In the past three years, streaming video pioneer Netflix (NASDAQ:NFLX) has gone from being an apparent wash-out to being one of the most important media companies in the world. Its market cap has exploded from as low as $3 billion to a peak of more than $50 billion this summer, though it has since pulled back a bit to $42 billion.
Clearly, investors have great expectations for Netflix, which still has only about $7 billion in annual revenue and is operating just above the breakeven line. Let's take an in-depth look at how Netflix could create enough value to justify this lofty valuation.
It's not as simple as it seems
At first glance, the answer might seem obvious. Netflix operates the most popular subscription video-on-demand service in the world -- and it is growing like wildfire.
However, Netflix's content library is mainly made up of second-run content. If a particular movie or TV series is popular, why can't the owner (who took the original risk of producing the content) charge Netflix enough to capture the bulk of the value from having it available for streaming?
Furthermore, even Netflix's original shows are produced and owned by other companies, for the most part. To maintain the streaming rights, Netflix needs to keep reupping for new seasons of each show. This scenario should also give the content creators negotiating leverage over the distributor (Netflix).
Finally, while Netflix spends quite a bit on technology -- $155 million just last quarter -- there are plenty of tech giants with the money and talent to replicate all of its key features. Why won't this competition ruthlessly drive down Netflix's profit margin over time?
Advantage No. 1: Superior information
One of Netflix's biggest strengths is its massive trove of user data. Since it knows what its tens of millions of users watch (and when they watch it), Netflix is pretty good at predicting whether new content will be successful.
Most famously, it used the insight that people who watched the original British version of House of Cards on Netflix also liked movies starring Kevin Spacey or directed by David Fincher to bet on its first big original series. Netflix has been happy enough with House of Cards that it has aired three seasons, with Season 4 on the way.
Not only does Netflix's data tell it what types of movies and TV shows to add to the service, it also gives the company a very good sense of what each one is worth. Since Netflix doesn't provide "ratings," and there are no third-party companies providing ratings for streaming video, the content owners have a much cruder sense of what a particular movie or TV series is worth to Netflix.
This helps Netflix get pretty favorable content deals most of the time. Most importantly, it allows Netflix to avoid wasting money on duds.
Advantage No. 2: Massive scale
A second key competitive advantage is Netflix's massive scale, both in the U.S. and globally. The marginal cost of distributing video content to more users is fairly negligible. As a result, Netflix's growth allows it to spread its content costs over an ever-larger audience. Netflix CEO Reed Hastings has called this a "virtuous cycle" of higher subscriber numbers and higher content spending.
This makes life unpleasant for competitors like Hulu. With lower revenues, Hulu cannot afford nearly as much content as Netflix, even if it's willing to tolerate dramatically lower margins. And with less compelling content libraries than Netflix, it's even harder for Hulu to gain subscribers.
Netflix is taking this to a whole new level with its ongoing international expansion. While most syndicated content is licensed on a country-by-country basis, Netflix now has the scale to pursue global licensing agreements -- at least for its originals. This will allow it to spread its content costs over even more subscribers.
Advantage No. 3: A destination for niche content
Netflix's third big advantage is that its large scale and vast treasure trove of viewer data allow it to make better use of niche content than anybody else. For the right price, Netflix can afford to buy content that doesn't have broad popularity, because it can target particular subscribers who may be interested via personalized recommendations.
"Linear" TV networks can't even consider broadcasting niche content except at very odd hours. If a channel can only show one program at a time, it has to serve up shows that can attract a wide audience during prime-time hours.
This is where the value gets created
It's not too difficult to buy a web domain, license some movies or TV shows -- or even create some new ones -- and roll them into a subscription video-on-demand package.
What sets Netflix apart is its deep understanding of how much each piece of content is worth, its ability to spread content costs over tens of millions of subscribers, and its ability to find audiences for niche programming. These are the advantages that could make Netflix worthy of its massive valuation.
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Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool owns and recommends 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.