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Debunking the Netflix, Inc. (NFLX) “Virtuous Cycle” Myth

More recently, Netflix declined to renew a broad licensing deal with Viacom, Inc. (NASDAQ:VIAB) for a variety of content, including popular kids shows such as Dora the Explorer and SpongeBob SquarePants. In Netflix’s Q1 investor letter, management stated that it was interested in renewing a few popular titles from Viacom, Inc. (NASDAQ:VIAB) on an exclusive basis rather than having a bulk, non-exclusive deal. However, it didn’t win any of that content, as Amazon happily stepped in and bought the streaming rights to Viacom, Inc. (NASDAQ:VIAB)’s shows.

Netflix is still spending more money on streaming content each quarter. However, for every major new addition to the content library, there are big subtractions. Netflix seems happy so far with its recent move into original programming, but it remains to be seen whether the long-term value (dollar-for-dollar) of Netflix’s originals will outweigh that of the programming it is losing. Downton Abbey averaged more than 10 million viewers in its most recent season on PBS (Season 3), whereas Arrested Development drew just 4 million viewers on average in its third season.

Netflix doesn’t release viewing statistics, so it’s impossible to know how many people are really watching its original shows. However, given the known popularity of the shows it’s dropping, investors should question whether the service is really “better” today than it was six months ago in the eyes of the marginal subscriber.

Beware the coming vicious cycle
So far, Netflix hasn’t suffered any ill effects from the loss of key content deals to Amazon. However, much of the lost content has departed Netflix in the past three months. We shouldn’t expect to see 1 million Downton Abbey fans cancel Netflix and sign up for Amazon Prime on the day that Netflix lost that content. Instead, the loss of content at Netflix and the improvement at Amazon (and, to a lesser extent, Hulu) will gradually lead to higher churn at Netflix, as users become disillusioned upon seeing that some of their favorite programs are gone.

For example, when Downton Abbey fans want to catch up on old seasons of the show before the Season 4 premiere next January, they may decide to subscribe to Amazon Prime. Some may keep their Netflix subscriptions as well, but many others will drop Netflix to save money. This type of behavior will lead to lower subscriber growth over time.

Netflix bulls often argue that Netflix’s viewing data allows it to drop the shows that aren’t cost effective, and therefore investors shouldn’t worry about content losses. However, bulls seem to ignore the fact that Netflix has to work within a budget. Two years ago, the lack of competition for streaming content allowed Netflix to avoid tough choices on content. Today, Netflix is dropping hugely popular content because it simply can’t afford to pay for everything that’s popular without crushing its streaming margins.

Over the next two years, Netflix’s domestic growth is likely to peter out, as rising content costs and budget constraints prevent Netflix from improving the overall quality of its offerings. In its recent investor letter, Netflix stated it expects content costs to continue rising, but that it has many multi-year deals in place to mitigate the effect. However, the flip side is that as these cheaper deals expire over the next few years, Netflix will continually be faced with an unpleasant choice between paying vastly more to renew the deals, or losing even more content.

Time to get realistic
Netflix’s growth days aren’t over just yet. But with the stock still trading for almost 80 times 2014 earnings estimates, investors appear to be counting on many more years of rapid growth. This scenario seems highly unlikely. Reasonable people can disagree about the quality of one show versus another, but it’s hard to make a convincing argument that Netflix has dramatically improved its content library this year. The content Netflix has lost is just as high-profile as the content it has added.

Time Warner Inc (NYSE:TWX)‘s HBO service has been incredibly successful in maintaining a big subscriber base despite offering a limited content library. If Netflix can develop some of its originals into popular franchises, the company may realize its dream of becoming the next HBO, even if its content library shrinks on a “net” basis.

However, investors should be careful of what they wish for. If Netflix continues to dump lots of popular third-party content to free up money for originals, user defections could soon balance out new subscribers. Then Netflix really would be on the way to becoming the next HBO: a highly acclaimed, popular service that can’t seem to grow. Somehow, I don’t think investors will be very happy when they get there.

The article Debunking the Netflix “Virtuous Cycle” Myth originally appeared on is written by Adam Levine-Weinberg.

Adam Levine-Weinberg is short shares of Netflix and and is long December 2013 $275 puts on Netflix. The Motley Fool recommends and owns shares of and Netflix.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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