Why Netflix can still win


As volatile Nasdaq reactions go, Netflix’s 15 percent stock-price slide this week is — from the perspective of investor psychology, at least — almost as disturbing as the much bigger 71 percent market cratering the company endured last year.

At least that decline was precipitated by tangible strategic mis-steps (i.e. the ill-fated price hike and a poorly-received attempt to spin off its DVD rental operation).

In its first-quarter earnings report Monday, all Netflix did was indicate an less-than-anticipated quarterly loss due to international expansion costs, and reveal that subscriber growth will be a little slow than usual in the near term.

Then all hell broke loose.

Sure, for a business whose stock price is driven by subscriber growth, that’s not great news. But overnight the investor community — the same one that originally built the company’s stock price to nearly $300 a share –seems to have concluded that Netflix won’t be able to grow its customer base fast enough to keep up with escalating content acquisition costs, not to mention a new wave of streaming competition.

Forget for a moment that investors boosted Netflix’s share price by nearly 20 percent in January after the company over-projected first-quarter losses of as much as $27 million (the red ink ended up being only $4.6 million) and under-forecasted U.S. subscriber growth at somewhere between 800,000 and 1.6 million (Q1 U.S. customer growth came in at 1.74 million).

Monday may have been a kind of sober, harsh-lit morning after for investors, who have finally woken up to Netflix’s limited earnings potential. From Hulu Plus to Amazon Prime to Verizon and Redbox’s soon-to-launch streaming service to TV Everywhere offerings like HBO Go, Netflix is about to have lot more in the way of over-the-top competition fighting with it for subscribers.

Then again, these investors might have just over-reacted a little. Here are few key edges working in Netflix’s favor:

Device penetration: Even without the recent addition of the Netflix player app on Sony Bravia Blu-ray players, Netflix has the most proliferated brand of any over-the-top programming supplier. In fact, many smart TVs and disc players now come with remote controls featuring dedicated red Netflix buttons, ensuring that the first streaming service many new OTT users sample going forward will be Netflix.

“One of the ways we win is to have a really broad selection, personalization, ease of use, and the other is to just [have the user be] able to see the red Netflix button on the remote control,” Hastings noted Monday.

Early entry into foreign markets: While Hastings conceded during Monday’s call that the developing Latin American region turned out to be more gnarly proposition than the company had bargained for, he’s not the only executive in the video business who believes the region has huge potential.

DirecTV, which has provided the model for Netflix’s southward migration, said last month at its Latin American Investor Day that it expects to double its revenue in the region to nearly $10 billion over the next five years.

Paving the road in Latin America isn’t cheap — there’s low device penetration, internet infrastructure needs development and just securing recurring credit/debit card transactions can be challenging. That explains much of Netflix’s $103 million in losses for its foreign streaming operations in the first quarter, but of course, when all of that is done, Netflix will be the first streaming service in on a well-spring of new subscribers.

Having already done much of its heavy lifting in the region, DirecTV, for example, added 590,000 new Latin American subscribers during the fourth quarter alone. Meanwhile, with Netflix’s entry last year into the UK and Ireland well received, growth of overall foreign subscriptions is already accelerating quite nicely, going from 380,000 new foreign customers in the fourth quarter to 1.21 million in Q1.

The content situation is better than it looks: Key to the souring of Netflix’s investor honeymoon has been the notion that, in order to keep up with the escalating prices program suppliers charge Netflix to stream their movies and TV shows, the service must add a corresponding amount of revenue through subscriber growth to keep up. Hastings even conceded that point on Monday.

In the first quarter, Netflix’s contractual obligations for content came in at around $3.7 billion, more than double the $1.8 billion they stood at a year prior. So it’s understandable why investors became concerned that, even with the company spending twice as much for content in the second quarter, Netflix said net U.S. subscriber additions would actually be slower than the year prior.

With the deal that brought Starz pay TV movies from Disney and Sony ended in February, Netflix is enduring a lean period in terms of big movies being available on its site. But in Q2, the business end of all of those content deals it’s made recently will begin to take hold.

Through its deal with emerging premium channel Epix, for example, Netflix will soon have access to such Paramount-distributed hits as Thor, Captain America and Transformers: Dark of the Moon. A pact signed two months ago with The Weinstein Company, meanwhile, will soon bring it the Oscar-winner for Best Picture, The Artist. Meanwhile, top family titles from DreamWorks Animation will begin showing up on the service next year.

By the time all this premiere content rolls out, Netflix’s streaming slate could look a lot more competitive than it does now, and it might be easier for investors to envision the company’s claim that it will add 7 million more U.S. subscribers by the end of the year.

And if Netflix is able to accomplish that goal, it might be in position to pull out the old elephant gun and go big-game hunting in a couple of years. Asked if Netflix might seek to add exclusive content deals with Disney, Fox, Universal and Sony when their respective pay TV deals expire over the next few years, Hastings responded, ” 2014 to 2015 are when most of them come up. And as far as I know, no one else has the right of first refusal.”

Then there are original series. It was perceived by some as grim news when Netflix didn’t reveal any performance numbers for its first foray into original programming, the Steven Van Zandt-led comedy-drama Lillyhammer.

But as Hastings noted Monday, the company certainly didn’t take a bath on this foreign co-production, which had much of its costs covered by foreign pre-sales. As HBO proved with The Sopranos a decade ago, one hit can be transformative to a subscription-based media model, and Netflix has several more at-bats upcoming in terms of originals, including the re-christening of the critically loved sitcom Arrested Development, as well as the debut of the David Fincher-led House of Cards.


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