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The Bull Looks at Netflix
Board: Netflix

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By SteppenWulf
March 29, 2007

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I just started taking part in CAPS. I am enjoying it too, as it forces me to think about the companies I am invested in, and why I would recommend them. If I can't think of good reasons, I figure I'd better do more research or sell them!

Anyway, Netflix was my first recommendation, and I went overboard and put in a lengthy bull argument. I thought I might as well copy it on the boards, and see who can poke holes through it ;)

BULL ARGUMENT for NFLX

The best risk/reward ratio of any stock I know. Buy today's superb execution at a discount, and get for free the leader at Internet VOD.

BUY TODAY'S SUPERB EXECUTION AT A DISCOUNT

1. First mover in mail DVD's with 6.3M subscribers. This low cost business model has been driving the main video store companies out of business.

2. ROE of 15.33%. YOY revenue growth of 46% with improving gross margins of 37.1%.

3. Pristine balance sheet with 400M in cash and no debt. Their gunpowder is real dry.

4. An excellent recommendation engine that is very sticky

5. An excellent distribution network throughout the US that creates a cost and execution moat for any potential competitor.

6. Excellent customer service that along with their recommendation engine and distribution network, keeps their churn at an industry-wide low of 4.1%/month (BBI Online churn is 10.7%/month).

7. Savvy management that has proven its worth by beating every past competitive threat, including giants like Walmart and Amazon. They are committed to creating long term shareholder value. In addition, we have a CEO so ethical, he is only taking $1/year in salary and giving his options to charity, because he has more money than he needs in company stock.

GET FOR FREE THE LEADER AT INTERNET VOD

There are a huge number of companies getting into internet Video-On-Demand. Why? Because everyone can see that it has the potential to be hugely profitable. Getting any movie or show, on your TV, when you want it, is going to be extremely attractive to customers, and will be hugely disruptive to both networks and studios.

Netflix is the current out-and-out favorite to win this battle. Why?

They have created a sublime VOD business model that plays to all their strengths - "Watch Now" which is currently in a phased beta rollout that looks to be very successful.

Why does it look like they are best placed to beat all their many competitors? Because their model is significantly different from their competitor's:

1. This is VOD streaming, instead of VOD downloading, which means that a consumer can begin watching the movie shortly after pressing the "Watch Now" button instead of waiting for a download. Yes, downloading can compete with that immediate gratification through technology techniques called "Progressive Download". But there is a more important difference...

2. Since this is streaming, the whole movie is never on your PC/TV at one time (just the way TV works). So it isn't bound by all the crazy DRM rules created by the studios. Unlike the Netflix streaming, competitor's downloading is bound by very user unfriendly DRM rules, such as automatically deleting a movie 24 hours after the user presses play, and also by high costs.

3. Talk about driving maximum penetration of a new technology - offer it free to your existing customer base. Netflix is providing VOD streaming as a free value for existing subscribers. In the current model, any existing subscriber (of 6.3M) can get a number of hours of downloading per month equal to their subscription price in dollars per month.

4. This free model is actually already potentially profitable for Netflix, because every video that is streamed is a video that doesn't have to be handled and mailed. Of course once the service is officially launched (slated for June), other pricing models can be added.

5. This model is extremely hard for a competitor to duplicate, because it depends on Netflix's strengths that other competitors don't have. Netflix can provide streaming free because they already have a subscriber base of 6.3M who are already paying monthly fees, and because it can record a cost saving in the form of postage and handling for every video streamed. In addition, Netflix has already built out the initial VOD streaming infrastructure.

6. Another very attractive element of this model is that it makes it possible for users not to have to bother with a downloaded library of videos, if they can simply stream what they want from Netflix for a monthly subscription. Let Netflix maintain the library.

7. Netflix's model, based on the amount of time that a user streams is also very innovative, and it opens up whole new ways for video consumption. Consumers can now browse videos, checking out movies they may want to see later. They can also bookmark videos, and stream from their bookmarks. Imagine the ways people will start using this - for teaching, for fan clubs, for seminars, etc.

RISKS

1. TV Connection for VOD. This is simple technology that Netflix needs to debut soon after the official launch of Watch Now - hopefully by the 3rd quarter of this year. The hard part is to make it dead easy for consumers, so that you get a box, plug one end into your TV, plug the other end into the internet, and it just works (with wireless to follow as 802.11n gains acceptance). The other hard part is to get the right price point - under $50 would be ideal, I think anything under $200 might be ok. If Netflix doesn't offer this within a couple of years, they could be left behind. I expect they already have plans to debut it this year.

2. Blockbuster - the only company that can currently compete against mailed DVD's and could potentially compete against Watch Now. I am not too worried because Blockbuster management to now has proved itself not too smart, while Netflix management has been beating all the elephants. In addition, Netflix has lots of money for a fight, while Blockbuster is in serious debt.

** Note: I don't consider any existing VOD downloading company as a threat to Netflix. As Netflix management so astutely observed, Netflix is in the business of streaming video subscriptions. The other companies are selling you their video downloads. This is as different a business model as buying a video at Walmart, compared to renting one from Netflix. The only other subscription model is Vongo, but they are still downloads with all the DRM issues, and they don't have the content that Netflix has.

3. VOD Content - a big risk is if Netflix is unable to get significant areas of VOD content. I think this is unlikely because Netflix rents so many niche and older films (the long tail). Studios are very happy to get incremental revenue from this part of their library, and streaming should allay their concerns about VOD, so they should be happy to deal with Netflix.

4. Management Loss of Focus - I am a bit concerned about Netflix's pursuit of exclusive content. This is a very different business from Netflix's core business, with very different risks and rewards. I understand the comparison with HBO's exclusive content like Sex and the City, but I don't think it is a valid comparison - there are lots of other ways for Netflix to win customers, and there aren't as many competitors to differentiate from. I would personally be much happier to see them expand their core business with additional content (such as games) or go to additional markets, such as foreign markets. This would leverage all of their existing assets, such as distribution, recommendation engine, and customer service. Foreign markets would be especially good, as they would be able to immediately leverage it for both their mail and VOD business models. I do have a great deal of respect for the management team, who has much more information than I do, so I assume they know what they are doing.

DISCLOSURE

I am of course long on NFLX. I was also the architect of one of the leading VOD services on the Internet today. I am proud of what I accomplished, but I was forced to implement all of the studio's DRM rules, which makes my service not very user friendly, and certainly not free. I am afraid my service will be left in the dust by Netflix's sublime business model. It's too bad I didn't get a chance to architect the Netflix service :)


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