Netflix's Brick and Mortar Problem

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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Witt: From revenue growth and operating margin expansion. We think that in the digital distribution world there is a lot more competition because barriers to entry are much lower.

Kobayashi-Solomon: These are competitors like Apple with their iTunes framework.

Witt: Amazon, you know about Hulu or VUDU, which was acquired by Wal-Mart. Best Buy has partnered with a technology provider. Basically, you don't need a lot of distribution centers around the country. There is not a lot of CapEx upfront. So it allows a lot of people to get into this industry much easier.

Kobayashi-Solomon: So, basically before Netflix had competed with a Blockbuster. So, they were kind of crushing their brick and mortar model, and now what you are saying is they've got some brick and mortar infrastructure that's not going to do them a lot of good.

Witt: Exactly, absolutely. So what happens with lots of competition is usually companies are going to have spend more on marketing, they might have to lower price, so overall it's not really good time for a company.

Kobayashi-Solomon: The competitors are pretty big...

Witt: Some of them are pretty big and even smaller companies, because there is not a lot of CapEx required it can get into this market and at least compete for a while, which could hurt Netflix, if a different competitor keeps popping up every six or 12 months, it might be just continual cycle of competition.

Kobayashi-Solomon: Let me just play the devil advocate for a second. I've also heard a lot about this recommendation engine. So in other words the subscribers – Netflix subscribers go on to the Internet and order movies. And they can – Netflix actually tracks that and can understand what movie a viewer would want to see, and wouldn't this create some stickiness some barrier to entry?

Witt: I think there is some stickiness built into the Netflix service. As you mentioned there's recommendation engine based on what people have ordered and also how you rate movies. I don't think it's that advantageous for newer titles or the most popular movies. People just know they want to see those movies.They don't need Netflix to tell them that. But it could definitely form some sort of an advantage for the longer tail content, old movies or less popular titles that maybe you haven't heard about, but based on these other movies maybe you've seen they might recommend those.

Kobayashi-Solomon: So, kind of some bifurcation of the market, in other words you've got one paradigm for the new movies and another paradigm for the older ones.

Witt: Right, no that absolutely could happen. If Netflix did decide that the digital content for news releases is just too expensive, which management has mentioned many times, it's just because of the different regulatory environment digital content is a lot more expensive to buy from the studios, so if they decide, we're just focus on the longer tale content and the older content, they could potentially dominate that market if they decided to shy away from new releases in general. But that being said people probably wouldn't be willing to pay as much. So the overall pricing might come down.

Kobayashi-Solomon: And not as much of a growth market?

Witt: Absolutely, absolutely. We think the potential for that market is probably smaller than the overall market that they are addressing right now.

Kobayashi-Solomon: Sure, sure. Well, Larry thanks for coming and talking to us about Netflix. We really appreciate it.

Witt: Absolutely, anytime. Thank you.

Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website where we have many more great option ideas based on Morningstar's fundamental research.