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Netflix's Biggest (and Most Costly) Bet of 2012

Jeanine Poggi|Staff Reporter

Netflix has a lot to prove in 2012, specifically how successful it can be in the U.K. and Ireland.

The company, whose stock lost 70 percent of its value just in the past three months, is so confident in the future of its streaming business overseas that it is even willing to take a loss in the new year.

But given 2011 was a year when Netflix turned a blind eye to customer and investor dissatisfaction, failing at its international strategy could ultimately destroy the company's growth prospects and further erode management's credibility.

Netflix plans to launch a streaming service similar to its $7.99 U.S. plan in the U.K. and Ireland in early 2012 and is currently working to secure streaming deals in the regions. It has already reached agreements with Miramax, Lions Gate , BBC, and MGM for television shows and films.

This will be Netflix's third major push outside the U.S., having launched a streaming service in Canada last year and in Latin America and the Caribbean in September.

Netflix's expansion into the U.K. and Ireland will be very different than its launch in these other regions, which were relatively uncharted territories. In the U.K. and Ireland, Netflix is up against Amazon's LoveFilm, which has already laid the groundwork in those regions and continues to ramp up its offerings.

Last Wednesday, LoveFilm announced that it struck an exclusive deal with Sony for films including "Salt" and "The Social Network."

The multi-year deal for streaming rights to "second subscription pay-TV window" blocks Netflix from receiving the same content in the market.

LoveFilm also already has locked up other exclusive deals with content providers including Time Warner and Walt Disney , drastically limiting the content available to Netflix for some time. LoveFilm also distributes DVDs, giving it a physical presence Netflix lacks overseas.

The competition Netflix faces in the U.K. and Ireland has made Wall Street hesitant.

"We are particularly skeptical about the company's prospects for success in the U.K., where competitor Amazon has a well-entrenched DVD-by mail subsidiary (LoveFilm) that it purchased for over $300 million last year," Wedbush analyst Michael Pachter wrote in a note.

"We think that the U.K. will be a battleground for Amazon to test a hybrid service of its own, and think that LoveFilm is well positioned to eat Netflix's proverbial lunch there."

The logic of CEO Reed Hasting's aggressive push for rapid growth internationally, especially given his previous promise that the company would not expand overseas if it comes at the expense of the bottom line, remains questionable.

"We are particularly concerned by the company's 'grow at all costs' business model," Pachter wrote. "We think that international subscribers will generate losses for the foreseeable future at a time when the company has alienated its more profitable domestic customers with its sharp price increases, further challenging its profitability."

At a minimum, Pachter said he expects Netflix to lose $100 million internationally in 2012, and believes that number could ride to as much as $250 million to $300 million based upon management's fourth-quarter guidance.

International is expected to drain profits for some time, according to analysts.

"International growth is not as large an opportunity as some investors might think, in our opinion," Canaccord analyst Jeff Rath wrote in a note last month.

"Combined, these new markets might be able to contribute four million to five million subscribers in a few years. While Netflix may be able to launch more quickly in these regions by leveraging its core technology and experience generated in the U.S., it lacks brand awareness, and in the U.K. in particular, faces much more substantial competition from Amazon, BSkyB and BBCUPlayer."

As of the end of September, Netflix reported 1.48 million international subscribers.

"We think that Netflix should have tempered its international expansion plans," Pachter wrote. "The company's stated strategy of growing its operating margins steadily and reinvesting any excess profits in content or subscriber acquisition was a sound one; its zealous pursuit of international expansion at the cost of all profits appears irrational to many, and the precipitous decline in Netflix's share price reflects that many investors have rejected its subscriber growth strategy."

Ultimately, Netflix's decision to forgo profitability to chase international expansion clouds the waters for exactly when the company can be profitable again.

Netflix declined requests to comment on its international strategy and profitability.

But Hastings' recent flubs could just be a fluke, and his plans for international growth could ultimately be the company's saving grace.

"While we were concerned Netflix was biting off more than it could chew with the multiple international launches (and its impact on 2012 financials), we believe it is the right long-term move to gain global penetration and will be demonstrated by 2013 [and beyond] results," B. Riley analyst Eric Wold wrote in a note.

This makes 2012 a critical year for Netflix investors, who must now decide if they will hang on for the ride or jump ship before it sinks.

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