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Are Netflix Investors Ignoring These 3 Issues?

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When a stock takes investors on the kind of ride that Netflix (NASDAQ: NFLX  ) has had in the last year, some investors may start to ignore obvious issues. While there is little doubt that the company is blazing a trail in streaming video, there are problems facing both the stock and the company's operations that need to be addressed.

Issues with the old
Clearly, Netflix is not as concerned with keeping its DVD subscribers, and you can tell this by the way the company's earnings reports are structured. In each earnings report, the company talks about its streaming subscribers both domestically and internationally. The company's focus is on growing its original programming and the streaming catalog.

While the DVD division isn't the focus it used to be, it still represents 20% of revenue for Netflix. In addition, this division still contributes more than $100 million in profit . Relative to the $166 million profit from the domestic streaming business, the DVD business is not an insignificant contributor to Netflix's bottom line.

While Netflix is not as focused on this business as in the past, Outerwall (NASDAQ: OUTR  ) is more than willing to take whatever Netflix gives away. The company's Redbox division drives almost 84 % of the company's revenue. In addition, Redbox is investing heavily in getting better results from this division. Redbox revenue was up 7%, while Netflix DVD customers left at a nearly 16% annual rate. Based on these numbers, there is little question that this cash cow is slowly dying.

Issues with the new
If you believe in the Netflix growth story, you have to assume that the company will continue to gain subscribers domestically, while showing impressive growth internationally. With 2.7 million new subscribers in the last quarter, Netflix seems to be doing well. However, an old foe seems to be gaining momentum. (NASDAQ: AMZN  ) is gaining ground with its Prime membership, and the company's Instant Video library is a serious contender to Netflix's dominance. In the current quarter, Amazon indicated it added "millions of new Prime members ," which is similar to the number Netflix added.

In just the last two years, Amazon's Instant Video catalog increased from around 5,000 titles to more than 40,000. While Netflix arguably has more titles, each company offers a compelling value. It's a near certainty that Amazon and Netflix will continue to try to outbid each other for exclusive content. Each company will also surely continue to develop its own content, but there is one big difference between the two.

In the past, it could be argued that Netflix had the upper hand because the company arrived first in the streaming game. The company's placement in many streaming video devices and televisions seemed to give Netflix the upper hand. However, as time goes on and these devices update, newer services, including Amazon Instant Video and Redbox Instant, end up right next to Netflix.

The biggest difference between Amazon and Netflix -- or even Outerwall -- is that Amazon offers a proprietary hardware platform through the Kindle Fire lineup, whereas its competition does not. While some might dismiss this as a non-issue, there is little doubt that a customer who buys a Kindle Fire will be more inclined to use Amazon Instant Video. While it's true that this same customer might also use Netflix, the fact that Amazon can offer special privileges to its Prime members is something that Netflix can't match.

Issues with valuation
Based on 2014 expectations, Netflix sells for about 85 times projected EPS . With analysts calling for earnings growth of about 22%, this gives the stock a PEG of 3.8. This type of valuation is reserved for the fastest-growing companies.

While Netflix and Amazon carry PEG ratios of 3.8, Amazon is expected to grow earnings at a much faster rate. Analysts are expecting nearly 36% EPS growth from the online retailer. If you project both Netflix and Amazon's earnings and growth out to 2015, there is an argument for choosing Amazon over Netflix.

In 2015, Amazon's faster expected growth means the company's PEG would drop to 2.8 compared to Netflix's PEG, which would still sit above 3. However, of the three companies we've looked at, Outerwall seems the best value of the bunch.

Outerwall is expected to grow earnings by 20%, which is nearly the same as Netflix, yet the stock sells for a P/E ratio that is 85% cheaper. If you are a value investor, Outerwall is hard to ignore, but if you want fast growth, Amazon seems like the better bet.

Sorry, Netflix investors. Your company has several problems, and even after all the ups and downs, you can't afford to be complacent. At its current valuation, Netflix investors are expecting perfection. If the company can't deliver, the stock's wild swings will continue.

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  • Report this Comment On November 17, 2013, at 12:29 PM, duuude1 wrote:

    Rocco? Rocco Pendola, is that you?

    OK Chad, if that's really your name... let's take a look at the problems you have with Netflix. First is what you call "issues with the old".

    Imagine a company called Netwriters that used to make typewriters - you know what those were, right? And Netwriters made a huge profit off of those old machines. But Netwriters knew that the future was digital, so they planned to move to digital text editors and digital publishing on these crazy little machines called personal computers. Meanwhile a company called Outer Typewall was willing to take the business of typewriters away from Netwriters. Your argument is that Outer Typewall is a better long term investment than Netwriter?


    And then your second problem is what you call "issues with the new". And you invoke Amazon. I own both, by the way. Outerwall immediately went into the digital trash, never to be considered. But Amazon and Netflix are both incredible businesses, and I have done incredibly well with both. But here's the thing... I own Amazon for its retail technology and massive growth, and I own Netflix for its digital video subscription business and massive growth.

    Yes Amazon's Prime membership growth is amazing. But it does NOT translate to video streaming. Who rules the streaming video customers? Look here:

    Netflix's fixed network traffic is more than 20X MORE than Amazon's.

    Netflix's mobile traffic more than doubled in less than a year, and Amazon doesn't even show up on the list of mobile video sources.

    And then you bring up Amazon's proprietary devices, the Kindle Fire - as an argument that more video will will be streamed by their owners.

    Do you know what the Kindle Fire market share is? It is in single-digit percentages. Last I saw it was 4%. Meanwhile Neflix is supported by most devices, phones and tablets, out there.

    So do you really want to make that argument as well?

    Finally you are concerned with "issues with valuation".

    I'm at heart a contrarian value investor. So neither AMZN or NFLX are stocks that really make sense for me. But both are by far my best investments. And so it is funny that you try to make an argument for earnings growth in favor of Amazon - how long have you invested in AMZN? You should know this - earnings is not exactly their first priority. A couple recent quarters of earnings growth is not a trend here. You can expect those earnings to crash back to zero or negative when Jeff Bezos sees the next technology investment that will further spike customer and revenue growth.

    So this is fundamentally what you are missing about both of these companies - AMZN and NFLX are both surfing an immense technology wave and showing us all how to transform industries by leveraging information and the internet. Both started by focusing on very uninspiring areas of industry - books and retail for AMZN and videos for NFLX. Not Biotech, not space, not interstellar teleportation. Books and video. But holy heck, look at what the hell these two companies have created in terms of technology to expand these very mundane business areas.

    Netflix is the place to invest if you want a winner for digital video distribution.

    So who is Outerwall again?



  • Report this Comment On November 17, 2013, at 3:43 PM, duuude1 wrote:

    Just to add a little color and verisimilitude to the typewriter story, here are some additional facts:

    IBM was the leading manufacturer of typewriters and other office equipment for many decades. It took the overwhelming lead in electric typewriters with the introduction of the Selectric models in 1961.

    But the rise of PCs and desktop publishing led IBM to sell its typewriter business to Lexmark.

    Look at the insane 1000% rise in Lexmark stock in its first 4 years. But of course, you know how this story ends, right? Because that 1000% peak was the highwater mark, and it has been a slow but steady decrease as Lexmark tries to figure out who and what they are as a business. Compare that to IBM which is up triple Lexmark's current gains.

    IBM made the right choice to abandon a highly profitable but outdated technology. Always look forward, and fully commit to better, faster, cheaper technology that improves customer's lives - and abandon even profitable businesses when it is clear that technology will trash it anyways.

    Likewise for Netflix. Though NFLX's attempt to abandon DVDs was hamhanded, the basic decision was the correct one. Let Outerspace or Offthewall or whoever they are keep DVDs like Lexmark kept the typewriter.



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