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Netflix's High Stock Price Is Indefensible

Stocks in this article: MORN NFLX

Netflix currently benefits from the so-called "first-sale doctrine." The first-sale doctrine is a legal precedent, allowing the company to pay just once for each DVD or Blu-ray disc and then rent it out an unlimited number of times to customers to generate sales and profit.

This system is fundamentally illogical and already fading. Film studios bear the cost of investing, filming, editing and marketing content and Netflix, and before it, movie-rental chains such as Blockbuster, bear no risk and enjoy seemingly unlimited aftermarket rewards without paying a percentage to studios. As content migrates online, eventually all devices will be synched to the Web, and all video will be streaming. Netflix doesn't own the Internet, or even any content, so its only bargaining chip with studios will be its technology platform and customer base, which has no incentive to stay with Netflix, unless the company has the best prices and offerings. Netflix has no competitive advantages in streaming so, eventually, it will suffer margin compression, at best, and a potential mass-migration of customers, at worst.

The debate is not if, but, when, this will occur. Whitney Tilson and others argue that it is already occurring. Value-oriented Morningstar issued a report last week, suggesting that Netflix's stock is well above fair value. The researcher is keen on companies that possess an "economic moat", some advantage that keeps competitors at a perpetual disadvantage. Netflix lacks this moat. In terms of hours of entertainment delivered, streaming is already outpacing DVD. According to Tilson, who lists the top 100 films from the American Film Institute's list, Netflix has streaming movie offerings inferior to those of Apple (AAPL) iTunes, Amazon (AMZN) OnDemand and Vudu, partially owned by Wal-Mart (WMT). For streaming television, Tilson ranks Netflix fifth, behind Hulu and others.

Netflix's major studio deal is with TV channel Epix, allowing it to stream movies from Paramount, MGM and Lions Gate 90 days after they're first shown on television, which is roughly three months after the DVD release. This presents a huge lag between DVD release and the movies showing up on Netflix streaming, but Netflix purportedly pays $200 million annually for this deal, a significant sum relative to its cash-flow intake and liquidity balance.

Another deal, announced in December with Disney (DIS), to stream television content from ABC, ABC Family and the Disney Channel, is costing Netflix $150 million for just one year of use and, again, with a notable lag between run date and streaming release date.

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