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Netflix Killers? Not So Fast


The streaming wars are heating up. Should you sell Netflix?

In the past two days, the long-awaited "Netflix (NFLX) killer(s)" seemed to have finally arrived.

On Monday night, Coinstar (CSTR), owner of the Redbox DVD kiosks, announced it would enter into a joint venture with Verizon (VZ) to supplement the physical DVD-rental business with streaming. Coinstar also bought out a DVD kiosk rival and posted profits that blew away expectations and have nearly tripled since the end of 2010. Coinstar executives say that they are poaching physical DVD customers from Netflix.

This morning, Amazon (AMZN) announced a content deal with Viacom (VIA) that will give Amazon Prime subscribers free access to Viacom's huge library of content for the same $79 per year, slightly less than the price of Netflix.

This is where the market says it's time to sell off Netflix like any of the millions of subscribers who decided to get their movies elsewhere. Right?

Maybe. Yesterday, when the announcement of the joint venture between Coinstar and Verizon hit the markets, Coinstar's stock exploded by almost 20% on the day. Netflix wasn't absolutely crushed by the news, but it's definitely not a positive. Netflix stock gained almost 4 percent before gradually falling down 1.06% below the day before. As of noon today, Netflix is down almost 3%.

Netflix has been slowly climbing out of the trough since the catastrophic drop that occurred after the sudden 60% price increase and botched splitting of the streaming and mail-order programs. Since the beginning of the year, Netflix is up 79%, vastly outperforming the NASDAQ Composite (^IXIC).

The brand is severely tarnished, but Netflix has a lot going for it despite that.

The last earnings report surpassed even the company's own expectations. The subscriber revolt of the summer and fall seems to have been stemmed. Marketing expenses have plummeted. Costs for streaming content -- the main reason that subscribers wouldn't leave -- is getting higher, though. There are rumors that the proposed Apple (AAPL) iTV would include Netflix. If that turns out to be true, Netflix's dominance is almost guaranteed.

The "first mover advantage" also works in Netflix's favor. It built this whole industry and built up a subscriber base of over 20 million before meeting any viable competitors. Verizon's FiOS TV, by contrast, has 4.2 million customers. Like Amazon, Netflix is showing willingness to forgo short-term profits in favor of expansion. From its privileged position, Netflix can afford to aggressively expand its catalog, keep its current subscribers, and raise its paltry sub-5% profit margin.

Jettisoning the Customers

In the third quarter of 2011, Netflix lost 800,000 customers. Subscribers continued to leave in the fourth quarter, but there was a net increase in streaming customers. The ones that it lost were mostly DVD streaming customers. Many who quit the DVD service stayed with the continued streaming. Still, more than half of the profit contribution came from domestic DVD subscriptions.

Note that when the company split up the streaming and DVD services, the legacy Netflix brand was pegged to the streaming service. It made no sense to call the mail-order service "Qwikster" when it takes longer to order movies by mail than it does to stream on demand. This can be a sign that Netflix sees its future in streaming. In a conference call, CEO Reed Hastings told analysts that the company has no intention of even marketing the DVD service and that DVD subscriptions are expected to contract "forever." In the long term, getting rid of the lower margin DVD business and losing the larger work force that it requires could improve profitability.

Content Is King

The battle this year is over content. The price of streaming rights started out cheap, but studios are demanding more. Netflix customers frequently complain about the lack of streaming content, and Netflix is aggressively adding to its already unrivaled catalog and successfully negotiating contracts, some exclusive, with most of the major studios.

Amazon's deal today with Viacom only means that Amazon subscribers can now access older material that Netflix already has. The Coinstar/Verizon deal is more of a concern because they will be offering more new content.

A bigger problem facing Netflix is the loss of exclusive streaming rights for Starz content. Starting this month, subscribers will no longer have access to highly desirable content such as the top-tier Disney movies. The company downplayed this loss because that content accounts for only 2% of viewing time, but the lower overall quality of the 20,000+ movie catalog is a problem. On the flipside, forgoing this content saves the company money.

Wedbush Securities analyst Michael Patcher, who rates Netflix as "underperform," sees the loss of high-profile exclusivity contracts like the one with Starz as the biggest threat to the company.

"Netflix has to make a choice: Either it will have high subscriber growth due to high-cost, high-quality content, meaning profits will be small or nil; or it will have lower subscriber growth due to low-cost, low-quality content, meaning it will make money but not be a growth story," Patcher said in a recent research memo. "In our view, the high-growth, high-profit story is not going to happen."

The Takeaway

Amazon's deal today shouldn't hurt Netflix's bottom line, as it gives current Netflix subscribers no incentive to switch. More competitors certainly isn't a positive for Netflix, however. A bidding war for exclusive contracts could wreck its bottom line. Don't expect a return to the stratospheric valuation from last summer, but Netflix isn't going anywhere anytime soon.

Twitter: @vincent_trivett
No positions in stocks mentioned.
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