The Netflix Success Train

I was going to write about sports, but I felt that this post would be way more compelling! Not too long ago, during the summer, I looked into possibly investing in Netflix. In Canada, I had noticed that the company's brand power was growing. Consumers were being persuaded that the unlimited streaming of videos for $7.99 a month was a more attractive model than the Blockbusters brick-and-mortar DVD rental stores. A quick look at the company's statement of income also showed that revenues had been increasing by substantial amounts for many quarters.

Despite all this perceived value, one look at the stock price turned me off completely: around $250 per share. This represented a price per earnings multiple of about 61.5x EPS. Clearly, I wasn't the only one that thought the company had potential for growth. I was convinced that the high valuation was the result of speculation, and did not necessarily represent the fair value of the stock. I thought that the price would have to come down one day, and the door would be open for value investors to reap some of the success of this amazing company.

Alas, Netflix has made some interesting business decisions of late, and their share price has taken a hit. Today, the stock closed at $79.40 on the Nasdaq. That's a 74% decrease from their high of $304.79 in mid-July. What caused such a drop? Realizing that the company's future lies primarily in online-streaming, rather than DVD direct mailing, Netflix had decided to launch a new, separate brand, Qwikster, for its DVD mailing service. This move was not looked at favourably by investors, and Netflix immediately retracted this idea. The damage was done, however, and the brand reputation has some lost ground to recover now. To make matters worse, the company lost 800,000 subscribers in the third quarter after a price increase was implemented for the DVD end of the business.

Most people would consider this bad news, but I see it as an opportunity. The share's P/E multiple is now at about 18x EPS, which is in line with a more "average" growth stock. However, considering Netflix has only begun to expand to the international market, there is so much more potential for Netflix to succeed, in comparison to the "average" growth stock.

Netflix will expand to Ireland and the UK in the first quarter of 2012 and it will continue to invest in its growing operations in Canada and Latin America. The company predicts losses on the international playing field for some time because of high marketing costs, and investment costs related to the purchasing of licenses to stream material. In my opinion, Netflix will recoup this investment, and be rewarded handsomely for years to come. Netflix has demand-side economies of scale, which means that the more subscribers the company attracts, the more value it can deliver to each customer. Once a customer base is established internationally, more and more consumers will be attracted to Netflix, and the company's growth will catch like a flame.

Another obstacle for Netflix' success is their streamable content. One of the company's biggest strengths is its massive library of content. But licenses for streaming seem to be harder to come by than the DVD counterpart. Some licenses are held exclusively by competitors, and it's also possible that some studios avoid selling licenses to Netflix because they are worried that the company will become too powerful. Despite these difficulties, Netflix continues to invest aggressively in their content library, and it seems that the company's libraries will only continue to expand.

All this to say that despite the significant devaluation of its share price, Netflix still has so much to offer consumers around the world, and its international expansion has only begun. For investors, this could be an amazing opportunity to get on the Netflix success train for cheap. If things don't go so well at first, be patient, and remember that this company has great potential to deliver on the long-run.