Source: Netflix.
Netflix (NFLX +2.39%) stock is up by an impressive 27% year-to-date, yet there's still considerable negativity surrounding the company, as Netflix stock carries a big short interest ratio of 9.8%. Let's look at a couple of the main bear arguments and why there's a big chance Netflix stock will continue inflicting a lot of damage to the shorts in the years ahead.
Competitive risk
Competition is always a risk, especially when operating in such a dynamic growth industry like online video streaming. Netflix is facing growing competition from multiple fronts, and that's not going to change anytime soon. Amazon.com (AMZN +3.37%) has built a strong library with more than 40,000 choices in Prime Instant Video, and the company is also venturing into original productions via its Amazon Studios division. Considering Amazon's competitive drive, it's only reasonable to assume that the online retailer will continue investing tons of money in online video in the years ahead.
Hulu is another relevant competitor, and Apple has recently announced that it has signed Time Warner (TWX +0.00%) HBO as its exclusive partner with its new HBO Now service. Apple devices, including Apple TV, will be the exclusive non-pay TV platform for HBO Now over the first three months. The service costs $14.99 monthly and provides access to all HBO content, including original series and third-party movies.
However, even if competitive pressure is on the rise, that doesn't necessarily mean the competition will crush Netflix. Just as traditional TV has provided enough room for multiple players to grow and thrive over time, online video streaming is an emerging industry offering enormous room for expansion.
Speaking during Netflix's third-quarter conference call about the launch of HBO's over-the-top service , CEO Reed Hastings explained:
On the consumer side, it's one more channel. So already consumers subscribed to us and Hulu and Amazon and they do pay-per-view and they do DVD and they do cable. So there's so many great sources of entertainment. And consumers subscribe to many of these.
So there's not much of a change in the direct competitive landscape. We and HBO have completely different content. So I don't think it will be a significant impact at the consumer level.
Content is king, and Netflix is building competitive differentiation via a powerful library of titles, including widely successful original productions such as House of Cards and Orange Is the New Black. As long as Netflix continues delivering valuable content for a competitively low price, increased competition in the industry is no reason to sell Netflix stock.
Profitability
Another popular argument among Netflix bears is that the company can't successfully face increasing competitive pressure while operating profitably. Content is expensive, and rising competition for high-quality content could erode profitability over time. However, that doesn't mean industry players will commit financial suicide by bidding for content at unreasonable prices.
In fact, Netflix is generating consistently growing profitability in the United States. The company produced a contribution margin of 28% in the U.S. streaming segment during the fourth quarter of 2014, and management expects this margin to expand to 30% of sales in the first quarter of 2015. The company estimates that the contribution margin in the U.S. will continue growing by 2% annually in the coming years, reaching 40% by 2020.
International expansion demands tons of capital, and global contribution margin fluctuates considerably on a quarter-by-quarter basis. However, management has said that markets launched more than a year ago are collectively profitable on a contribution basis, which shows that Netflix is clearly moving in the right direction when it comes to proving its ability to make money in different countries.
The company surprised most analysts during the last quarter by announcing that Netflix is planning to complete in its international expansion over the next two years. From the company's latest letter to shareholders:
Progress has been so strong that we now believe we can complete our global expansion over the next 2 years, while staying profitable, which is earlier than we expected. We then intend to generate material global profits from 2017 onwards.
We already offer Netflix in about 50 countries and have learned a great deal about the content people prefer, the marketing they respond to and how to best organize ourselves for steady improvement. Acceleration to 200 countries is largely made possible by the tremendous growth of the Internet in general, including on phones, tablets and smart TVs. We intend to stick to our core ad-free subscription model. As with our initial round of international expansion, we'll get some things wrong and do our best to fix them quickly.
The online streaming revolution is here to stay. Netflix is a major driving force behind that trend, and also one of the main beneficiaries from it. The company has clearly consolidated its competitive position in the industry, and it's also proving that it can generate expanding profitability both at home and abroad. Betting against such a vibrant business could be hazardous to your wealth.
