Can Netflix Walk This Slippery Slope?

Shares of Netflix  were sliding heavily, but seemingly regained footing after their recent earnings beat. 

Netflix is valued at 200 times current earnings and 50 times forward earnings estimates. That means analysts are expecting massive growth in the subscriber base, a raise in prices, and/ or new advertising placements with Netflix's highly trafficked site, 

The very rich valuation is further complicated by the fact that new profits will have to offset Netflix's slowly dying DVD business, which accounted for half of the companies profits last quarter at $110 million. 

Off-balance sheet liabilities
Netflix currently has nearly $7.3 billion in off-balance sheet obligations for coming content. This is a hefty albatross to bear. While Netflix is raising prices for future customers, if consumers are price sensitive Netflix may have to do a large secondary offering to pay these liabilities, diluting current shareholders.  

Who's your sweetheart
Early on, Netflix got sweetheart deals from companies when it first started streaming, because they were the only ones interested in the old content. Dish Networks wanted to create a competing streaming service around the Blockbuster name, but found content prices too high. Their CEO claimed Netflix got "a sweetheart of a deal."

Give Netflix credit for first-mover advantage here. By the same token, when these original deals come up for renewal, expect competing bids to push content prices up -- rarely good for profitability.

Paying through the nose
Netflix also paid top dollar for more recent content deals. It has let the studios know that, when these contracts come up for renewal, it won't be paying the same premium. The challenge is that Amazon  and Yahoo  will be bidding for the same content, with far healthier balance sheets and deeper pockets. Yahoo's pockets will soon be infused with massive amounts of cash from the Alibaba IPO, and Amazon can borrow money far more cheaply than Netflix can based on their growing revenues. 

And why will Amazon or Yahoo be willing to pay top dollar for content? Because it keeps users entrenched and maneuvering through their ecosystem. Video is fodder for keeping them there/upselling them. Simply put, Amazon/Yahoo can monetize the traffic in a variety of ways as opposed to the flat monthly subscription that Netflix uses.

Original content
House of Cards cost Netflix nearly $4 million per episode and Netflix only secured exclusive streaming rights for the first few years. At that point, it opens up to the highest bidder again.

So, why did they acquiesce and pay such a premium? Netflix paid top dollar for a seat at the table. It outbid everyone for the House of Cards pitch with known all-star players (Kevin Spacey/David Fincher), knowing that once it becomes known as a player and outlet for original content, other top producers would see it as a viable distribution platform.

While you might want to criticize the price paid for House of Cards, the idea is defensible; without having done so, it would have been squeezed to death by rising prices for also-ran content.

Bottom Line
Netflix shares will continue to decline. The risk and liabilities of the company are very high, content prices aren't decreasing, and until recently, people were tripping over each other to bid up shares in a near-tulip mania. While the decline has been precipitous from $450, even with the recent bounce-back post earnings, I believe the valuations on the company to be far too high and recommend taking profits.

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Margie Nemcick-Cruz has no position in any stocks mentioned. The Motley Fool recommends, Netflix, and Yahoo!. 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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