3 Reasons Why Investors Should Stay Away from Netflix

On Wednesday, March 7, word got out that Netflix (Nasdaq: NFLX) has been in talks with several cable TV service providers with the intent of adding a Netflix option to the content already being offered by these cable companies.

While no details of these meetings were divulged — and certainly no deals have been struck yet — the market initially applauded the idea with a little buying. Unanswered concerns popped up a few hours later though, and the stock managed to end the day in the red, despite what started out as encouraging news.

Are investors rightfully concerned, or is a partnership with a cable company a “no-brainer” idea that shareholders should get behind? Unfortunately for Netflix shareholders, the concern is merited.

Here’s a closer look at three reasons why the not-so-secret meetings could be seen as a red flag of desperation rather than a creative idea for new revenue.

1. Cable companies don’t need Netflix
Subscription-based online video content was novel back in 2008 when Netflix added the option to its fading DVD-by-mail business. Now that the dust has settled, Netflix doesn’t have as strong of a digital content advantage as CEO Reed Hastings may want to believe. 

The flexibility of the online streaming service offered by Netflix is admittedly solid. Hundreds of movies and TV shows are available at any time, and they’re rotated on a regular basis. All of that content, however, is dated, ranging in ages from several months to several years old. While there is a market for it, the market  for new and fresh content is even stronger. Most “on-demand” movies and pay-per-view offerings from cable services are features not yet available on Netflix.

Simultaneously, TiVo (Nasdaq: TIVO) and DVR capabilities have given cable subscribers a similar flexibility in how and when TV content is viewed.

To be fair, comparing Netflix to available on-demand content and a DVR device isn’t an apples-to-apples comparison. From a consumer’s point of view, however, the difference may not be worth another $8 a month.

2. Thin margins would get thinner
When Netflix revamped its pricing policy in the middle of last year, it wasn’t a strategic maneuver. It was a measure taken in response to stop the trend of dwindling margins. Opening up another content outlet could exacerbate the problem.

In 2008, when Netflix put online streaming content on the menu, studios and entertainment distributors such as Liberty Media’s (Nasdaq: LMCA) Starz cable channel were more than willing to give the new medium a try. Liberty gave Netflix favorable terms for access to its content in a $30 million deal, which included movie hits “Toy Story 3” and “Chicago.” It’s not likely Liberty had any idea how successful Netflix would be at getting that content distributed. When it came time renegotiate content contracts and Liberty/Starz saw what kind of potential revenue was on the table, the company made Netflix an offer it had to refuse.

What’s that got to do with offering Netflix content through a cable TV venue? Many investors may not realize it, but most of the company’s current digital content contracts only give Netflix the right to stream TV shows and movies via the Internet — not to play them through a cable TV box. If Netflix has to go back and contract cable TV usage of that content, it may once again find it simply unaffordable.

Add in the likely 50/50 split of any new revenue generated by a cable partnership, and suddenly such a deal makes no fiscal sense at all.

3. The greater the success, the more competition it draws
In an ironic twist, Netflix has been so successful that on-demand competitors have popped up in all shapes and sizes. Each of them makes a Netflix offer at least a little less meaningful to a potential cable television partner.

Comcast (Nasdaq: CMCSA) is mounting a direct attack with its new Streampix offer, which for all intents and purposes is a clone of Netflix, but with a different content collection. Amazon.com (Nasdaq: AMZN) is going full throttle into the digital TV arena as well. It already competes with Netflix for DVD rental as well as on-demand streaming customers, but the latest whispers are suggesting Amazon is even tiptoeing into producing its own original content.

Regardless of how it’s done, if Netflix manages to break into the cable TV business, then others will follow. And, in the same sense that Netflix is explaining how its presence would give the cable companies some contract leverage with Time Warner’s (NYSE: TWX) HBO, Amazon could undercut Netflix, Apple (Nasdaq: AAPL) could undercut Amazon with its rumored forays into this space, and so on. Such a service could become a commodity, and a low-margin one at that.

Risks to Consider: Taking on a pessimistic view of Netflix might mean missing out on a hype-based rally, especially if the company gets a foothold in the cable TV business.

Action to Take –> If a potential cable TV partnership deal is the only thing piquing your interest in Netflix as an investment, then you may want to keep on looking — there are better selections elsewhere. Netflix remains trapped between increasing licensing costs and pricing pressure from more and more competitors. It may have pioneered the industry, but it has not remained competitive in it.