Here’s Why The Netflix Moat Is Running Low

In business, I look for economic castles protected by unbreachable moats.” -Warren Buffett

Netflix (NASDAQ:NFLX) was founded in 1997, and by 2007 it shipped its billionth DVD to a subscriber in Texas.  Netflix challenged the traditional movie business model by shipping movies directly to a subscriber’s mailbox.  It capitalized on the rise of DVD players in America and added a convenience factor of not having to leave your home.  Movie rental giant Blockbuster even failed to keep up as the company filed for Chapter 11 bankruptcy last year.  Netflix expanded its customer base by launching cheap access to online streaming video last November.  Netflix built an economic moat by giving customers a cheap alternative way to watch movies and television shows. However, as the dot-com bubble proved, investors can get carried away by internet success stories.

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Although Netflix built itself a castle, it was protected by a narrow moat.  Less than a year after launching its all-you-can watch online service, the company is running into several problems.  The content costs for the movie provider continue to climb.  Some analysts estimate that streaming content costs for Netflix could jump from $700 million to $2 billion.  In an effort to offset rising costs, Netflix announced a 60% price hike for its current $9.99 one DVD and unlimited streaming plan last July.  Even more troublesome, is the possibility that more media companies start hoarding video content in order to starve Netflix and its 25 million subscribers.  Earlier this month, negotiations between Starz (NASDAQ:LSTZA) and Netflix broke down.  Starz will not be renewing its licensing contract with Netflix, which is set to expire February 2012.  Starz explained, “This decision is a result of our strategy to protect the premium nature of our brand by preserving the appropriate pricing and packaging of our exclusive and highly valuable content.”  More entertainment giants could replicate this move and continue to drain the moat that once surrounded Netflix.  The company also has to compete with an increasing number of companies, such as Hulu, Google TV (NASDAQ:GOOG), Apple TV (NASDAQ:AAPL), and Amazon Instant Video (NASDAQ:AMZN).

The day after the 60% price hike announcement, shares touched a new all time high of $304.79.  Today, shares are trading near $130, a decline of 57% with the majority of the decline coming in the past week.  The company has taken a beating as customers turn the channel.  Netflix announced last week that it expects to have 24 million subscribers in the third quarter, instead of its previous estimate of 25 million.  Netflix is also splitting its DVD mail and streaming movie service by rebranding its DVD mail service as “Qwikster,” which means quick delivery. The streaming video service will retain the Netflix name. Although doom and gloom still surrounds Netflix, shares received two upgrades this morning. UBS (NYSE:UBS) upgraded shares from Sell to Neutral, while Wedbush Securities upgraded shares from underperform to outperform.

The upgrade from Wedbush Securities is interesting because shares were upgraded on the belief that the online streaming business of Netflix will be bought by Amazon (NASDAQ:AMZN).  Analyst Michael Pachter said, “In our view, Amazon has always wanted to be in the streaming business, and has been constrained from buying Netflix due to tax considerations.”

Considering the highly controversial move by Netflix (NASDAQ:NFLX) to split its DVD and online streaming business, this makes sense. Amazon is already known for their retail online presence, and now has an opportunity to expand its instant movie streaming business without taking on a DVD mail service.  By avoiding the physical DVD mail service, Amazon can continue to avoid sales tax issues. Furthermore, Amazon would be able to retain the Netflix brand name since the DVD mail service applies to Qwikster.  One has to wonder, why did Netflix choose the Qwikster name to describe its snail mail service?

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