Good Luck Killing Netflix

Everyone's loving Netflix (NASDAQ: NFLX  ) these days.

Even the shorts are having second thoughts about their bearish wagers.

There were more than 15 million shares sold short this past summer as Netflix was bottoming out in the low $50s. Now that Netflix shares have more than tripled -- burning more than a few of those naysayers -- shares sold short have fallen to 9.7 million. It's the first time that Netflix's short interest has fallen below 10 million since March.

Burned skeptics will argue that this is a contrarian indicator. They'll point out that Netflix is ridiculously overvalued at this point. They may be right on both counts, but they are ultimately wrong about Netflix.

There's a reason that Netflix has been one of the hottest stocks since last summer. There's a reason that a service that seems so unnecessary and easy to cancel is now sitting on a record 33.3 million subscribers. There's a reason that a company with a streaming service that seems capped at a mere $7.99 a month can command an $11 billion valuation.

The bottom line is that Netflix -- as incredulous as it may seem at first -- actually has one of the healthiest moats in the business.

Taking on Netflix? Good luck
Netflix spends $2.5 billion a year on streaming rights. Amazon.com (NASDAQ: AMZN  ) , its nearest rival, spends roughly $1 billion a year, according to estimates by Janney Montgomery Scott analyst Tony Wible.

Amazon isn't poor. It could certainly afford to pay up if it was worth it. It's not. Amazon will never have the 33.3 million streaming subscribers worldwide to make it financially feasible. If it were to ever begin charging for video -- something that it doesn't do now since it merely offers it as a free perk to folks paying $79 a year for Amazon Prime memberships -- its subscriber base would be puny.

After all, how much cheaper than $7.99 a month can you get when you still know that you only offer a fraction of the content that's residing in Netflix's digital vault?

It's also not just the sum of money that Netflix is willing to spend on acquiring content; nobody knows better than Netflix the content that consumers are actually viewing. Remember the catalog of member ratings on DVDs that helped Netflix make superior recommendations? Well, it's also crunching all of its data on the streaming end to make sure that it doesn't pay more for content than it has to when it's time to renew.

Oh, and let's not forget about the value proposition to studios. A TV show producer naturally wants to make money by selling streaming rights, but they also want to expose earlier seasons of current shows to as many viewers as possible. It gets them hooked, as we've seen with Mad Men, The Walking Dead, and other shows with which Netflix has been instrumental in growing audiences.

If Amazon and Netflix offered a studio a deal, which one do you think would be more valuable? Which one would be critical if exclusivity was desired?

In short, even if a company had $2.5 billion a year to spend on streaming rights, it still couldn't duplicate the Netflix model.

Beyond Amazon
Comcast
(NASDAQ: CMCSK  ) and Netflix are passing ships. Comcast used to have more video subscribers than Netflix just two years ago.

After shedding 459,000 net subscribers in 2011 and 336,000 accounts in 2012, Comcast has fewer than 22 million video customers.

Comcast also isn't poor. It has spent a whopping $34.2 billion on acquisitions since 2009, according to Dealogic, and that includes its recent move to swallow all of NBCUniversal. It has been one of the leaders of the TV Everywhere movement, in which cable companies and broadcasters allow Comcast to offer their shows online as a retention tool. Surely Comcast could afford to spend $2.5 billion -- or more -- to acquire streaming rights for customers. As leveraged as many of the cable and satellite television providers may be, investing in streaming video would seem to make sense given the rise of Netflix and the gradual decline in premium TV.

Unfortunately for them, here's where Netflix's $7.99 a month comes in. The average Comcast video customer is paying $153.54 a month. Would Comcast be willing to cannibalize its bread-and-butter business in pursuit of a $7.99-a-month video service? Of course not.

Comcast knows that its model is on a slow but certain death spiral. Why do you think it's spending so much to own content via NBCUniversal? However, it wouldn't dare try to challenge the Netflix model head-on.

As rich as Netflix may be, Comcast commands a market cap north of $100 billion.

The great disruptor
Let's not even entertain Redbox Instant, which is launching with a small catalog of movies and tethered to the dying optical disc as a differentiator. Let's not assume that HBO, Showtime, and other premium movie channels would slash their price in half and allow stateside subscribers to stream their content without paying up for costly cable plans first.

The only company that could possibly pose a threat to Netflix would be Apple (NASDAQ: AAPL  ) , but that challenge would happen years from now, after its long-rumored HDTV initiatives have the kind of scale for Apple to do to streaming video what it has done to other forms of digital media.

Then again, Apple would seem to be better served by selling the piecemeal rentals that Netflix has so far refused to offer than to take on Netflix in streaming itself. Yes, its Rolodex is thick with video producers, but that same connection hasn't really helped Amazon.

Microsoft (NASDAQ: MSFT  ) is the one that would be more than likely to take on Netflix than Apple, and that's a move that would explain why Mr. Softy is starting to acquire exclusive video content for Xbox users. It would also explain why Netflix CEO Reed Hastings left Microsoft's board last year.

However, even then Microsoft would struggle -- and not just because it's Microsoft.

The biggest hurdle for any company wanting in on this space is that Netflix has the first 33.3 million people willing to pay for streaming video. We don't know how big the market will ultimately be, but it's going to take more than lower price points and better content to woo those accounts.

Get it? Netflix's moat is healthier than you probably thought.

Do you know all you need to about Netflix?
If you're invested in or are considering investing in the DVD and streaming king, check out The Motley Fool's premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. We're also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.


Read/Post Comments (19) | Recommend This Article (18)

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 21, 2013, at 11:33 AM, TomatoSauce wrote:

    "If [Amazon] were to ever begin charging for video"

    But they do charge for video. They charge for 1-2 day rentals. They charge for purchases. These are additional choices on top of the free prime content they offer.

    It's a different model than Netflix - instead of a monthly fee it's a pay-as-you-go. And for some people (including myself) I like this model a lot better. With Netflix I have to get my $8 worth of content every month, otherwise I'm not getting my money's worth. And so there is a pressure there to watch stuff every month with Netflix.

    With Amazon (and iTunes, and Google Play) - the choice is in my hands. Spend more one month, less the next. Maybe overall I spend about the same (or even more) than I would on Netflix - but at least I have the choice. With Netflix you have no choice - that monthly fee is always there, pressuring me.

    By the way, I was a Netflix customer from the early days, but I cancelled last year and do most of my watching through Amazon.

  • Report this Comment On February 21, 2013, at 1:05 PM, tom2727 wrote:

    If Amazon and Netflix offered a studio a deal, which one do you think would be more valuable? Which one would be critical if exclusivity was desired?

    ----------------------------------------------

    Why would "exclusivity be desired" if you're a studio? You said yourself they want to expose their shows to the widest audience, right? That's an argument for a new show that is critically acclaimed but still has relatively low ratings. What about shows that are already super popular, or shows that are near the end of their run?

    And don't forget that the studios make real good money selling DVD sets of their most popular shows, and selling them pay per view. So that's an argument on the side of not spewing them out as widely as possible to the streamers. No one will watch the PPV or buy the DVD if they get it free already. That seems to argue in favor of giving a show to AMZN versus Netflix if they offer the same price, BECAUSE fewer people can access it for free.

    That is unless the studios are getting some sort of fee every time someone downloads the content. Is NFLX offering these deals already? I wish I knew.

  • Report this Comment On February 21, 2013, at 2:26 PM, TMFBreakerRick wrote:

    TomatoSauce, yes, Amazon, Apple, and now even Redbox charge for piecemeal rentals. The comment was solely based on Amazon's Prime Instant Video streaming service. There MAY be a market there someday, but they'll never get a Netflix button a Blu-ray player the way that Netflix has. And spending $8 a month on Netflix than to stream two movies a month for $8 through Amazon or Apple isn't my idea of value.

    Tom, the exclusivity here is desired by the streaming service. You're seeing the battle lines (like Amazon with Downton Abbey recently).

  • Report this Comment On February 21, 2013, at 3:24 PM, duuude1 wrote:

    Great post Rick - I've been a shareholder since 2007, and gone through insane volatility from my first batch of shares - so this recent crash from $300 to $50 and back to $200 - though extreme - is par for the course. I've never sold, and grabbed many falling knives during the past year. So I am clearly biased in my opinion of the company.

    But...

    The heart of the business so far has been tremendously technical. Renting DVDs (automated distribution of DVDs, recommendation engines, etc), and now streaming (digital content distribution, dig data analysis, etc).

    And the brains of the business focused on agility and foresight to outmaneuver Blockbuster (twice now), Apple, Vudu/Walmart, Youtube/Google, Hulu, Redbox/McDonalds... and right now all the big cable/broadcast/entertainment companies.

    But...Now central to NFLX's success going forward is developing original content to, as they say, become HBO before HBO becomes NFLX.

    This is a whole different skill set. This is managing artists, generating new content.

    What says they have these new skills?

    Where's the data from any of their creative endeavors so far (Lillyhammer, HoC) to demonstrate their skills?

  • Report this Comment On February 21, 2013, at 6:29 PM, kakkineni wrote:

    I'm not a short and definitely not a long. None of this article speaks to value expectations embedded in the stock price. the question is whether three company can leverage its existing advantage enough to so grossly outperform the competition on order to justify the extremely high expectations that the price implies? And how will it do this? The more players that enter, the less advantage a form is expected to have in the long term, unless its adapting faster than the competition is mimicking it. What happens when a company emerges as a platform that allows content producers to sell their own content, taking a simple cut off the top? Or some other new business outer tech advancement?

  • Report this Comment On February 21, 2013, at 9:05 PM, greenember wrote:

    Apple has a crap ton of cash. Why don't they just BUY Netflix?

  • Report this Comment On February 21, 2013, at 9:28 PM, jpparnell wrote:

    "Amazon will never have the 33.3 million streaming subscribers worldwide to make it financially feasible. If it were to ever begin charging for video -- something that it doesn't do now since it merely offers it as a free perk to folks paying $79 a year for Amazon Prime memberships -- its subscriber base would be puny.

    After all, how much cheaper than $7.99 a month can you get when you still know that you only offer a fraction of the content that's residing in Netflix's digital vault?"

    I have both Netflix and Amazon Prime streaming service through Roku set top box. Amazon DOES charge for video streaming through Prime, Instant and also Purchase.

    Prime is $79 a year which comes to circa $6.60 a month. You can also pay for Prime monthly for about $7. Either way that's less than Netflix's monthly charge.

    I really find no difference in the content that is available on both Netflix and Amazon. However, I only watch movies so I could be incorrect as pertaining to TV shows.

    I'm actually considering dropping Netflix because I can watch the same movies on Amazon for less through Prime AND enjoy their Free Two-Day shipping. I shop a LOT on Amazon.

    "Nobody knows better than Netflix the content that consumers are actually viewing. Remember the catalog of member ratings on DVDs that helped Netflix make superior recommendations? Well, it's also crunching all of its data on the streaming end."

    Amazon has been selling a massive amount of DVD's with customer ratings for years. The streaming video service has customer's ratings as well. Whether or not Amazon is "crunching" all that data, I don't know, but I would like to think/hope that they are.

    I would tend to agree with Tom2727 that it actually might make more sense for studios to go with Amazon. I also see both Netflix and Amazon gaining exclusive rights to many shows in the future.

    I don't really see Amazon having original content but then again, I didn't see Netflix having it either as it does now with House of Cards.

    Comcast, Apple, RedBox and Microsoft? Hmn, maybe someday but they will all be WAY behind Netflix and Amazon.

    I don't own stock in either company, although I certainly considered Netflix last summer. Alas, I didn't get in when the getting was good.

    I completely agree that Netflix has a very healthy wide moat but I have to say that Amazon does as well. Streaming video is nowhere near it's potential and it will be interesting to see where it is in a couple of years and on down the road.

    By the way, I've been a member of Motley Fool for 8 years now and this is my first comment on an article. I have opened Pandora's Box now....

  • Report this Comment On February 21, 2013, at 9:46 PM, rgrubic wrote:

    I tried Netflix for 30 days free. And cancelled because they had no content selection. Everything I found on IMDB.com that I wanted to see like Avatar (Worldwide box office leader) was not available. After I watched the half a dozen or so movies on netflix the first week that I had not recently watched from the public library, There was literally nothing on netflix interesting to choose from for the rest of my trial month.

    Netflix favorites software is seriously flawed. For example I love Sci-Fi but hate horror. I watched a SciFi movie like Star Trek and rated it 5 and because of that netflix insists on suggesting horror movies like Passenger or Sixth Sense.

    Your analysis completely left out Netflix's main competitor in the low price market. The public library costs me the price of gas to deviate from my fastest route to my normal errands (about 15 to 35 cents). The total of which is about $1-2/mo far less than $8 per month for Netflix.

    Excepting movies released on DVD within the last 3-6 months nearly everything including Avatar is available free for a week from the public library. The Public Library has Netflix completely trounced on selection. Since I already have the selection I want for under $2/mo of gas, why should I pay anything more, let alone $8/mo, for a service that does not even have any of the majority of movies IMDB shows me that should be available from a pay-for-it service?

    Blockbuster is the only pay-for-it service that has the libraries beat on selection. That is because libraries have their disks wear out. And the libraries only replace DVD's that are popular. So Blockbuster has a better selection of less popular movies older than three years, for example, Chain Reaction.

  • Report this Comment On February 21, 2013, at 10:39 PM, AceInMySleeve wrote:

    Amazon looks more like it's there to pick up the pieces if Netflix screws up royally. Almost no one else has a reasonable chance of going head to head with the same business model, and likely won't try. There's a lot of market to split in the domain of internet tv, and Netflix is only one player.

  • Report this Comment On February 21, 2013, at 11:27 PM, jb757 wrote:

    Excellent article. We look forward to the followup in December when Netflix passes 40 million subscribers. Huge DVD/BD/Streaming Catalog plus right price = Value!

  • Report this Comment On February 22, 2013, at 12:01 AM, BentMike wrote:

    It always interests me to see investors assume their own tastes in entertainment are part of a majority cohort. It is a cognitive bias that will not pay off well going forward.

    I am wary of the flip side. Since I really enjoy NFLX, find the content, presentation and recommendations very user friendly and useful, and since I view it more than any other video entertainment source, I have to beware that I think everyone else is like me. (All I have to do is look how well my voting plays out during elections.)

    I do think NFLX is proven now (I can count to 30 million sort of); NFLX is making a lot people happy. Not everyone, but a big bunch. Further it is a big world and no one else has their sights on that in the same way. They serve children very well; content I never look at, but content that is valuable to the check writing family members regardless if they like it themselves.

    Anyway, I am very grateful that some people think NFLX is a bad investment. Every time I buy some I need a seller.

  • Report this Comment On February 22, 2013, at 12:20 AM, DigitalMediaView wrote:

    The concluding argument for NFLX un-crossable moat: "The biggest hurdle for any company wanting in on this space is that Netflix has the first 33.3 million people willing to pay for streaming video. We don't know how big the market will ultimately be, but it's going to take more than lower price points and better content to woo those accounts."

    So, NFLX has significantly penetrated the addressable market, and it's unclear if there's any real room for new services to come in and snap up new subs...or by the same token for NFLX to significantly grow. Therefore, NFLX nose-bleed valuation predicated on growth upside seems totally unjustified...Further, these month-to-month, no contract subs won't switch for better content and lower price points, because the earlier argumentation says NFLX has locked up more good content than anyone else and has the lowest price.

    This post makes no sense.

  • Report this Comment On February 22, 2013, at 12:54 AM, never2dull4u wrote:

    I have read so many crap about how the competitors (deep pockets) will eventually crush NFLX over the past years (including Tilson's report). The reality is...the ONLY true competitor of NFLX is NFLX itself. NFLX is NO different then when they were trading at $300 vs $50. It was just a matter of perception that they were going BK when the truth is NOTHING really changed from a fundamental standpoint.

    I wonder what Michael Prachter must be thinking? That fool is just another blow hard ignorant fool! At least Tilson is on the right side of the trade this time. He's definitely running in circles around Prachter.

  • Report this Comment On February 22, 2013, at 1:10 AM, AceInMySleeve wrote:

    Plenty of room to grow. Essentially every one with broadband(80M) and Pay TV (90M) will have some form of internet TV, and likely from a variety of providers. Netflix at low price and broad mainstream selection is capturing the earliest adopters. Later players or Netflix will begin to capture more than 8$\month by bringing in more specialized content, live programming, sports, or some other manner of differentiation etc. Competitors are best served by making a play on niches other than the one dominated by Netflix. If you're going to kill Netflix, you are gonna have to do better than Amazon (and then you have both Netflix AND Amazon to deal with).

    There's a reason the heads of streaming for Amazon in US and Europe left. It's not all peaches and cream over there.

  • Report this Comment On February 22, 2013, at 10:11 AM, HiWho wrote:

    Bad timing buddy.

    Nflx is down 7%, as we approach 31 days post earnings and those who wanted to void wash sale rules are free to dump stock, and go back into AAPL.

    I cancelled Netflix, so I get redbox. Pick up two movies on Friday night, return them Sunday on way to church. Beats having gone to see them in theater at $12 a head ( well I buy AAA discounted tickets at $7 a ticket, shhhhhh). Then gas is $4.10 and theatre is not near me.

    Comcast is another Enron. Only fools pay full price. I have a $79 plan, but they discount it by $39. If we could attach photos here I would share my bill.

    Amazon will come hot and heavy as Walmart and frys eat their lunch. I just bought HDMI cables for $2 each at Frys and will pick them up at store.

    Aapl will be lone riser post March 1, Amzn and Nflx to lose 30% and 45% value by June triple witching Friday.

    Goog under $600 too June Triple witching too because Yahoo, linkedIn and others are soaking up ad revenue.

    First off all, your hail hit&er sign for recommending needs to go.

    Second, it is counterintuitive to put it at top of post, since people read posts going down, and there is a phase problem, by which I mean, you cannot tell which article the Hail Hi&ler is for.

  • Report this Comment On February 22, 2013, at 10:43 AM, Ronz8In wrote:

    Great article- finally, someone who "gets" Netflix vs. the competition. I bought at $65 in 2012 when I realized that Netflix has the saturation and branding that truly matters; when people get the flu or are snowed in, they "do Netflix" all week/weekend. NO ONE ELSE is even close. I am both a Netflix streaming and Amazon Prime subscriber, and watching Amazon is an afterthought for me as there is NO free-to-subscriber content on Amazon I'm interested in that isn't available on Netflix.

    However, some of the comments critical of Netflix are right on. Netflix's "Favorite" and "Search" functions are terrible. Their only saving grace is that the others' software interfaces are MORE horrible. The fact that you can't search DVD content if you're a Netflix streaming-only subscriber is brain dead.

  • Report this Comment On February 22, 2013, at 12:28 PM, georgekingx wrote:

    The elephant in the room regarding streaming versus discs is the aging population. Until streaming can provide subtitles with their films, the aging boomers will become more and more dependent on discs, the only source of subtitles.

  • Report this Comment On February 22, 2013, at 1:30 PM, contrarianstock wrote:

    I have been following NFLX for 2 years now. This is the sanest SWOT analysis I have seen. I don't know if this stock is going to $300 or $50 in the 6 months. But unless it is acquired, NFLX has the inside track to a very profitable and secure international business.

  • Report this Comment On February 23, 2013, at 12:24 PM, KickBackAt40 wrote:

    Netflix has a moat? I really don't see it.

    Don't get me wrong, I love Netflix. However, I still have a little hatred in my heart over what was done to the DVD subscribers and over the fact that the countless ratings that I took the time to enter on movies are no longer available to the streaming-only customers.

    Their large customer base is not a moat when it only takes five minutes to switch from Netflix to Hulu to Amazon to Redbox to whatever.

    Their massive content library, for which they are paying through the nose, could be considered a moat. But, seriously, I don't see how it is in the best interest of the content providers to provide any kind of exclusivity on their product. Eventually, if the copyright holders are paid on a per view basis, this apparent moat could vanish in a blink of an eye.

    You might have a moat if Netflix was only accessible on a set-top box that you had to pay $500 for, or sign a 2-year contract, like with a wireless carrier.

    So, do they have a moat? Perhaps, for now, but it could silt in or freeze over pretty quickly.

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