Monday, July 23, 2012

Is It Possible That We Are Too Bearish On Netflix?

We all know that Netflix NFLX was one of the biggest disappointments of 2011. The company, on a great track for growth, shot itself in the foot when it raised prices. Customers left or downgraded plans, forcing the company to twice lower subscription numbers. Netflix was forced to halt stock buybacks and stop international expansion plans after the UK and Ireland. The company also announced it would be losing money starting in Q1 of 2012.

Netflix has fallen from nearly $305 to close Wednesday at $80.45. There was an 11% rally in the stock after more M&A chatter involving the company and customer usage rates. The company's customer satisfaction ratings have taken a beating, and the company has had additional flops in public relations, including the spinoff of its DVD business that was ultimately scrapped. There have been many bears that have come out against this name, and analysts even have price targets as low as $45 on the name. With all the calls for this name to never be profitable again, and for the stock to be at $0 eventually, I am beginning to wonder, are we too bearish on Netflix? Let's look at each side of the argument:

The Bear Side:

Netflix bears believe that the company, once it starts losing money in the first quarter of 2012, may never get back to profitability as they have lost too many subscribers and content costs increase. This camp believes that Netflix's business model cannot succeed. Here are their main points.

Eroding Customer Base:

This is what Netflix said when it released its second quarter earnings:

  • We expect 25 million total US subscriptions at the end of the third quarter. 10mil streaming, 3mil DVD only, 12mil both.
  • In Q4, the company expects strong US performance, a return to year over year subscription growth, and the possibility of our first Billion Dollar revenue quarter.

In September, the company warned regarding subscription guidance domestically. They lowered their estimates for the quarter to 9.8mil streaming, 2.2mil DVD, and 12mil both.

That equates to 21.8mil streaming and 14.2mil DVD. But that was too optimistic. When they reported third quarter numbers, they only had 21.45mil streaming and 13.93mil DVD.

Furthermore, they lowered guidance again for domestic subscriptions at the end of Q4:

  • 20.0 to 21.5mil streaming.
  • 10.3 to 11.3mil DVD.

The company did not realize how much the price hike would have on its customers. The company is realizing quickly that customers don't want and don't need to pay extra money to receive DVDs if they have the ability to stream. Netflix derives a large chunk of its profits from the DVD business, and given the potential for more subscription losses in this segment, the future does not look good.

Financial Results:

I said above that Netflix believed that they could have a billion dollar revenue quarter in Q4. That's not going to happen. When Netflix announced its third quarter results, the midpoint of its revenue guidance was $858 million, exactly where analyst estimates are currently. They were at $920 million before the Q3 report. Current expectations still would be a 44% year over year gain, but much less than the 68% gain they were hoping for two quarters ago. Netflix is currently expected to show 47% revenue growth in 2011, but 2012 growth is expected to be just 13.6%.

In terms of earnings per share, Netflix guided to a range of $0.36 to $0.70. Analysts at that time were at $1.09. They are now at $0.57. Since Netflix said it would lose money in Q1, analysts currently project a $0.24 loss, down from the $1.35 or so they were hoping for. For the full year in 2012, estimates have come down from about $6.50 to just 14 cents. They could be forecasting a loss if Netflix guides down again.

In terms of profitability for the international business, the company has said that it takes one to three years to become profitable for a country. They said Canada will be profitable in one year, a great success. The company is entering the UK and Ireland soon, and if it takes 3 years to be profitable, you are looking at 2014 or 2015. Does Netflix have that much time to wait?

Cash Flow:

Netflix believed it was in such financial strength in Q3 that it bought back nearly $40 million of stock at an average price of $218. The company then announced a halt of buybacks and further international expansion plans to save cash. They said that they had an adequate amount of cash on hand to run the business.

However, just a month ago, they entered a convertible debt deal to raise $400 million, an effort to "ease supplier concerns that they wouldn't be able to pay". If converted, the capital raise would equal a stock sale at $85. They shouldn't buy stock at $218 and sell at $85.

Competition:

Netflix had a good partnership with Starz going, but the two were unable to come to an extension, which ends early in 2012. Thus, Netflix decided to trash Starz in their Q3 report, saying that Starz was only a small portion of their business, and that more than 90% of their viewing hours come from non-Starz content. Do I sense a little bitterness here? Of course I do.

In early December, Netflix provided an update at the UBS Media Conference. For a great overview, I'll defer to my colleague Rocco Pendola, who has a great summary on their update.

In June, CEO Reed Hastings said the following about HBO:

"HBO won't take our checks yet, because they're not big enough."

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