Netflix  is a fundamentally strong company with stellar subscriber, revenue and earnings-per-share growth. The online video firm saw a big recovery in its stock price after a considerable drop earlier in the year. I am bullish on Netflix, however, I decided to explore the bearish investment thesis on the company. Two major headwinds for Netflix come down to heightened competition and rising content costs.

Heightened competition
Netflix has managed to fight off competition from a large number of online and linear TV competitors and is the leader in the online TV space. However, some of its major competitors are making huge investments in the space to catch up with the growing technology.

Amazon has been very aggressive as of late in spending hundreds of millions of dollars in exclusive content for Amazon Prime. The e-Commerce company's content library grew to more than 40,000 titles, as the company made a string of big investments. Notably, Amazon struck a $300 million/year deal with Time Warner to add old catalog content from HBO, as well as newer seasons that will be made available 3 years after their HBO release. As a result, Prime's 20 million plus subscribers can now tune into HBO favorites including The SopranosTrue Blood, and Boardwalk Empire to name a few. 


Netflix will also face more competition from Time Warner's HBO. In the last earnings call, Time Warner's management stated that they will be investing heavily to grow the technology and more wide-spread adoption of HBO Go. Netflix and HBO have vastly different content and likely have millions of viewers who subscribe to both services, but competition for newer subscribers will increase. 

In addition, Hulu, which is part-owned by Disney, is growing revenues and paid subscribers at a brisk pace. Hulu's ad-supported paid platform, Hulu Plus, recently crossed 6 million subscribers. Using the shows from its parent companies which include Disney, NBC Universal, 21st Century Fox, and an increasing number of Hulu Originals, the platform has gained good momentum in adding subscribers. Netflix is seeing a lot of competition in the space, however, the company is well ahead of its competitors with more than 48 million subscribers, and due to its original shows, the service is also starting to look vastly different as well. 

Rising Costs
Netflix has been going through a massive investment phase adding large swaths of exclusive and original content, and some of these contracts with various content creators are worth a few hundred million dollars annually. The world's leading Internet TV network recently struck a deal to roll-out a new talk show and stand-up comedy special from well known TV personality, Chelsea Handler. Such exclusive deals will increase the company's durable competitive advantage, but are very costly. 

At the end of Q1 2014, Netflix had a total of $7.1 billion in content obligations that stretch out over 5 years. However, a little over $3 billion in streaming content obligations are due in 1 year, and the rest over the course of 5 years. Netflix's trailing twelve month revenues stood at $4.62 billion, and as a result, a significant portion of those top line revenues will go toward paying off content costs in the near-term. As the competition for Internet TV heats up, Netflix will likely make bigger bets on original content to differentiate its service from peers and that will lead to more content costs for the company.

However, Netflix does have $1.2 billion in cash on its balance sheet and can also tap the debt markets if it needs additional working capital. In addition, ISPs like Comcast have started to charge both the consumer and Netflix to "maintain" streaming quality that customers receive.

Comcast and Netflix had a public exchange of words after Netflix hesitantly paid Comcast to maintain the video streaming quality for its customers. Such fee extractions from powerful ISPs might be a drag on Netflix's bottom line, but Netflix continues to grow its topline in a robust manner. In the last quarter, Netflix's revenues grew 24% year-over-year to $1.27 billion and the company also implemented a $1 month price hike for new customers. The price hike will lead to incremental revenues for Netflix in the future and will make its content costs obligations more manageable as well. 

Going Forward
Netflix is likely to see a big growth in subscribers in the future, mainly attributed to International consumers. The addition of International subscribers to Netflix will likely be much higher than the current count of 12.6 million, as the company will be rolling-out its operations in Europe. 

Netflix should see more consumer adoption from Europe and that will go a long way in managing the headwinds mentioned above. Netflix's margins are expanding as well, and its EPS should also get a boost. In Q2 2014, analysts are anticipating EPS of $1.14 which implies a 134% year-over-year increase in earnings per share. So the competitive and cost structure headwinds are unlikely to be material for the company down the road. 

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The article The Bear Case for Netflix originally appeared on Fool.com.

Ishfaque Faruk owns shares of Netflix. The Motley Fool recommends Amazon.com, Netflix, and Walt Disney. The Motley Fool owns shares of Amazon.com, Netflix, and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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