costs were ~$900. I think ~$600 of that was dvd fulfillment leaving ~$300 for content. Add in an estimated ~$600 for the recent Epix and Disney deals as well as estimates for what Starz renewal will cost and NFLX will account for something like $900 in content procurement or around 12% of what Comcast alone pays for content.

    The content providers need NFLX like they need a hole in the head. Who needs 20M cheapskates?

  • Report this Comment On February 14, 2011, at 10:12 PM, dvena wrote:

    "EATING UP 85% of the Internet's Bandwidth in the evening from 7PM till 2AM"

    Actually, I read the news story. What it said was that 85% of the traffic if from Netflix. The current traffic that is no where near the available bandwidth capacity. Capacity is an ever increasing target. Netflix will never eat up 85% of bandwidth, though I suspect it could end up being even more than 85% of traffic.

    HUGE difference.

  • Report this Comment On February 14, 2011, at 10:44 PM, ironman50 wrote:

    MKArch is correct on all points. Just a matter of time till this implodes. Netflix and all of the other momentum stocks that are screaming into the stratosphere are exactly like the stocks before the dot com bubble burst - it is funny how investors want to forget that bubble because of course this time you may think that it is different - just like all of the analysts were saying back then. Irrational exuberance and the greater fool theory only last so long because everyone thinks that they are smarter and faster than everyone else and will sell out at the top - I wish everyone good luck on these stocks and hope that they keep making money - but unfortunatly many people getting into these stocks at these levels will be badly burned. I will just stick to value investing like the last 35 years - it does work.

  • Report this Comment On February 15, 2011, at 6:12 PM, greghamy wrote:

    Here's the simple situation at NFLX:

    Company made at $125 million last year and as noted, may have accomplished this by accounting irregularities. Company market cap is 100 times last years earnings!

    Business model has a fixed revenue even though clients can use the service in an unlimited fashion for about $7 per month, so income stays the same as cost of providing unlimited content will grow with more use. Not good!

    Amazon, Wal-Mart, Google and Apple..among others are getting into the business soon. Sorry this isn't like taking on Blockbuster or Coinstar.

    Reed and other insiders are Selling stock NOT buying.

    Once the fools paying 100 times earnings realize the above..price MUST go down....this isn't 1999 folks!

  • Report this Comment On February 15, 2011, at 7:00 PM, deathinacan66 wrote:

    I love netflix. I think its a great business model. What I do not like is how many other companies see Netflix as a "microsoft" monopoly-like business, and limit them through whatever means necessary to keep them from obtaining complete dominance in the video market.

    I for one have never gone over my "bandwidth allotment" of 250 Gigabytes, because frankly, even with HD options turned on, I don't watch that many movies a month.

    To run out of bandwidth like this, you would need to be using around 7.2 gigabytes a day, which is well over what the normal user requires.

    However, where Netflix fails is in its delivery to the marketers - I believe Blu-Ray and DVD's are both transition mediums to a completely non-physical format.

    We're in a revolutionary stage, which started a long time ago when people would take DVD's, rip the data down to a 700 mb file, and still enjoy the sub-dvd quality movie on their hard drives, without worrying about it getting scratched, lost, or destroyed - you just copy, paste, and bam, its there.

    Netflix business model is as good as you can get. "If a person is doing anything other than Netflix, we are failing as a business... Netflix should be the only thing people DO" ... While the statement is a bit overwhelming, falling slightly short wouldn't be a bad thing either.

    Netflix needs to carry all of its existing titles on streaming. People do not want to wait 3 days for a DVD to be delivered. Digital streaming saves money on shipping, reduces waste, and gives people of the U.S. a genuine way to save money by staying home during the weekday.

    ... Lastly - I believe that if Netflix were able to charge for newly released movies in theatres (IE: 20 dollars per viewing), we'd see a huge jump in households skipping the movie theater experience altogether...

    3D is over-rated, and shouldn't be offered to avoid the increase demand on streaming. period.

    I laugh over how hard hollywood is pushing for the 3d concept to catch on. I always picture a movie in 3D already - why would I need to wear a 140 dollar pair of goofy uncomfortable glasses and watch screen flicker for 2 hours?

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