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By Erik Kobayashi-Solomon | 07-14-2010 12:02 PM

Netflix's Brick and Mortar Problem

Morningstar's Larry Witt thinks Netflix will have trouble replicating its mail-order movie business success in the online streaming arena.

Securities mentioned in this video
NFLX Netflix Inc

Erik Kobayashi-Solomon: Hi. I am Erik Kobayashi-Solomon, Co-Editor of Morningstar's OptionInvestor. Today it's my great pleasure to welcome Larry Witt, who is an equity analyst, covering Internet companies and media companies for Morningstar.

Larry, thanks for coming.

Larry Witt: Thanks for having me.

Kobayashi-Sovlomon: So Larry, just a very short time ago, I did a bearish strategy, option strategy on a company that you covered Netflix, and want to ask you a little bit about your bear case on Netflix.

Witt: Sure.

Kobayashi-Solomon: So recently, if I read through the headlines, I see this news about very quick revenue growth for Netflix, seems like they've got a lot of tailwinds with them right now. What makes you bearish on them in a short-term?

Witt: Sure. I think you're right that in the very near-term, over the next couple quarters, you're probably still going to see really strong revenue growth. The one thing that we kind of look for in the short run to potential derail that, maybe over the next 12 to 18 months, is one of the big factors that has been – let me take a step back, sorry, that has been driving this revenue growth is the distribution deals that they've had?

Kobayashi-Solomon: This is like through Wii or…

Witt: Yeah, the Xbox, PS3. They had various TVs or softwares being built in, but we think the biggest driver has been these gaming consoles. They have millions of installed bases across the country. And so as these deals anniversary, I think we'll see a deceleration in revenue growth. The Xbox deal has already anniversaried. It was launched here couple of years ago, but…

Kobayashi-Solomon: And you saw that kind of drop off after that good anniversary?

Witt: Well, actually it's being masked right now, because they also – as soon as that anniversaried, they signed the deal with PlayStation 3 and then most recently with the Wii. So, as all three of those eventually roll-off, which should be next spring, couple of quarters after that you might start seeing some deceleration.

Kobayashi-Solomon: So, basically they got a couple of really big contracts.

Witt: Exactly.

Kobayashi-Solomon: And those are going to start kind of becoming part of the normal growth.

Witt: Exactly, so those people, most of those potential subscribers, are probably already subscribing or will shortly. So that growth will definitely decelerate over time.

Kobayashi-Solomon: Now, what about a longer term view and this is maybe in the next 12 to 18 months, you are looking at these kind of anniversary deals falling off, what about longer term?

Witt: Yeah, longer term we're actually – I don't want to say we are overly bearish on the company, but we definitely don't think that the current momentum is sustainable.

Kobayashi-Solomon: Current momentum from a profitability standpoint.

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