Why I Bought Netflix

Big news out of Netflix (Nasdaq: NFLX  ) last night. The leading supplier of streamed video programming has struck a deal with DreamWorks Animation (NYSE: DWA  ) in which the latter will forego pay TV as a distribution source for its films and TV specials.

This isn’t why I bought shares of Netflix 11 days ago, but it is reflective of why I still consider Netflix to be a tremendously disruptive competitor.

Neither Amazon.com (Nasdaq: AMZN  ) nor Hulu could have done this deal and given DreamWorks distribution that’s comparable to pay TV. Only Netflix has that sort of reach; Amazon and Hulu aren’t available on that many devices.

Netflix’s real source of competitive advantage
Bears will tell you that content is what matters and that deep-pocketed competitors will get more of it, destroying Netflix’s advantage. The company’s eroding position was an ongoing theme of the Fool’s Superior Investing Ideas conference in Alexandria last week.

You know what? I think the bears have it wrong.

Reach is Netflix’s advantage. Start a movie on a computer, move it to a tablet, and move it again to a TV, all without ever losing your place. Netflix does this seamlessly. YouTube, which has similar distribution but little premium content, has yet to figure this out. Hulu has the experience down but isn’t widely available. Amazon is great on a computer; not so great elsewhere.

Distribution -- or better yet, consistent distribution -- across devices is why Netflix accounts for roughly a third of primetime streaming bandwidth. The company’s content library is a small part of the equation.

Just look at the expiring Liberty Starz (Nasdaq: LSTZA  ) deal, which CEO Reed Hastings says accounts for only 8% of streaming traffic. Seems right to me; my kids are the primary Netflix users in our house and they’re most often found watching TV reruns. I can’t remember them using “Starz Play.”

It’s hard to be easy
Exactly 10 devices in our home offer Netflix. Hulu is present on four. Amazon is available on five. Our kids never choose Hulu or Amazon. Netflix is what they know and like most because it’s easy. There’s no downloading. There’s no configuring. Sit, click, and watch.

Most interesting are the days when my smallest two are watching a rerun on the Wii while my oldest watches his shows on his MacBook Air as my wife and I catch up on old USA Network shows upstairs. Netflix handles all the streams from our one account. Granted, this doesn’t happen often, but consider the infrastructure required to deliver these streams simultaneously and seamlessly.

Not only do you need a distributed server network attached to a massive storage array. You also need high-speed point-to-point connectivity to pull from storage systems and deliver to my home network. Level 3 Communications (Nasdaq: LVLT  ) seems to be doing most of the heavy lifting in this area.

You also need algorithms capable of loading and logging each stream so that if I end a stream on one device and pick it up elsewhere, my place won’t be lost. And finally you need monitoring to track stream quality, and to reset automatically, if any point on the network becomes clogged.

My point? Tech simplicity often requires a tremendous amount of complexity. Netflix is no exception. Hulu and Amazon are going to have to bolster their distribution infrastructures and support a lot more devices in the quest to disrupt Netflix. Don’t expect it to be easy for either -- Amazon especially, having seen its cloud computing network, which supports Twitter and others, teeter and fail multiple times in the past year. (Affecting Netflix in at least one case, ironically.)

Not exactly losing the content war
Yet Amazon may very well be the one to crash Netflix’s profit party. Earlier today the e-tailer announced a breakthrough streaming deal of its own, with News Corp.’s (Nasdaq: NWS  ) Twentieth Century Fox.

Before that prompts you to sell, look at what’s being offered. Amazon is getting old videos to stream to Prime members. Think of it as a lightweight version of what Netflix gave up when it chose not to pay $300 million to renew the Starz deal.

DreamWorks, on the other hand, will give Netflix streaming rights to new films that would otherwise be distributed via pay TV channels such as HBO. The deal, which kicks off in 2013, isn’t cheap; Netflix could pay upwards of $30 million per film, according to reporting by The New York Times. But it does represent a shift. Studios want content to go where it’ll be seen most and the Internet is the world’s most pervasive network.

The illusion of static
Assuming Netflix would fail to find a workable streaming model always struck me as a loser’s bet. Sure, studios want more for content, but let’s not forget we’re only a few years removed from Steve Jobs convincing a once-immovable music industry to accept $0.99 a track pricing in exchange for seamless distribution via the iTunes Store and iTunes software, which was built not just for Macs but also all iOS devices and Windows. Creative distribution won out, and can win here too.

Let’s also remember that Netflix has a history of streaming titles for a time and then dropping them. So does Hulu. In streaming video, there’s no such thing as a static library. Netflix will make deals, end them, and then make new deals. Its library will change as it always has, leaving the abysmally named Qwikster DVD-by-mail unit as a secondary source for those who want content not available for streaming.

Feeding the bears
None of this is to diminish the good bear cases made by my Foolish colleagues. Motley Fool Hidden Gems advisor Seth Jayson has a piece worth reading, as does my Motley Fool Rule Breakers teammate Rick Munarriz. I’m nevertheless content to remain in the bullish minority.

My take, simply, is that a legitimate but largely overblown content scare has tricked investors into forgetting about Netflix’s true advantages -- distribution and simple pricing. Advantages that continue to disrupt a cable and satellite industry that produces more than $100 billion in annual revenue. Netflix has less than $3 billion by comparison, but if I’m right, its share will grow geometrically from here.

Do you agree? Disagree? Please weigh in using the comments box below. And if you’re in the mood for more Web-centric stock ideas, try this free video. You’ll walk away with a better understanding of the cloud computing movement that Netflix is profiting from and a winning stock idea from our Rule Breakers scorecard. Click here to watch now -- it’s 100% free.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Netflix at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Google or Twitter, where he goes by @milehighfool. You can also get his insights delivered directly to your RSS reader.

Motley Fool newsletter services have recommended buying shares of Netflix, DreamWorks Animation SKG, and Amazon.com. Motley Fool newsletter services have recommended creating a bear put spread position in Netflix. 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. The Motley Fool has a disclosure policy.


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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 September 26, 2011, at 3:46 PM, nhalden wrote:

    So here's the problem....

    NF is cash poor. This was proven when they decided to let the Starz deal fall through. $300M is not chump change to be sure....but when looked at per movie or series it's significantly better than 30M per movie.

    STARZ accounts for 8% of all of NF total streaming content. 4 -6 movies a year from DreamWorks isn't going to cut it. PLUS it's not gauranteed the NF will opt to buy all of the movies that come out...30M here 30M there...it's almost like financing for streaming content. PLUS there is the royalty per play.

    NF just doesn't have the cash or the will to make the big deals that are needed to maintain and grow their streaming service...so in this case I feel that you are way off. DEEPER POCKETS WILL RULE IN THE END. CONTENT WILL BE GOD...Other devices will/DO stream Hulu, VUDU, AMAZON (eventually) NF as know it is short for this world and it's their own doing...if you buy now you are what your screen name implies a "fool".

  • Report this Comment On September 26, 2011, at 6:27 PM, TMFDukenewkirk wrote:

    Exactly, while it made me feel a little sick to do it in this short term state of uncertainty, reach and ease of use, is why I bought today. I'm looking to own a little bit of the long term winner of the entertainment media wars. This will take years to determine, but I had to pick the one horse that's way ahead. I'm in Canada, I've never even seen anything on HULU or AMAZON...because I can't. Canada, we're practically a state.

  • Report this Comment On September 26, 2011, at 6:47 PM, Threedollarbill wrote:

    Re: nhalden: Deeper Pockets? They didn't want to over pay for Starz which was overpriced for what they offered, and I'm glad they didn't, that makes sense to me, and why I'm still hold my NFLX shares. I haven't been happy with every move that Hastings has done, but he seems to know how to manage and make money, that's good enough for me.

  • Report this Comment On September 26, 2011, at 8:51 PM, TMFDukenewkirk wrote:

    rd nhalden's comment

    NF is cash poor. This was proven when they decided to let the Starz deal fall through.

    Clearly, nhalden hasn't much experience in negotiations. Good business does not mean paying whatever suppliers demand, regardless of cost or value. Proving you have Deep Pockets by doing so does little to prove you have any real business acumen. This race is very long from over. Netflix is in the lead still on most levels, and buying at a 60% discount, to an, arguably, overly-enthusiastic 52-week high over $300, is hardly foolish. It's still certainly risky, but hardly foolish.

    Whoever does win this race over the next 5 years will likely be a true media giant. Netflix moving into 'just released' territory with Dreamworks is the sign I was looking for, that this is in fact the end game. It's no guarantee of anything at all right now, but suggesting Amazon or HULU, who haven't even stepped outside their backyard yet, are 'obvious' winners seems at least equally, if not considerably more foolish then hitching our wagons to Netflix now.

  • Report this Comment On September 27, 2011, at 9:17 AM, nhalden wrote:

    So to all who think $300M is over priced....

    From a Starz content (new per year/per movie/series) comes to about $8M/per

    Compared to $30M/per for the Dreamworks deal.

    The difference being...300M up front vs 30M option to buy.

    Again STARZ = 8% of all streaming media for Netflix. This is THOUSANDS of titles that will be gone by years end (3 months). vs. 6 or so new titles per year from Dreamworks starting in 2013. Howeverm they will probably only opt to buy 2 or 3 of the top grossing films.

    People assume that NF may buy past dreamworks content (not the case) they will only buy newer content (if they are smart) Then again if they were smart they would have kept the Starz deal.

  • Report this Comment On September 27, 2011, at 9:36 AM, nhalden wrote:

    @Threedollarbill:

    I don't know when you bought into NF or if this is a relatively new purchase...but over the last few months NF share have droped by more than 50%.

    NOW that they have split the company into 2 separate entities and I believe Qwikster will have it's own stock offering. NF is really only work half as much...if that. AGAIN I go back to the STARZ deal. This shows they do not have the capacity to maintain current content or significantly grow new quality content. They just don't have the cash to do it.

    Look $30M 4 years ago for STARZ is highway robbery. Today $300M is a fair rate for the amount and quality of content. (Disney and Sony)

    Hastings even said that he didn't think that growing content or having new releases for the streaming service was that important.

    Buying this stock NOW is not smart. I guess selling it now maybe a bit brash too since you've already waited through what's probably hte biggest down turn...however I think there is easily 15 to 20 points left on the down side...In fact if they aren't making more deals by the end of the year, the price should be less than $90/share.

    They have neither the content, the funds, nor the will to grow. On the other hand the competition will continue to grow. DISH will most likely GET STARZ (they now have FOX, which no one else has) HULU plus is growing, Amazon is growing, VUDU has the most HD titles.

    You should have sold at $200 (at min)

  • Report this Comment On September 27, 2011, at 12:22 PM, TMFDukenewkirk wrote:

    Dealing with Dreamworks is cutting out middle-men, the way this will have to work in the future. Why pay Starz at all? Why not wait it out and then when the window opens, deal directly with Disney and Sony? I'm betting Netflix is looking further ahead. We probably have to wait for 2013 Dreamworks offerings for precisely that kind of reason. Dreamworks may have to wait to not step on toes of previous partners.

    Amazon and Hulu haven't even left their back yards yet. Leave the states and nobody even knows they stream movies. Don't forget, a tremendous amount of the world doesn't get US TV for many months to years after initial release. That content may play very well as old content outside the US borders.

    I'd like a direct link to Hasting saying content wasn't important, by the way.

    Stating buying now is not smart, and selling now, is not smart, pretty much covers all the bases then doesn't it? I can safely say you are at least 100% wrong on one count. Frankly, I have little to no idea, and neither does 'anyone' else, what their shares will be worth by the end of the year, nor do I care. This story will play out over several years and nobody is working with the model that will ultimately work yet, aside from Netflix. Also, pretty bold statement about what their 'will' is. I would argue they have greater will to grow in this industry than any of their competitors, as they are specialized and focused on one business, as opposed to the jambalaya their competitors work with.

  • Report this Comment On September 27, 2011, at 12:45 PM, TMFDukenewkirk wrote:

    Also, nhalden, Amazon has 'exclusive' rights to Wonder Years, not all Fox content. Enormous difference there. For instance, Netflix has all 8 seasons of 24. I dare say, exclusive rights to Wonder Years isn't bringing down the house of cards. And besides, why would Fox tie its hands so completely? In any case, ultimately, Netflix, or whoever wins this race, won't be doing it by buying content second hand in the long run. Content providers, like Dreamworks will not remain so completely obligated to the networks they've dealt with for the last few decades, as Dreamworks has just proven. My hope, and indications are, this is where Netflix is rightfully setting its sights.

  • Report this Comment On September 27, 2011, at 1:27 PM, nhalden wrote:

    Never said Amazon....re-read...I said DISH (blockbuster)

    With Dish/blockbuster you can watch any Fox show the day after it airs if you are a subscriber and if you aren't 9 days later.

    THIS IS HUGE and not like NF deal that has to wait until the season is over and released to DVD.

    COMPLETELY DIFFERENT.

    As to STARZ vs studios...well that's simple..that would cost EVEN MORE MONEY. Case in point is the deal with Dreamworks which IN FACT does cost more than STARZ content for content.

    NF beat the hell out of the studios withthe DVD game and the studios don't want to make it easy for NF to stream content...Also by dealing with a pre packaged provided like Starz/HBO/Showtime etc... you get multiple studios and the premuim series.

    At some point which was about $100/share ago...the defenders of NF have to realize that NF has killed it's self...specifically Hastings has killed his company.

  • Report this Comment On September 27, 2011, at 1:31 PM, nhalden wrote:

    Wait what...I just read the "focused on one business line.

    CLEARLY THAT'S NOT THE CASE. Which is why they split. NOW they are BUT NOW they have no way to make the revenu required to bring in and grow quality new content. Dreamworks is a start yes...but not enough.

    Now there are too many competitors. DVD was the bread and butter in the combined business...Now NF will starve.

  • Report this Comment On September 27, 2011, at 2:17 PM, nhalden wrote:

    Here you go...link to where he repetedly states that Streaming is a "complement" to DVD and that he can't afford newer content "like customers want"

    Also that he would like to do a deal with HBO (like STARZ) not gonna happen EVER now

    enjoy

    http://robhof.com/2011/06/01/reed-hastings-at-d9-conference-...

  • Report this Comment On September 27, 2011, at 5:55 PM, TMFDukenewkirk wrote:

    Very good, thanks for the link. Maybe they could do very well as the trailing season provider of TV, at $8/month. Just released DVD though, they are clearly thinking about considering the Dreamworks deal.

    Dish Network costs at least 4 times as much, very comparable to my basic cable already. Hardly apples to apples. Like expecting a new car for the price of a used car.

    What's to happen in the distant future though, I'm guessing neither of us knows. Pretty sure it wouldn't be the most strategic way to go for Reed to be out yapping that he's going to eat NBC's or HBO's lunch one day.

    First thing that must happen, especially if the world is smart, which granted, there's little true indication of, is they stop paying for cable, make it clear to the studios they'll wait for more reasonable pricing and allow Netflix to grow enormous over many years to the point where they have enough mass to dictate terms on newer content.

    If not, I still believe going worldwide as they have begun, the second hand store in media content model will likely work well in most other countries. My little stake in the company will still have room to run.

    Don't get me wrong, I was bear side with a $300 price tag not so long ago, and I was ragging on the content as well, but having bought in at a 6 Bill market cap, I'm much more comfortable with the second hand store for the world. There is much room to grow outside US borders. Up in Canada, I don't know anyone who has Dish, not a soul. Furthermore at 4 times the cost, it should have more. I do think they offer it but it doesn't look attractive compared to what my local cable company offers. And as I said, Amazon and Hulu, we can't even get.

    It may never get to be the big, fat, bloated pig that TV networks are, but I'm feeling it's very unlikely they starve.

    For what this was all worth.

  • Report this Comment On September 27, 2011, at 6:20 PM, TMFDukenewkirk wrote:

    By the way, nHalden, thanks for the banter. It's helped guide me as I keep digging into future potential and possible outcomes. Funny, because two months ago, I was in your shoes, bear side, but again, as I said, Netflix was already priced over 12 Billion bucks at that point.

    For me, personally, Netflix is worth nothing for movies as the movie a week I see in theater pretty much covers anything worth watching. But for TV, waiting a year, until I already know what the good shows are, so I don't waste much time on them before I realize they suck, makes so much more sense at $8/month. I'll be surprised if they can't maintain at least that, and then simply grow the company by going worldwide.

    I suppose, king of current content dreams, even many years out in the future, may be just dreams. That would mean a big fight, with powerful companies. However, the world is a big place, and if Americans, in large numbers find Netflix worth their while, I can't see South Americans, Europeans or Asians failing to be impressed enough to make me some good money from here going forward.

    Again, nHalden, thanks. Once I buy, I shamelessly go bull and need negative nhaldens to keep me honest. Best of luck wherever your money is parked;)

  • Report this Comment On September 27, 2011, at 6:24 PM, StockGuru504 wrote:

    I went to a movie this past weekend .. it cost me $37 for two. - $5 gas + $20 tickets + $12 for popcorn and drinks. If I go every weekend, it will cost me $148. for two people. With Netfllix, I can watch all the movies and documentaries I want for $8 per month or $16 if I want to get the latest movies not available via the internet. Anyone who thinks they can get a better deal from Amazon or Disk Network has no idea what they are talking about. As to renting movies at $1 each from RedBox ... there's no comparison given the limited selection plus the time and gas to get there. Also, since getting Netflix, I've cancelled all my Cox Cable pay channels - which saves me more than the $16 cost for Netflix AND I can watch what I want when I want! And, if I could find a way to get CNBC on my TV without going through Cox, I'm get an indoor antenna and drop my cable completely.

    In my opinion, the stock is being driven down by a combination of : (1) hedge funds who want to buy in at lower levels, (2) cable companies hoping to keep their "money-train" going as long as possible, and (3) "weak hands" investors who can't think for themselves.

  • Report this Comment On September 27, 2011, at 6:42 PM, TMFDukenewkirk wrote:

    There you go StockGuru, I'm just looking for Netflix to add millions upon millions of folks just like you to their membership worldwide and I'm laughing. Hell, if it's good enough for David Gardner, you'd think the majority of us peasants could be satisfied ;)

  • Report this Comment On September 28, 2011, at 3:43 PM, nhalden wrote:

    LOL....not trying to be negative...just realist.

    As subscriber myself, who hasn't jumped ship, I can't help but be irritated. First about 2 years ago they remove all of the social stuff (which I thought was nice). Then the streaming boomed, and subsequently they removed the instant queue feature, then the view similar DVD feature, then the Drill down feature by category...This was a purposeful limitation of the Streaming service.

    (much of which also happened on the DVD side also.)

    This tells me (hindsight) that they knew SEVERAL MONTHS out that this split was going to occur. Anyone who has been higher than rank in file in business would know that something like Netflix/Qwikster split takes more than a few weeks to plan and announce. This was easily a year in the making. - BUT no one said anything. (FAIL)

    As to Stock Guru---talk about comparing apples to coconuts.

    NF is not trying to compete with Movie Theaters, or in their words Network TV/Cable.

    People go to movies and pay the premium for the experience of going.

    One thing that has to also be understood is that NF in the near future will JUST BE STREAMING CONTENT...and yes you can watch whatever you want whenever,,,but "real" people want specific things...content, series, etc..NF isn't really providing NEWER content, and isn'g really growing this offering. (let's be real)

    Regardless of what DISH costs...people have it and it's the ONLY provider that has Fox on demand. Fox's site shows it's shows for free 10 days later...

    Lets be honest and it's important to do so when 70% of stocks worth is in the toilet. NF as a combined serivce for a flat fee is FANTASTIC. Even with the Price hike it wasn't that bad...BUT they did ultimately reduce the actual offering. (# of DVD's) Now that they split the serivce and admit not having cash for newer titles and deals...EVEN WITH RECORD # of subscribers...how can you grow or maintain when people are leaving left and right?

    You can't. If the bet is that NF will grow and the stock will go up....House wins.

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