Short This Soaring Stock Before it Heads off a Cliff

Anybody with a home theatre has known for some time that the DVD’s days are numbered. Eventually, streaming movies will be the standard. Eventually, films will also be streamed directly to a movie screen. There will be no front projection. Movie theatres will be nothing more than a choice between a large screen and a really large screen (IMAX, which is enjoying an undeserved stock run at the moment, is toast unless they change their business model.) [See: Our take on IMAX]

Investors might think that this is good news for Netflix (Nasdaq: NFLX), which is moving heavily into the streaming content business. The company recently made a big announcement that it will spend $1 billion over five years to have exclusive streaming rights to content from Epix 90 days after the content’s pay-TV window. Epix is the joint venture between MGM, Paramount, and Lionsgate (but it excludes the big Dreamworks releases).

This is not a reason for Netflix investors to celebrate. In fact, it’s a huge mistake and the beginning of the end of the company. Here’s why, and why Netflix is ripe for short-selling:

DVDs are on the way out. That’s Netflix’s current primary business. The company knows this, so it wants to broaden into streaming for content delivery. However, streaming technology is going to become commoditized just as DVD players were, and VHS players before that. The reason is that there is no technological barrier to streaming.

So Netflix made this deal with Epix because the only winner in a commodity-based business is the one with the brand name. The Epix deal is an old-fashioned land grab. While there are no serious streaming threats out there, Netflix wants to extend its brand identity to become the most well-known name in streaming content delivery.

Sounds like a good plan, right? Wrong.

Does any smart investor think other companies are just going to let Netflix corner the streaming market?

Does a smart investor really believe that Google (Nasdaq: GOOG) and Apple (Nasdaq: AAPL) and any number of other companies aren’t already developing their own technology? Of course they are. [Also see: Why Google and Apple Will Spell the Doom of Tivo] (Nasdaq: AMZN) is another entrant into this arena, according to some sources. The company pioneered the delivery of content via mail and the Kindle device years ago.

Whoever pays the most for content will get the rights to stream it. You don’t even need to look at the balance sheets of Netflix versus Google or Amazon. Guess who has deeper pockets? Netflix is trying to become a brand name in a field where they’ll be up against other massive, already-established brand names. And they’ll pay for that mistake. Maybe not today, and maybe not tomorrow, but eventually.

Worse, they have already vastly overpaid for this mistake.

Shelling out $1 billion for the rights to stream Epix programming 90 days after it appears on pay TV? Who is going to cancel Epix from their local cable or satellite operator that’s paying $9.99 a month in order to become a Netflix subscriber for $1 less a month and have to wait 90 days for Epix’s content? If I do not already enjoy either Netflix or Epix, chances are I am not suddenly going to become a Netflix subscriber because of this deal.

Netflix would have to add two million subscribers every year to break even on this misguided deal, after adding four million in the past year alone. Are new subscriptions really going to leap +50% as a result of this deal? No way.

And yet, when you look at Netflix’s stock behavior, investors seem to think this concept is great. The stock ran up more than +200% in the past year and leapt another $10 when Apple announced that Apple TV would be able to stream Netflix movies — when it could already stream Netflix movies in the first place.

Meanwhile, Netflix is seeing subscriber acquisition costs rise dramatically: $75 million spent in the first fiscal quarter of this year brought in almost 1.7 million new customers, but only 1.1 million in the second quarter. Competition from Redbox is eating into revenue, as the company came in $5.2 million below expectations in the most recent quarter, and now will have to pay out $200 million a year for the Epix deal. Netflix’s total net income for the past two fiscal years is only about $200 million, which means the company will have to grow at an incredibly rapid rate in order to avoid breaking even.

Action to Take –> Investors looking for a short play should consider Netflix. DVDs are on the way out, and streaming will be the final model. There is no barrier to entry for streaming, and companies like Google and Apple will eventually make Netflix obsolete.

Add to this that every bit of news — even if it is redundant — sends the stock soaring. It’s irrational exuberance. Netflix is starting to feel like Iomega to me. The stock went nuts in the mid-1990s because nobody believed the ZIP drive could ever be replaced. Do you still own a ZIP drive? That’s why the stock cratered and the company was purchased for next to nothing.

I believe Netflix could face the same fate.