Is the Picture Flickering at Netflix?

 Netflix (NFLX) is a powerful entertainment aggregator that has used the Internet to build a compelling value proposition to over 20 million subscribers. Over the past several decades, movie distribution has expanded from theaters to television licensing, VHS, DVD, and now online distribution, as broadband speeds have increased to handle digital delivery. Netflix is a well-managed company with strong growth prospects. However, we believe the shares are overvalued at over $220 per share. We think the game changes for Netflix as streaming content replaces DVD delivery.

CEO Reed Hastings and the Netflix management team have done an outstanding job of using the first sale doctrine to carve out a dominant DVD rental franchise to the detriment of its brick and mortar competitors, as well as movie studios selling DVDs at $20 a pop. The first sale doctrine allows rental companies to purchase DVDs, and then rent them to customers with no additional per-use costs, a crucial benefit to the rental business since the VHS days of the 1980s. In a nutshell, anyone who buys a DVD is free to sell, exchange, rent, or lend it to others. Therefore, rental companies like Netflix and Redbox can buy DVDs from the cheapest source, and rent them as many times as they desire. However, the studios work with Netflix directly, and negotiate either revenue-sharing or fixed price deals that usually prohibit Netflix from selling the DVDs after their rental cycle.

Consumers have been watching ad-supported video content over the Internet for several years, usually broadcast television shows on websites owned by content owners, or partially owned, in the case of Hulu. In its latest earnings conference call, Netflix stated that over one third of its new subscribers are signing up for its $8 per month streaming-only plan (one DVD at a time, and streaming cost $10 per month). Clearly, consumers are looking for streaming content. However, we believe the transition to streaming levels the playing field for Netflix's competitors, especially as television content becomes a more crucial part of Netflix's offering.

Several companies that already sell or rent digital content such as  Apple (AAPL),  Amazon (AMZN), Hulu, and Vudu (owned by  Wal-Mart (WMT)) could emerge as strong competitors to Netflix. We believe Amazon is a likely competitor, with its huge customer base and desire to make up for lost physical media sales, including DVDs. Amazon already sells digital video content, and is more than capable of opening a streaming rental storefront as well. We view Netflix's growing subscriber base as a head start as opposed to a sustainable competitive advantage in streaming content. We think some of the recent content deals demonstrate that the content owners have much better negotiating power relative to being backed into a corner by the first sale doctrine.

Netflix agreed to a five-year deal with EPIX, a new pay-TV channel that offers movies from Paramount, MGM and Lionsgate, for streaming rights that reportedly cost as much as $200 million annually. The movies are available for streaming 90 days after they are first shown in the pay TV window, which is usually several months after the DVD release. Furthermore,  Viacom  (which owns a portion of EPIX) indicated in its recent conference call that the five-year deal has an initial two-year period of exclusivity for broadband-only distributors like Netflix, and then can also be licensed to other distributors. We expect Netflix to pay much more annually to Starz (which holds streaming rights to  Disney (DIS) and Sony (SNE) movies in the pay TV window) after their agreement ends in early 2012. These deals illustrate how the economics of streaming video are much different than DVD delivery for Netflix. A library of DVDs has a long shelf life, but streaming content can disappear when a contract ends. Content firms have the power to reprice programming as demand for content shifts.

Netflix and Disney announced a one-year agreement in December 2010 for streaming rights for library (noncurrent season) TV content from the ABC network, ABC Family and Disney Channel. Some of the titles included in the agreement were Desperate Housewives and Lost from ABC, and Hannah Montana from Disney Channel. Any current season content will have either a window of 15 days or until the current season is already over, which means the newer programming licensed to Netflix will be available on Disney-owned websites much sooner than through Netflix. The short length of the deal and the rumored price tag--for as much as $150 million--is another sign that Netflix will have to pay up in the future for more current or sought-after content, especially if other aggregators make a serious push into streaming content. We think TV content owners will be selective, and negotiate hard with aggregators like Netflix, especially for highly-rated TV content that has tremendous value in syndication.

Despite our concerns about the future competitive landscape of streaming content, we acknowledge Netflix's rapidly growing subscriber base, its deep library of DVD offerings and the value it offers subscribers. However, we think the optimism currently priced into the shares does not account for the changes in content delivery that will lead to heightened competition for Netflix.