If an investor has a directional view as to which way a stock is likely to go, but the stock initially goes the other way before heading in the predicted direction, is the investor wrong or just early? Some perfectionists claim that being too early is the same as being wrong, whereas realistic value investors (like me) understand that the short term is unpredictable and what counts is getting the long term right.

Bearish on Netflix

Case in point: video rental company Netflix (NasdaqGS: NFLX). Long-time readers of my column know that I have been bearish on this stock for more than a year, first recommending it as a short back in a July 2010 advisor roundtable, and then recommending a bearish option trade on the stock five months later in my Best Options Trades for 2011.

Throughout the first half of 2011, Netflix continued to climb, hitting a high of $304.79 on July 13^th. The stock’s continued ascent made my bearish view look awfully early, which I will cop to, but I’m convinced that early does not equal wrong.  Since its July peak, the stock has declined more than 30% and I think the downward slide is just beginning.

Cancellation of Starz Video Streaming License is the Beginning of the End for Netflix

Today (September 2^nd) Netflix has collapsed 10% — more than $22 per share – on news that Liberty Starz (NasdaqGS: LSTZA) will not renew its content licensing deal with Netflix when the contract expires on February 28, 2012. This license cancellation is a big deal, because Starz controls the distribution rights for movies from Walt Disney (NYSE: DIS) and Sony (NYSE: SNE), which provided Netflix with most of its recently-released films. That means that 2,000 video titles are no longer available to Netflix subscribers for streaming, which is ironic because it happened on the same day that Netflix raised the price for its joint DVD rental/video streaming service by 60% ($9.99 to $15.98).  While many Netflix subscribers cancelled upon hearing of the price hike, many remained, but those remaining thought that Starz movies were part of the deal. How many will remain now?

Netflix CEO Reed Hastings has tried to downplay the importance of the Starz cancellation, stating that Starz movies account for only 8% of the content being viewed by Netflix subscribers, with the percentage to decline even further to between 5% and 6% by the time the content is removed in February 2012. But this statement doesn’t ring true when you consider what Hastings wrote in his Q4 2010 letter to shareholders (p. 6):

While we have a broad range of content, carrying Starz is one of our most important deals.

The reason Starz cancelled is because it wanted Netflix to pay more money to renew – A LOT more money. The original licensing deal was struck in 2008 and paid Starz only $30 million per year (one-twentieth the fee paid by pay cable channels like HBO). Starz was apparently willing to settle for such a small license fee because Netflix didn’t have many customers and consequently wouldn’t divert much business from pay cable channels. But since 2008, Netflix subscriber base has grown to 25 million, and the cannibalization effects have become severe. Consequently, CEO Hastings conceded back in June that it “wouldn’t be shocking” if Starz demanded $300 million per year to renew the license – ten times more! I interpreted Hastings’ statement as meaning that Netflix was willing to pay $300 million. The fact that Starz broke off negotiations suggests to me that Starz wanted even more than $300 million. 

Video Streaming Competitors Have More Money Than Netflix

Starz thinks it can get more because there are several companies with much deeper pockets than Netflix that want to get into the video streaming subscription business and are willing to pay big bucks. Compare the cash Netflix has on its balance sheet with the cash the following competitors have:

Source: Yahoo! Finance

The problem for Netflix is that Starz is just one of several distributors of video content that will be demanding huge increases in licensing fees over the next year or two. One analyst estimates that Netflix annual licensing fees will rise from $180 million to $1.98 billion next year. Given that Netflix’ annual profit in 2010 was only $161 million, such a huge fee increase would turn the company into a money loser. Netflix warned shareholders about this risk in its February 10K filing (pp. 6-7) and it is now happening.

Netflix’s Business Model is Not Sustainable

No one can argue that Netflix has generated amazing returns over the past few years. But that’s the past. The question for investors — which I discuss in my articles on fund manager Chuck Akre — is whether these high returns on capital are sustainable. To determine this, you have to examine the company’s business model and whether it has a competitive advantage with a high-profit “runway” of length (i.e., duration) and width (i.e., reinvestment opportunities). Netflix has neither.

To borrow a phrase from Karl Marx, power lies with those that own the means of production. Netflix owns nothing; it merely is a conduit for the movies produced by others. These video producers are finally asserting their power to maximize the value of their movies for themselves. 

Does a company like Netflix which has no control over the means of production deserve to be trading at 54 times trailing earnings and a 1.62 PEG ratio? Or even half those figures? I think you know my answer.

Energy Companies Also Own Their Means of Production

Besides video producers like Disney and Starz, investors should consider investing in another industry where companies own the means of production: energy. According to Elliott Gue, editor of the market-beating Energy Strategist investment service, “oil prices should remain elevated in 2011, generating plenty of earnings growth” for exploration and production (E&P) companies.