Netflix: A Pricey Stock With A Troubled Future

Summary

NFLX faces serious headwinds from increased competition, net neutrality, and a saturated US market.

NFLX's current valuation is too sanguine and I expect a significant pullback in 2017.

Many prudent NFLX investors have likely held onto their stock until the Trump administration's reduced tax rates become effective. Expect selling pressure once the new rates are announced.One of the main tenets of successful investing is to find companies that possess a competitive advantage. This advantage gives the company a superior position compared to competitors for a variety of reasons. Warren Buffett espouses the importance of investing in companies only if they have a significant competitive advantage in order to create a moat between the company and competitors. This moat allows for pricing power, which ultimately leads to profits.

Netflix (NASDAQ:NFLX) was the first mover in the industry and cannibalized Blockbuster by successfully envisioning the future. However, with the proliferation of competitors, it is apparent that this advantage is rapidly degrading. The industry remains marred by low levels of brand loyalty. The type of content the competitor has is the most influential buying criteria for the customer. As such, NFLX must pay an increased amount for new content and is required to lock-in long-term deals, which makes NFLX an inherently riskier company.

Headwinds

Competition

By being the first major player in the industry, Netflix enjoyed relatively high purchasing power. Licensing of titles is typically done through multi-year exclusive subscription video-on-demand licenses (SVOD). Through this method, Netflix was able to lock in content at attractive prices. Unfortunately, with the recent heightened competition from a wide range of companies such as Amazon (NASDAQ:AMZN), Hulu, Microsoft (NASDAQ:MSFT), and AOL (NYSE:AOL), these costs are set to rise dramatically. Moving forward, Netflix will have to pay substantially more for content, which will impinge upon margins. Evidence of this trend is percolating as the divergence between free cash flow and net income continues to increase. (I'll further explain this trend below).

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