Is Netflix’s Business Model Already Obsolete?

• Content providers that operate their own streaming video services make Netflix’s business model obsolete.
• Netflix is making more money from its subscribers than HBO is.
• Netflix reported a negative cash flow of -$74 million in September 2014.
• High license fees for content are eating up Netflix’s revenues.
• Netflix is literally financing competitors like Disney with license fees.

Shark Tank star and NBA owner turned investment guru Mark Cuban might be setting himself up for some huge losses with his faith in Netflix (NASDAQ: NFLX). Instead of being the cash cow and potential acquisition target Cuban thinks it is, Netflix might be a dinosaur based on an obsolete business model.

Netflix’s current business model is to offer one-stop shopping for streaming video. The idea is that those that want streaming video will pay for a Netflix subscription. Right now that business model is sort of working; Netflix reported that its subscriber revenue for second quarter 2014 was $1.146 billion, which was slightly ahead of Time Warner’s (NYSE: TWX) HBO. HBO reported subscriber revenues of $1.41 billion for the same period.

Netflix Beats HBO…Barely

The available numbers indicate that Netflix’s subscribers are more profitable than HBO’s. Netflix generated slightly more revenue than HBO with around 50 million subscribers in the second quarter. HBO reported 127 million subscribers in the same period.

It should be noted here that many HBO subscribers simply buy the channel as part of a cable package and don’t actually watch it. The Netflix subscribers actually go to the Netflix site and download video, so they are more active than HBO’s.

A more telling sign of the quality of Netflix’s subscribers is its TTM revenues, which have been growing dramatically over the past few years. Netflix reported a TTM revenue figure of $5.19 billion on September 30, 2014, up from $4.14 billion in September 2013 and $3.54 billion in September 2012. Its business model does generate revenue, but does it make money?

Why Netflix Might Not Make Money

The current answer to Ben Graham’s all important question about Netflix is no. Netflix is not making money; the company reported a negative cash flow of -$74 million on September 30, 2014, down from $8.29 million in September 2013. Despite its subscription revenue, Netflix is having a hard time maintaining cash flow; it may not have any float.

Netflix’s current cash flow seems to validate predictions that content costs—license fees the service pays studios and others for movies and TV shows—will eat up its revenues. Sum Zero contributor David Trainer calculated that Netflix’s revenue costs grew by 30% between 2009 and 2013 while its revenues grew by 27%. Trainer also noted revenue growth at Netflix slowed between 2011 and 2013, falling to 23%.

The situation gets worse because Netflix is essentially financing some of its competitors through those license fees. The media companies Netflix has to pay license fees to include The Walt Disney Company (NYSE: DIS), Time Warner, AMC Entertainment Holdings (NYSEY: AMC), and other content providers that operate their own streaming video services.

Disney makes its own films and Marvel and Pixar movies available through its Movies Anywhere Channel. Time Warner operates several streaming video services, including a new one for HBO called HBO Go.

The Conflict That Could Destroy Netflix

Not only is Netflix financing its competitors with license fees but it might also be setting itself up for some very destructive conflicts with content providers.

What happens if AMC or HBO or, worse, Disney decides to stop providing movie or TV content to Netflix? Or if Netflix and Disney get into a dispute like the one between Disney and Amazon.com (NASDAQ: AMZN) in August or the battle between Time Warner and Dish Network (NASDAQ: DISH), in which channels got blacked out?

Yes, Netflix produces some of its own shows, such as House of Cards and Orange Is the New Black, but those programs only make up a small part of its library. How are subscribers going to react if they go to Netflix and discover that their favorite show or movie is no longer available there? My guess is that they would start canceling subscriptions.

Other content providers now have a strong incentive to raise license fees to Netflix—to drive customers to their own sites, where they can get all the revenue. There’s another good reason for content providers to fight with Netflix—to keep Netflix from developing into a dominant video content provider like Amazon.com has for eBooks. Entertainment companies do not want to end up like publishers, at the mercy of a giant online retailer that has the ability to set prices for the industry.

The content providers have many good reasons to weaken Netflix by raising license fees and no real reason to cut it any slack. Netflix’s position is a terrible one, and it will get worse.

Why Netflix Is Not an Acquisition Target

Companies like Disney also have far less of an incentive to acquire Netflix, which is what Mr. Cuban seems to be betting upon. Why spend $23.20 billion (Netflix’s market cap on Oct. 24, 2014) to buy a company that does something you can already do in house? Instead, why not spend far less revenue promoting your own cheaper streaming video service and offer exclusive content on it to attract more subscribers?

That means instead of becoming a cash cow, Netflix might find itself in a desperate struggle for survival in the next few years. Instead of a dominant player, it will find itself a niche content provider struggling to compete with giants with far greater resources.

Those that take Mark Cuban’s advice about Netflix could be setting themselves up for some nasty losses. Smart investors would be well advised to stay away from Netflix and Mr. Cuban’s stock picks.