Should You Buy Netflix?

In an unusual turn, Netflix (NASDAQ:NFLX) got what looked like a presidential endorsement before the much anticipated season 2 of "House of Cards". The release was successful for other reasons though. As it grows, several challenges have become visible for Netflix. For instance, the proposed merger between Comcast (NASDAQ: CMCSK) and Time Warner (NYSE: TWC) has been pointed to as significant for streaming companies including Google (NASDAQ: GOOG) and Amazon.com (NASDAQ:AMZN). As major technology companies enter the fray, the premium for quality content is rising. Annual revenue for Netflix was over $4 billion in 2014. With a P/E greater than 200, a look at this business may be worthwhlie to see if investor expectations are well placed.

Big cable may not be that big a problem
If Comcast and Time Warner merge, the resulting entity will be big. Comcast brings about 22 million subscribers to join roughly 12 million from Time Warner. Before the second season of "House of cards," Netflix was estimated to have about 30 million customers in the US.

Netflix has however bitten the bullet and come to an agreement with Comcast. The cost implications are not yet clear. Similar agreements may follow with other broadband service providers. A good thing is that Netflix saw this coming and was prepared.

Overall, customers for Comcast and Time Warner seem to be declining. However, the numbers for Netflix are not. Before the merger announcement, a good sign was rumors of talks between Netflix and Time Warner. They need not be abandoned. What is good for Time Warner need not be bad for the combined entity. Netflix brings valuable benefits to cable companies, particularly new distribution opportunities. Perhaps the recent agreement with Comcast sets the stage for deepening ties.

The bigger challenge is content acquisition costs
Netflix's growing subscriber base is an indication of its ability to distribute content to consumers in a way that drives adoption and usage. No other paid television streaming service is as successful at this scale. With its Open Connect technology it has also developed a solution for broadband service providers to ease the burden of distributing its content . By tackling the technical challenges of the transition from the distribution of DVDs to streaming, its software capabilities have enhanced its reputation as a technology company.

The hard nut is bringing down the costs of content. The success of original shows from Netflix demonstrates how well it knows its customers. This hasn't made "House of Cards" any cheaper to produce. Amazon and Netflix compete in acquiring content. They join traditional bidders like cable networks. The exception is probably Google which gets its Youtube content essentially free.

Netflix is said to be testing another pricing model. This could improve monetization of its huge library of movies. An additional source of revenue could be physical and digital merchandise, like toys and games, derived from original productions especially those targeted at children and youngsters. For instance, its collaboration with Marvel Studios could provide such an opportunity. Perhaps its capabilities in DVD distribution and deep knowledge about its customers, including families, could be useful here.

International expansion poses new and old challenges
The challenges don't end with the costs of content for Netflix. Its plan for expanding internationally continues. The costs of acquiring local content suited to the needs of each country may follow patterns in the US. In addition, it faces more marketing costs being a new brand in many markets outside the US.

There's more. Content unique to a country will also have to be prepared for Netflix's software to provide appealing movies for local customers to watch. This process repeats itself for Netflix with each new market that has a distinct local media industry. Over time these costs may become cheaper but imagine German, Norwegian and Hindi!

Finally, emerging markets have a few extra challenges. The availability of cheap broadband is a limiting factor. As media consumption is on the rise, if Netflix gets the content right, demand for movies is not an issue. However, revenue may be less until both Netflix and broadband services becomes popular .

The numbers in perspective
Google, Amazon and Netflix are vastly different companies in terms of businesses and business models. An important plus is that Netflix is moving much faster in streaming than its competition. However, Google and Amazon have other and much larger sources of revenue. Regrettably, Netflix has streaming and the DVD rental business which may decline thanks to Netflix having disrupted itself. Though its streaming business is growing, its P/E ratio appears driven by expectations far greater than its current business model can deliver.

What a Fool thinks...
In the long run, Netflix is extremely well equipped to develop an entirely new business by applying its present capabilities elsewhere. It shows no sign of doing so for now. It may also develop better ways to tackle costs or monetize. There's a feasible chance of solutions to the challenges it faces. At present, the greatest challenge is the cost of content. Perhaps, it's better to wait and see how Netflix responds.

The article Should You Buy Netflix? originally appeared on Fool.com.

Renjit Ebroo has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Google, and Netflix. The Motley Fool owns shares of Amazon.com, Google, 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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