Why I Am Neutral on Netflix, Inc. (NASDAQ:NFLX)

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March 10, 2014 11:33am NYSE:FDN NYSE:PBS

netflixFor video streaming giant Netflix, Inc. (NASDAQ:NFLX), the first quarter has played out with all the intrigue of a House of Cardsepisode. And while it’s not yet clear how the year’s events will affect Netflix’s long-term business, what is clear is

that investors like what they’re seeing.

After quadrupling in 2013, shares were up another 25% through February 27. What’s more, that figure comes despite a mid-January tumble in response to a crucial federal court decision that gutted the Federal Communications Commission’s (FCC) Open Internet policy, better known as “net neutrality.” That policy mandated that Internet service providers (ISPs) – including Verizon Communications Inc.(NYSE:VZ), which challenged the rule – treat all web traffic the same.

The court said that ISPs are free to favor their own content over that of providers such as Netflix if they wish, or require Netflix and other video companies to pay additional fees for bandwidth. That shaved 9.5% off Netflix shares from January 3 to January 21 before a strong earnings report sent the stock soaring to an all-time high.

Just a month later, Netflix and Comcast Corporation(NASDAQ:CMCSA) announced a deal that will increase Netflix streaming speed to Comcast customers. Comcast, despite being one of the largest ISPs, was among the slowest of broadband providers streaming Netflix content. Representatives from both companies said that discussions were underway well before the January court decision.

The agreement will see Netflix connect directly to Comcast’s pipes rather than route traffic through other companies. Although Netflix is paying Comcast for the direct connection, technically net neutrality is not violated since Comcast is not playing favorites in terms of the content reaching end users.

While opinions differ on how the deal might impact the industry, the market accepted the news calmly, with the stock only slightly off the post-earnings high.

Given the way investors tend to behave, a little market melodrama comes as no surprise. But what should those of us on the side lines make of this?

First, let’s take a closer look at the net neutrality issue and our bet on what the recent Court of Appeals decision is likely to mean in practice.

The court’s decisions opens the door for ISPs like Verizon and Time Warner Cable Inc(NYSE:TWC) – which own the pipes through which Netflix delivers its content and have their own video-streaming businesses that compete with Netflix – to reduce streaming speed for their web-based rival while ensuring that their own content streams faster. However, ISPs might think twice before they go down this road.

First, the FCC and the Obama administration are committed to a free and open Internet. The FCC has already said it will rewrite its net-neutrality rules in a way that will pass court muster. Failing that, the agency could go so far as to designate ISPs as utilities and consequently subject them to common-carrier rules. This would certainly prevent providers from offering different levels of service. (It, too, would no doubt draw a court challenge.)

Second, cable companies and ISPs are not typically the most beloved of companies, and they’re locked in a kind of “frenemy” relationship with Netflix. Few things are more frustrating to a streaming- content viewer than that annoying buffering wheel, and those people will know who is to blame if they can’t access their Netflix’s content… the cable company.

Consider that one in six Netflix subscribers streamed at least one episode of season two of the political drama House of Cards on its February 14 release date, according to Procera Networks.

According to CBS Corporation(NYSE:CBS) chief Leslie Moonves, “at the end of the day, if you have the right content you’re always going to have the power.” He should know. When CBS and its subsidiary, Showtime Networks Inc., pulled their programming from Time Warner in a dispute last August, the cable provider lost more than 300,000 subscribers.

Analysts suggest that the deal between Comcast and Netflix could offer a solution for the industry’s largest content providers. However, smaller content providers with less market power could find it increasingly difficult to compete. Moreover, there are concerns that the greater power accruing to industry giants could result in a corporate-controlled internet.

It’s clear that Netflix’s original programming has fueled expansion in its subscription base. The company recently announced that it has more than 44 million subscribers globally, with 2.33 million added domestically in the final quarter of 2013 and an additional 1.6 million in the first quarter of this year so far.

With the company’s history and management projections of more than a 140% increase in earnings this year, it’s likely the stock will continue to see growth, particularly if the FCC manages to prevail in the fight for net neutrality.

However, there are some concerns, particularly with the company’s negative free cash flow. Original programming is expensive, and Netflix has been funding their wildly popular shows through the debt and credit markets rather than through internally-generated funds.

by Rebecca Baldridge, Investment U Research

Investment U provides cutting-edge research and strategic financial recommendations for all levels of investors through its morning publication Investment U Daily and its related publications.

Complete List Of ETFs That Hold “Netflix (NFLX)

Netflix Inc. is an Internet subscription service for watching tv shows and movies. Subscribers can instantly watch unlimited TV shows and movies streamed over the Internet to their TVs computers and mobile devices and in the United States subscribers can receive standard definition DVDs and Blu-ray Discs delivered to their homes. 

Click HERE for a complete list of ETFs that hold Netflix

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