Video-streaming and DVD-by-mail giant Netflix (Nasdaq: NFLX) reports first-quarter results tonight. I've owned shares of this company for more than four years, and I've been covering this company for the members of the Motley Fool Stock Advisor service for the past two and a half years. I'm definitely looking forward to tonight's release.
What I'll do this week is present to you why I'm a bull regarding the company and its shares, even at today's nosebleed prices. This argument has four parts to it, and I'll cover each in a separate article, so be sure to come back each day to catch the whole argument. Then on Friday, I'll look at the five major risks facing Netflix and how it is dealing with them, as well as why I think shorting a growing company like Netflix is probably not a good idea.
In summary, I'll discuss the following:
- Netflix is an information gatherer.
- Netflix can control what it spends for content.
- Netflix is focused on one type of delivery.
- Netflix has a huge growth runway ahead of it.
- The risks it faces, how Netflix is dealing with them, and why you shouldn't be short.
The spaghetti model of content delivery
For more than 50 years, traditional cable and network television has followed a content delivery model that I like to refer to as the "spaghetti" model. They have to air content (by "content," I mean television shows and movies) that a large enough fraction of viewers will be willing to watch. This means there is a big enough audience that advertisers are willing to pay to have their ads hosted. That's the whole reason: Get enough viewers to watch the ads.
The trouble is, they don't know what content will succeed until they find out what people are watching through measurements like the Nielsen ratings.
In other words, throw it and see what sticks to the wall.
As a consequence, content tends to devolve to broadly popular stuff. More focused content, while tried every now and then, rarely lasts. How many times have you or people you know really enjoyed a television series, only to see it canceled? For instance, I've heard that Firefly was a great series, but it got canceled after less than one season on News Corp.'s (NYSE: NWS) Fox network.
It's not who you know, it's what you know that counts
In contrast, Netflix has been gathering information for more than a decade about the viewing habits of its customers. From this, it knows:
- What content is in your queue.
- What DVDs you've had mailed to you.
- What content you search for and what you add to your queue from that.
- Whether you move something to the top of the queue.
- What content you've rated as like, love, or hated.
- The names of all the actors and directors and producers of all the content it carries and who is watched and who is not.
- Categories for all the content and which ones are popular and which ones aren't.
- Whether something its recommendation engine suggests is added to your queue.
- For streaming, what content you watch and whether you come back to watch something stopped in the middle.
Or at the very least, if it isn't tracking all this, management's not paying attention, and I would be extremely surprised. Internet companies can do this.
This is a huge competitive advantage that Netflix has over cable and network; over Amazon.com's (Nasdaq: AMZN) new streaming service; over News Corp., Walt Disney (NYSE: DIS), Comcast (Nasdaq: CMCSA), and General Electric's (NYSE: GE) Hulu; or over other providers of streaming content. Netflix has information on millions upon millions of hours of content viewed by millions of people.
So what?
This information leads to success because Netflix can provide content that it knows its customers will view. Just like Amazon has with books, Netflix is ruthlessly exploiting the long tail of content. There is a lot that is not profitable for big studios or cable companies or network television to either produce or show. Yet Netflix and its customers have turned that content into a desirable asset, both to obtain and to sell. For instance, in 2008, 41% of Netflix's DVD spending for films was on those that made less than $30 million at the box office, such as The Last King of Scotland and Babel. Netflix's customers choose to watch this content and Netflix obliges them. This creates loyalty among its customer base because they get access to content they like to watch that others don't show.
In other words, Netflix knows precisely what content it should acquire and what it should pay for it. That's why it decided recently to pay for the first showing rights to House of Cards -- because management decided enough people would be willing to watch it, both current and future subscribers.
This is information that every other streaming company does not have. They'll have to follow the spaghetti model or do what Netflix did: Build it up over time.
As I mentioned, I've been holding Netflix for more than four years, which for many investors means "forever," and I have no plans to sell. Tomorrow, I'll present the second reason why I'm a bull on Netflix.
