The biggest reason for being bearish on Netflix is the high price-to-earnings ratio at which they are currently trading (657.96 times its 2012 EPS at close of trading on March 26). The high operational costs of the company and its very low profit margins do not justify such irrational exuberance and high P/E number. It is not an overpriced stock but an outrageously overpriced one. It is a stock that is currently the darling of speculators but may prove to be the nemesis for investors, especially those who have a short term perspective.
In the fourth quarter of 2012, its net profit margin was a dismally low 0.84 %. On revenues of $945.24 million in the quarter, it was able to post profits of only $7.90 million. At a time when Apple and Google are trading at around 10 times and 25 times their EPS respectively, the high P/E ratio of Netflix looks more than a bit strange.
High operational costs squeezing profit margins
The high operational costs of Netflix can be attributed to its current business model. Netflix gets its content by entering into licensing deals with producers or other broadcasters of content. These licensing deals are based either on fixed fee or revenue sharing. However, once a program starts streaming through the internet via Netflix it cannibalizes the television revenues of the broadcasters or producers. This has led to many broadcasters and producers asking for much higher licensing fees or refusing to share content with Netflix. Because of lack of differentiation in terms of content, Netflix is unable to pass the increasing costs to its customers. In the past when the company raised the subscription fee, the customers showed high price elasticity of demand and many of them chose to stop using its services. After all the comparative advantage of its business model lies in offering to its customers television programs and movies at much lower prices than traditional pay television. An average Netflix subscription costs only around $8.20.
The high costs of content production and content exclusivity:
To partially overcome this problem, Netflix has entered the content production route. It is entering into exclusive agreements with content producers right at the production stage. House of Cards is a big budget political drama starring two-time Academy Award winner Kevin Spacey in the leading role. The budget of its first 30 episodes is approximately $100 million. The first season of House of Cards premiered exclusively on Netflix in February this year and was very successful. Netflix recently signed an exclusivity contract with Walt Disney to be the exclusive broadcaster of all new Walt Disney releases from 2016 onwards. The price that Netflix paid for this deal has not been disclosed, but those in the know say that that it paid dearly. The company hopes that through this strategy it will get differentiation in terms of content. This will not only give it more pricing power but will also drive the growth in subscription revenues. However, on the flip side, such a strategy also will end up increasing operating costs further.
Increased competition likely to put further downward pressure on profit margins:
Competition is intensifying. Amazon is expanding the scope of its online streaming service. HBO Go and Vudu are other major competitors. Many channels and broadcasters are setting up their own video streaming services; broadcasters will have an advantage because of their competency in producing screen content. This means that Netflix either strengthens its comparative advantage further, while controlling costs at the same time, or it creates some kind of differentiation (again while keeping the operational costs under control).
Netflix is trying hard to increase its revenues. It has expanded its services to countries like Denmark, Finland and Sweden. Such an expansion is likely to give a boost to its subscription revenues while giving it the cost benefits from economies of scale. Successful international expansion may prove to be a game changer for the company in the medium and long term.
Cost control versus revenue generation:
In the short run at least, Netflix’s problems come from its dismal profitability because of very high operating costs. The right strategy, in such a scenario should be to focus more on cost control rather than on revenue generation. However, the company is continuing to focus more on revenue generation by strengthening its product differentiation. Chief Content Officer, Ted Sarandos says that Netflix’s differentiation comes from its ability to let customers watch “what they want, when they want it,” unlike the case with television. However, trying to compete with television may be the wrong strategy for the company. It should focus on the niche customer segment that prefers to watch television programs and movies on the internet.
A bubble without fundamentals:
So there are enough reasons that support the bearish stand on the shares of Netflix. The current bubble in its share prices is likely to burst sooner than later. In the medium and long term things are still not very clear. It is very likely that it may end up getting acquired by a company like Google or Yahoo. In that case, investors who are investing in it with a long term perspective are likely to benefit greatly. For those thinking of investing in Netflix with a short term view there is a word of caution – the bubble may burst sooner than later. Fundamentals do not support such an exorbitant P/E ratio. The stream of Netflix has started flowing but the obstacles in its course are no little.