Don’t Buy Netflix, Inc. Until This Happens (NFLX)

Today's downgrade of Netflix stock only scratches the surface of the headwind it faces

It’s not difficult to superficially pinpoint why Netflix, Inc. (NASDAQ:NFLX) is in the red today — Macquarie downgraded Netflix stock from “Neutral” to “Underperform.” Between that and the fact that the market wide bullishness we all enjoyed on Monday has reversed course on Tuesday, it would be surprising if NFLX wasn’t in the red.

On the other hand, the Macquarie downgrade of Netflix stock is just a microcosm of some much bigger problems NFLX has been increasingly facing, and it will continue to face as time marches on. Macquarie analyst Tim Nollen merely simplified the bigger headwind into just a few cogent words.

Netflix Stock Downgraded

For the record, Macquarie’s price target for Netflix stock didn’t change. It’s still at $85 … about 13% below the stock’s current value. Nollen simply feels the company now presents a weaker-than-average opportunity.

At the heart of his concern is — ultimately — an inability to meet international growth expectations with the company’s current content and cost structure. At the same time, Nollen is worried that the company’s domestic growth could be stymied from new and improving competition.

He said of NFLX’s international expansion efforts, “We believe success will require partnering with local content providers and/or investing in more local content, or in content that will travel,” suggesting the company would only accrue 73 million overseas members by 2019 as opposed to the consensus estimate of 75 million.

Domestically, Nollen is worried about alternatives ranging “from HBO Now to skinny bundles to virtual MVPDs like Hulu Plus,” which are already making competitive showings.

In a vacuum, Macquarie’s call could be chalked up to the one pessimist that’s always out there. Yet, Nollen’s assessment largely mirrors some of the same things Axiom Capital’s Victor Anthony reiterated just a few days ago. Namely, he explained “The competition is now real. It’s starting to impact subscriber growth.”

Two observers independently saying the same thing, knowing it would incur the wrath of investors who desperately want Netflix stock to remain on everyone’s pedestal? Maybe they’re on to something.

NFLX: A Collection of Problems

Actually, although it almost seems unfair, NFLX is facing a litany of interrelated issues, which together lead to the same trouble. That problem? Netflix can’t charge enough to pay for the content it’s delivering.

That wasn’t the case just a few years ago, when studios (the owners of the content NFLX needed) viewed over-the-top television as a curious side project that could put some nickels and dimes in the piggy bank while they were busy fishing for whales; they didn’t care much about the fledgling idea.

In the meantime, over-the-top television has become the whale, in that it has become a legitimate alternative to traditional cable television and the video rental store.

Nollen mentioned Hulu as one of those threats, and he’s right. The service — jointly owned by Time Warner Inc (NYSE:TWX), Walt Disney Co (NYSE:DIS), Twenty-First Century Fox Inc (NASDAQ:FOX, NASDAQ:FOXA) and Comcast Corporation (NASDAQ:CMCSA) — not only have a delivery platform, but they have access to a large library of content that has already created value for use on the small and big screen, and can now be repurposed for little more than a song. Netflix, conversely, must fiscally justify its in-house production just through sales of its subscription service.

SlingTV, from DISH Network Corp (NASDAQ:DISH), and Vue, from Sony Corp (ADR) (NYSE:SNE), are two more recently created venues that blur the lines between over-the-top television and traditional cable television; both offer some degree of major network broadcasts.

Another hurdle NFLX is struggling to get over: Competitors like Time Warner Cable and Comcast also control many of the broadband connections Netflix needs to deliver its service. Netflix will eventually win the moral battle of throttling and data caps, but the time it needs to wage that war will be time those competitors use to entrench themselves.

And just this week, on-demand-video rival, Inc. (NASDAQ:AMZN) reported it was considering beefing up its ODV offer with a foray into live sports broadcasting … an arena NFLX has made a point of avoiding in the past.

Bottom Line for NFLX Stock

Where too many investors — and arguably Netflix itself — trip themselves up is resting secure in the fact that NFLX is still the king of on-demand and over-the-top video. Just as Netflix proved disruptive to the cable industry though, all the other newcomers to the OTT venue in time will prove disruptive to NFLX.

Most of the major initiatives in the war against Netflix have only materialized within the last year. It will take time (though not a whole lot of time, if NFLX doesn’t turn up the heat) to chip away Netflix’s dominance in the space. Nollen and Axiom’s Victor Anthony are simply pointing out that among the plethora of on-demand and OTT choices consumers now have, at least some of them will siphon off Netflix’s existing and potential customers.

Digital video content has become a commodity. Netflix stock could struggle until CEO Reed Hastings realizes he can’t continue operating as if it’s 2011 and there’s no one else in the same business. It’s not clear exactly what has to change, but it is clear that something has to change, simply because the industry did.

The thing is — each of those other players has a way of driving revenue outside of on-demand and over-the-top television. NFLX only has one path to revenue, limiting its options.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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