Why We're Buying Netflix

Netflix (Nasdaq: NFLX) is back. And the stock market is slowly, but surely, recognizing that fact. We believe the company has a very bright future ahead of it, and can even envision it as a multibagger from here.

It's funny how much has changed for Netflix since the autumn of 2011. Back then, the stock market had left the company for dead, after CEO Reed Hastings appeared to botch several crucial decisions affecting the company's future. An ill-conceived price hike along with an attempt to spin off its DVD business angered customers, and led many of them to cancel their subscriptions. Hastings, who was one of the most-respected leaders in American business, began popping up on worst-CEO lists across the Web.

Netflix has emerged stronger and healthier over the past year, however, as a result of the painful transition it has embarked upon. And that's why we've decided to buy shares for our real-money, 10-Bagger portfolio.

Back when disruption was fun
Netflix changed the way we watch movies and TV shows by offering DVD rentals by mail. No more going to the store. No more late fees. Just select the video you want to watch in your online queue, and a red envelope would magically appear in your mailbox in a couple of days.

While little red envelopes were being delivered by the post office to houses across America, those same households were beginning to consume more and more content from the Internet. Whether it was on a PC or a wireless device, people were now watching videos anywhere, anytime. You didn't need to be Steve Jobs to recognize that this was potentially disruptive to Netflix's booming DVD business. Given the reality of the streaming video wave, Netflix was determined to lead the way when it came to the next generation of digital entertainment distribution.

A look at the company's subscriber numbers over the past three quarters paints a very vivid picture of this change.

Source: Netflix. Data in millions.

DISH Network (Nasdaq: DISH) saw the chance to jump on the bandwagon as well. It purchased the assets of Blockbuster in April 2011, wanting to give Netflix some competition in both DVD rental and streaming. However, the challenge hasn't materialized. Coinstar (Nasdaq: CSTR) has also jumped at the chance to grab those dwindling customers with its Redbox DVD rental kiosks. But we wonder how long that will last.

Streaming is clearly the future, and Hastings was quick to recognize that he needed to disrupt his own business. In the fourth quarter of 2011, Netflix subscribers watched more than 2 billion hours of streaming video. Recently, Hastings said the members watched 1 billion hours of video in the month of June alone. That works out to about 80 minutes of content per day per member. The switch to streaming is growing very rapidly, and Netflix members continue to ramp up their consumption. This is very good news for investors of the company.

Reed Hastings gets it
Hastings' instincts have been correct all along. He knew early on that subscribers are moving from renting DVDs to watching movies and TV shows by streaming video. Where Hastings got it wrong, in our opinion, was deciding to split Netflix into two separate parts. Yes, the DVD rental business would die someday. But why not hang on to the cash cow and reallocate that capital to growing the streaming business?

After the stock got hammered, customers started complaining, and subscribers started leaving, Hastings decided to pull the plug on spinning off the DVD business. Regardless of the communications debacle, Hastings is right about streaming being the wave of the future, and it's clear that he's dedicated to making Netflix the leader in this space. Hasting went from genius to fool in a short period of time. But as streaming takes off, he'll be back on those best-CEO lists in no time.

It's the incremental member, stupid
As streaming reaches scale, incremental members become very valuable to the company. Here's the response by Netflix CFO Ellie Mertz when asked why Netflix keeps pushing for more streaming subscribers when DVD subscribers are six times more profitable:

So, a marginal streaming subscriber is almost pure contribution margin. There is a little bit for credit card, CS, and CD end fees, but it is pretty modest. A marginal DVD subscriber has a number of variable costs -- the postage and DVD fees, in particular. So, actually it is the opposite, which is the profitability of a new streaming subscriber, the contribution margin is almost twice what it is for a DVD subscriber.

Adding more subscribers is important to Netflix -- and it goes beyond rising profits. As more subscribers join the mix, incremental profit goes up. Those profits can be reinvested in additional content. But the extra members can also increase the bargaining power of Netflix with the content providers. With more content available, more customers are likely to join, creating a positive feedback loop for the company. That helps keep potential competitors like Amazon.com (Nasdaq: AMZN), which offers streaming video through Prime membership, at bay. Netflix not only does offer a better experience today, but access to more content in the future, such as the deal cut with DreamWorks Animation (NYSE: DWA) in 2011 for Shrek and its other franchises, keeps customers happy and raises switching costs.

The best news is that subscriber growth is back. And as the company invests in international markets such as Canada, the United Kingdom, Ireland, and Brazil, membership growth should continue for quite a while.

Disrupting oneself
Netflix is early in the second act of its remarkable growth story following a short intermission last fall. The business continues to make strides, though investors have been hesitant to return to the stock. Part of that might be a result of a misunderstanding of the company's content obligations. Those only become a big risk if revenue starts falling off dramatically, which is not happening today.

We're very optimistic about Netflix's future as the leading streaming video provider, and that's why we're picking up shares. Netflix has a powerful franchise that will become even more valuable over time as it adds more and more subscribers to its membership base. It takes a lot of fortitude to disrupt yourself, especially when your original business is still throwing off a lot of cash. We suspect Netflix is at an inflection point in its journey, and we like the new direction it's headed.

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