A tenet of value investing is to buy a stock at a point of extreme, perhaps maximum, pessimism. We may be reaching that point with Netflix Inc., given the reaction to the news this week that Amazon struck a deal to start Internet streaming of movies that previously had been Netflix's exclusive purview.
"Is this the end of Netflix streaming video?" asked a blogger on the website Seeking Alpha as he explained why he was shorting the stock. A dialogue on U.S. business cable channel CNBC between an analyst and a trader produced agreement that the deal was "the final straw" for Netflix.
At the same time, however, Netflix can't reasonably be called a value pick. Even though its current price of about $55 (U.S.) is less than one-fifth the all-time high set in the summer of 2011, its trailing price-to-earnings ratio still tops 30, and negligible profit expectations means the forward P/E is something on the order of 200 or so.
That valuation, combined with the very real questions about the company's future underscored by the Amazon news, should give investors pause before getting on board in hopes for a return to Netflix' glory days.
In making this argument, I'm reversing course. I never bought into the Netflix story at its peak, but in October 2011, as its trailing P/E tumbled from nearly 85 to less than 20, I suggested the company, trading around $80, had indeed been reborn as a value stock. "The company still has 25 million subscribers; the broadest, deepest library of content; and the ability, as long as it wishes, to deliver it via DVD or stream. Despite the recent fumbles, it is Netflix's game to lose, and we are far, far away from the company's end," I said then.
It seems that some, but not all, of that is true today. Most importantly, the changes in the competitive landscape suggest Netflix is indeed beginning to lose the game.
This week's Amazon deal, while not necessarily the final straw for Netflix, helps illustrate the company's challenge. EPIX, a joint venture that licenses movies from the studios Paramount, MGM and Lions Gate, had been providing titles exclusively to Netflix for the past two years. That arrangement ends this month; Amazon will now add the studios' movies to its Prime library even as they remain at Netflix.
While analysts estimate the titles are responsible for less than 10 per cent of Netflix viewership, analyst Michael Olson of Piper Jaffray notes that Netflix is increasingly unable to offer a compelling reason to subscribe to its streaming content.
Mr. Olson, who has a "neutral" rating and $74 price target, looked at the Top 50 movies by box-office receipts in 2010 and 2011. Netflix has just 15 of the 50 available for streaming, and 11 of those come from the EPIX arrangement. "In other words, the majority of the Netflix new release movie availability will now be matched by Amazon Prime Instant Video," he says.
At the same time Netflix is seeing its competitive position eroding domestically, it's spending heavily to enter international markets, the chief reason for the current depressed profit expectations.
Michael Corty of Morningstar Equity Research calls international expansion "the worst decision the company has ever made" because it's wrong in believing that its North American success can be replicated in countries where it didn't have the head start of building a customer base by sending DVDs through the mail.
Mr. Corty lowered his fair value estimate of Netflix to $55 earlier this year, saying its business model is flawed because the economic benefits of streaming video flow to the content owners, not Netflix. The company's shift from DVD distribution to streaming "levels the playing field" for Netflix's competitors, he says, which include Amazon and Apple, whose $100-billion in cash represents 30 times Netflix' annual revenue.
Ultimately, Netflix owns little of the content it distributes and none of the Internet pipes it streams the content through. In essence, it's a customer list. A list that will grow far more slowly, and more expensively, until it grows no more, and loses more of those customers to its bigger competitors. The end is not here, or even near, but it now seems to be in sight. And that would make these shares too expensive.