Netflix: Beyond the Crystal Ball

Netflix recently reached the 40-million-member mark. While this is still far away from the goal of catching HBO at 114 million members, it's a big improvement over the 30 million members seen in the year-ago quarter. Netflix is also now available in 41 countries, offering over one billion hours of television shows and movies per month for the low price of $7.99. However, that comes out to $95.88 per year, making it more expensive than Amazon Prime at $79.99 per year.

We need to take a closer look at Netflix to see if it offers a better investment opportunity than Amazon based on all the content it offers, and what it expects to offer in the future.

Most importantly, a comment made in the company's letter to shareholders provided an important clue about the potential for the stock.

Original content drives membership
Netflix's ability to offer unlimited content from anywhere at any time combined with popular and high-quality content like House of Cards and Orange is the New Black has driven membership and the company's popularity among investors.

House of Cards becoming the first Internet television series to win a Primetime Emmy Award helped a great deal, and Orange Is the New Black is the most watched original series ever. Based on the social media fanfare for the latter, the popularity of the show should increase going forward. These trends helped domestic net additions jump 11% to 1.3 million in the third quarter year over year, and international additions to total 1.44 million versus 690,000 in the year-ago quarter.

Present and future content
Despite the potential for original content, the biggest viewing percentage is for complete season-after series, such as New Girl, The Walking Dead, Breaking Bad, and Pretty Little Liars.

Netflix isn't stopping there. It has a deal with The Weinstein Company, which will give Netflix exclusive the rights to the company's first-run films.

Netflix also signed a multi-year deal with DreamWorks Animation , in which DreamWorks will produce 300 hours of programming for Netflix. This content will be based on past and future films. Thanks to the acquisition of Classic Media, DreamWorks also has licensing rights to use Casper the Friendly Ghost, Rocky and Bullwinkle, Mr. Peabody and Sherman, Dick Tracy, Gumby, Voltron, and more. Netflix will also launch the DreamWorks original series Turbo F.A.S.T. in December. This all works out well for DreamWorks, which wants to branch out so it doesn't have to solely rely on feature films.

Netflix is attempting to increase its appeal to younger audiences, recently adding Goosebumps, The Magic School Bus, Super Why!, Caliou, Wild Kratts, and Arthur. Adding a second season of Mako Mermaids (for teens) helps broaden that target audience.

Luck or skill?
The advents of Apple TV, Roku, Chromecast, tablets, and smartphones have all helped fuel growth for Netflix. Timing is everything, and some would say that Netflix has great timing. In reality, the company has managed to change with the times, or even ahead of the times, which has been the primary reason for its success.

Amazon aims to steal share
That DreamWorks animation deal, along with a $350 million Disney deal, were key for Netflix after its deal with Viacom fell through. Amazon quickly jumped on that opportunity, with Amazon Prime Instant Video winning rights to programming from Comedy Central, MTV, and Nickelodeon. The latter plays a big role. If Amazon can win the loyalty of younger generations now, it could pay big dividends down the road. The popularity of Nickelodeon programs is ever increasing.

Amazon also has rights to Under the Dome through CBS, but that's not going to be enough to catch Netflix in this arena. However, Amazon is in just about every consumer market you can imagine, which gives it more diversification then Netflix. Despite that diversification, Amazon hasn't outpaced Netflix on the top line by much over the past several years:

NFLX Revenue TTM Chart
NFLX Revenue TTM Chart

NFLX Revenue TTM data by YCharts

Both Netflix and Amazon trade at extremely high valuations. Netflix trades at 95 times forward earnings and Amazon trades at 115 times forward earnings. This brings us to the most important point, which was hinted at in the introduction.

Red flag for the stock, but not the company
In the third quarter's letter to shareholders, I was somewhat surprised to read the following comment:

"In calendar year 2003 we were the highest performing stock on Nasdaq. We had solid results compounded by momentum-investor-fueled euphoria. Some of the euphoria today feels like 2003."

If you read between the lines, it seems like Netflix feels its stock is overvalued. The comment above was followed by this:

"Despite the huge swings in our stock price since our 2002 IPO ($8 to $3 to $39 to $8 to $300 to $55 to $330), we've continued to grow our membership every year fairly steadily. We do our best to ignore the volatility in our stock. The progress we've made over the last 10 years is stunning. We want to make the next 10 years even more remarkable."

That statement makes sense. It's truthful, and it shows that the future for the underlying company is bright. However, the first comment indicates that this might not be the ideal entry point for investors.

The bottom line
Netflix is a growing company with enormous long-term potential. It's constantly ahead of industry curves, and its original content potential combined with its licensing deals, convenience, and affordability should prove to be growth drivers. That said, based on the recent comments made in the company's letter to its shareholders and the extremely high valuation, you should consider avoiding Netflix at this time.

More important information on Netflix and Amazon
Americans reportedly spend nearly 34 hours a week watching television! With television viewing taking up almost as much time as the average work week, the potential for profits in the space is enormous. The Motley Fool's top experts have created a new free report titled "Will Netflix Own the Future of Television?" The report not only outlines where the future of television is heading, but offers top ideas for how to profit. To get your free report, just click here!

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool recommends, DreamWorks Animation, and Netflix. The Motley Fool owns shares of and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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