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Market Update

Lack of Economic Moat is Glaring in Netflix's 3Q Results

The long-term competitive pressure facing this no-moat firm have been fast forwarded over the past three months.


 Netflix (NFLX) reported third-quarter results and a bleak fourth quarter outlook and projected an overall operating loss in the first two quarters of 2012. This outlook was much worse than we anticipated. Some of these issues are self-inflicted based on poor management decisions, but we believe the long-term competitive pressure facing this no-moat firm have simply been fast forwarded over the past three months. We've lowered our fair value estimate to $80 from $150 based on lower near-term forecasts as well as a much lower estimate of long-term profitability.

Within the third-quarter results, the standout issue is the loss of over 800,000 domestic subscribers to 23.8 million (a 3% decline) and expected continued bleeding into the fourth quarter. Clearly, the price increase sparked defections, and we continued to be perplexed at why the management team is dismissing DVDs so quickly. The company implemented a 60% price increase to $16 from $10 for the hybrid plan of 1 DVD plus streaming, which is the one long-term differentiator Netflix held over emerging competitors in streaming.

The projection for an operating loss in the first two quarters of 2012 is both shocking and alarming. The loss is blamed on investment in international expansion, a strategy we've questioned from the outset. The alarming portion of this near-term outlook is that blaming international seems to be a way to cover for the decline in domestic profitability. We've argued for some time that Netflix only has access to so much "quality" content from the major TV and movies studios as this content has so much value in the pay TV ecosystem. CEO Reed Hastings talks about increasing content investment in order to satisfy current and new subscribers, but we think the company lacks negotiating power with content providers. For example, we can't imagine the licensing deal with stale CW network content adds much value.

The stock has dropped significantly from its near-term high of over $300 per share in July when the stock was a deep 1-star call. However, we'd caution investors looking at the stock on a relative basis, especially since the all-time high was a bubblelike price. We think the company lacks an economic moat, faces significant competition, and must deal with content owners that have no need to license their quality content and can consistently reprice the existing streaming content that Netflix values. The management team did a great job of building its DVD business but has no track record with managing a streaming business, which admittedly is in its early stages. We think the international expansion will struggle to reach profitability, not only in the short run but in the long run.

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Michael Corty does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.