A Bear Gives a Bull Case for Netflix

Ah, Netflix (NASDAQ: NFLX  ) . I just can't seem to make my mind up on you. I've owned shares early on, sold when the price looked insanely high, shorted you around the time of the whole Qwikster debacle, given you a red thumb in CAPS, and now ... I might just have come full circle.

Why the sudden change of heart? Well, I mainlined House of Cards, of course, like so many others. (Who needs hygiene when Kevin Spacey's so busy scheming?) Of course, I would never change my investing thesis because I happened to enjoy one product personally. I'm revisiting my thesis because Netflix knew I would like it ahead of time, an advantage I didn't understand when formulating by bear thesis.

Earlier this year, I stated my case against Netflix like so:

In some ways Netflix is a victim of its own success. Its rapid growth disrupted the industry, startling long-sleeping cable giants into investing in their own streaming services, and attracting the attention of tech giants new to the space. The result ... is that content owners now have their choice of distribution partners, strengthening their pricing power. As technology advances in video-on-demand services, streaming will become an undifferentiated product: Watching a video will be the same whether it is being streamed by Netflix or a competitor. That means the battle for viewers' TV time will be waged on content: Whoever has the movies and TV series that viewers most want to see will be able to attract more subscribers and charge more for their services.

I still think this is true. But I also thought that Netflix was an underdog in competing for content, because it didn't have the big pockets of an Amazon.com (NASDAQ: AMZN  ) or an Apple (NASDAQ: AAPL  ) , or studio-backing like upstart Hulu, which is owned jointly by Fox, ABC, and CBS. Netflix envisioned itself as a competitor to Time Warner's (NYSE: TWX  ) HBO, with Chief Content Officer Ted Sarandos actually claiming, "The goal is to become HBO faster than HBO can become us." That comparison initially struck me as ridiculous, because HBO has been pumping out cutting-edge original programming since 1997, while Netflix has neither the experience nor the pockets capable of producing similar programming. But Netflix has two potent weapons in competing to create the best content, and both were on full display for House of Cards.

Big data goes prime-time
Netflix may not have experience, but oh, boy, does it have data. What you watch. How you rate it. When you watch it. When you pause, rewind, or stop watching. Aggregate this data across millions of members, and Netflix knows its viewing market better than any media provider could ever dream.
So when House of Cards producers approached Netflix to ask whether the company would be interested in buying rebroadcast rights in the show, Netflix consulted all this data and found that millions of members loved watching actor Kevin Spacey, director David Fincher, political thrillers, and the original British House of Cards. Looking at this "perfect storm," Netflix pounced, and as a carrot it promised full creative control to the creative staff, confident in their data that viewers loved this team.

In the future, instead of using data to selectively accept proposals, Netflix could notice that there was a market for a kind of show not currently being fulfilled, and bring trusted professionals on board. If Netflix knows there's a market for a project before greenlighting, the company could dramatically reduce the amount of content that flops. This could be revolutionary, as studios waste billions of dollars funding content that doesn't interest viewers. In 2011, 67% of the 43 new shows produced by the big broadcast networks were canceled after one season, primarily because of low ratings. The average broadcast network episode costs $3 million to produce, with ABC's short-lived Pan Am costing $10 million for the pilot episode alone. These are costly failures. If Netflix's unparalleled market research can bring the failure rate down even slightly by making tailored content, it could rake in both cash and subscribers.

Shove it in my face, why don'tcha ...
Netflix also doesn't have to worry about "finding the right audience" or spending much on marketing. It already knows who will enjoy its programming, and its content delivery platform can push shows directly to their target audience. Part of the reason I binge-watched House of Cards so quickly was that every time I turned on my Netflix, the app served up a giant banner ad inviting me to watch the next episode.

That's not just more effective than traditional marketing -- it's also massively cheaper. Big studios commonly spend $100 million or more marketing a film before it's release, and sometimes these expenses are big enough to turn what would have been a breakeven performer or even a mild hit into a disastrous flop. For example, in 2012 Disney's John Carter actually earned back its production budget at the box office, but bloated marketing costs led Disney to declare a $160 million loss for the quarter thanks to the film. Similarly, HBO had a big hit with the gritty historical crime drama Boardwalk Empire, but HBO spent north of $10 million promoting the pilot episode, which itself cost $18 million to produce.

Netflix still did spend money promoting House of Cards the traditional way. But with the ability to literally shove its content right into the faces of its target audience, I imagine the company will find that it doesn't need to, especially if it can leverage its data into content like House of Cards that inspires zealous fandom.

While the company's first-mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep-pocketed rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These are must-know issues for investors, which is why we've released a brand-new 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 (9) | Recommend This Article (14)

Comments from our Foolish Readers

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  • Report this Comment On February 24, 2013, at 3:59 PM, wolfhounds wrote:

    I have never understood the valuations of NFLX, and this article does nothing to change that opinion. In fact, I don't remember the last time any article at MF attempted it. Do me a favor and create a long term case for holding this stock.

  • Report this Comment On February 25, 2013, at 6:26 AM, assisgnmeaname wrote:

    Well said Wolfhounds. There is no mention of the stock doubling in a few weeks, or the sky-high P/E...just some musing about possibly lower content costs and better marketing data justifying a bullish outlook? Typical soft science from MF.

  • Report this Comment On February 25, 2013, at 7:50 AM, scottberdine wrote:

    I agree with the other comments. NFLX's valuation defies any metrix of true presnt or future value--except the shorts who are constantly covering and keeping the price propped up.

    I saw no mention of anything in the article that shows how this can make enough money to offset the financial negatives. On a cash flow basis this company is doomed to falter.

  • Report this Comment On February 25, 2013, at 8:15 AM, jb757 wrote:

    A lovable high flyer like Netflix is always "overvalued". A media company that picks up 7 million global subscribers in 2012 obviously is not doomed to falter.

  • Report this Comment On February 25, 2013, at 9:23 AM, pauldeba wrote:

    Although I found 'House of Cards" to be unwatchable and nuked it after 25 minutes, other people seem to like it for some reason.

    No one has compared the cost ($100 million for 2 seasons, or something?) with expected net subscriber adds. It would have to be 500K to be a breakeven, I guess that's possible, just skeptical that people will sign up for this show.

    I think the only way they can make it is with advertising and tiered pricing with better content. The content is terrible now and worthy of cancellation after 6-12 months, growth in the US is not possible, international growth is stunted by even worse selection unless they sign up via VPN to the US site (which many do). The problem with the VPN signups is that it overestimates US penetration and overestimates international potential. That will come home to roost in the next 6-9 months and send this back to $50 or so.

  • Report this Comment On February 25, 2013, at 9:52 AM, DigitalMediaView wrote:

    Excellent points in this discussion. IF NFLX had zero cost of doing business and already had the subs they need to pay their multibillion dollar content bills, they'd need over 1M net new subs @8/mon retained over a yr to pay the incremental cost for HoC. But of course they do have costs and the big bets they've already made on things like Disney content require them to significantly grow their base. So they have promotional ploys like HoC to help do that. If you consider the show in that light, as marketing expense, with their gross margins in the streaming business below 20%, they would actually need 5M net new subs retained for a yr to be whole on this subscriber acquisition vehicle. Not going to happen

  • Report this Comment On February 25, 2013, at 9:56 AM, DigitalMediaView wrote:

    The other point I'd like to make is that quants can identify what people already know they want, but not what people don't know they want. The biggest hits fall in the latter category. Hollywood already does a lot of the former and look at what we get, sequels and genre movies. The NYT article on NFLX data-driven approach this past weekend had a great commentary on this:

    John Landgraf, who, as president and general manager of FX Networks, has had a good run at the channel in finding hits, said he thought numbers-crunching would never have predicted the success of “The Sopranos,” “South Park,” and “Mad Men,” among others, including hits he has said yes to, like “Sons of Anarchy.”

    “Data can only tell you what people have liked before, not what they don’t know they are going to like in the future,” he said. “A good high-end programmer’s job is to find the white spaces in our collective psyche that aren’t filled by an existing television show,” adding, those choices were made “in a black box that data can never penetrate.”

  • Report this Comment On February 25, 2013, at 11:51 AM, TMFCatoMinor wrote:

    I'm not the right person to ask for a full-throated endorsement of Netflix, as I said I'm very on the fence. I, too, am alarmed at the current valuation. I do believe its possible for the company to grow into it over the next decade or two, but only by capturing many more subscribers and, more importantly, passing through price hikes, which subscribers have so far resisted.

    I don't think it's impossible to think that in ten or fifteen years time, a period during which there's significant generational change, tens of millions of households will use streaming services exclusively. Millenials are much more likely than their parents or grandparents to cut the cord, and I think as this generation becomes the primary consuming generation, cord-cutting will move from a fringe phenomenon to a common option.

  • Report this Comment On March 03, 2013, at 2:09 PM, lowmaple wrote:

    Netflix doesn't get much profit on their $7.95 or so but it is cheap enough so many won't drop the service because of that. Of course if you hate the company or Reeds for some reason they won't have you for a customer, but that's only a small %tage.

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