Thursday, January 23, 2014

NFLX – 3 Reasons Netflix Stock Is Still a Screaming Sell

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There's always insanity surrounding Netflix (NFLX) quarterly earnings. With the latest results released after the bell yesterday, we’re going to dig a bit into the Netflix earnings report … but we also want to make sure the numbers are put in context with regards to NFLX stock as a long-term investment.

nflx-stock-netflix-earnings Source: Flickr | Flickr

Still, let’s start with Netflix earnings. NFLX exploded after-hours yesterday thanks to a few strong data points. Take a look:

Netflix earnings came to 79 cents per share — a dramatic improvement from earnings of 13 cents per share a year ago, and 13 cents above forecasts. Revenue rose by over 24% to a whopping $1.18 billion. NFLX stock investors were most impressed by subscriber growth, though. Netflix added 2.3 million U.S. streaming subscribers in the quarter, which was about 15% above estimates. Plus, Netflix gobbled up another 1.7 million international streaming subscribers. Looking forward, that growth should continue. NFLX expects to add roughly the same number of subscribers in the first quarter. And looking back, Netflix ended 2013 with over 33 million domestic and almost 11 million international subscribers, making for a grand whopping total of 44 million.

Once again, though, a few solid numbers from the Netflix earnings report aren’t enough to make a call long-term. So to really decide if Netflix stock is worth your money, we need to look at the details behind the company’s revenue, expenses, profit and cash flow.

Current and potential NFLX stock investors can pull these numbers from a spreadsheet on the company’s website … and doing so shows some waving red flags for sizzling Netflix stock.

Why NFLX Stock Could Be In Trouble: No International Profits

The international streaming segment saw paid subscribers double year-over-year during the fourth quarter, generating a 120% increase in revenues with only a 45% increase in cost of revenues and a 10% increase in marketing. So, yes, Netflix is adding these subscribers efficiently.

Meanwhile, domestic paid streamers increased from 25.5 million to 31.7 million year-over-year during the same period — a 25% gain, creating an almost equivalent percentage gain in revenue. That came on a 17% increase in cost of revenues but a 34% increase in marketing costs.

The bad news: The international segment still lost $57.3 million in the quarter. That should definitely concern NFLX stock investors … especially considering other troubles on the horizon.

Why NFLX Stock Could Be In Trouble: Thinning Margins

The Netflix DVD business is dying, as we all expected. DVD paid members tallied 6.8 million last quarter, down from 11 million in Q4 of 2011. The segment contributes $100 million to profit, about half of what it was two years ago. Investors should expect this profit stream to slowly erode over time as the world moves to streaming.

Which brings us to some uglier numbers. The contribution profit of all segments came to $226 million, but there was another $144 million in other operating expenses. Operating profit for the quarter thus came in at $82 million, while the operating profit for the full-year was $228 million. Knock off another $29 million in interest payments, and NFLX ends with $171 million in net income before taxes.

This compares very favorably year-over-year, but is half of the Netflix earnings reported in fiscal 2011. The takeaway? The DVD business has much higher margins (48% now) compared to domestic streaming (20%). And remember, international streaming still isn’t profitable at all.

So Netflix is transitioning to a lower-margin business, which means lower profits over the long term. That should definitely worry NFLX stock investors.

Why NFLX Stock Could Be In Trouble: Off-Balance-Sheet Obligations

Now let's head over to Netflix balance sheet. Operating cash flow for the year after taxes was $112 million. Cash and short-term investments sit at $1.2 billion. And the company has $500 million in long-term debt. But the key to understanding NFLX going forward is its relationship to studios … which comes in the form of around $7.3 billion in off-balance-sheet content obligations.

Netflix stock fans must ask themselves the obvious question: How can NFLX afford to pay that when it has just $1.2 billion in cash and is only generating $112 million in operating cash flow annually? Even if NFLX keeps adding subscribers and raises prices (which it will have to do eventually), there is no way these obligations can be met (even with additional equity or debt capital raises).

This is the ultimate problem with Netflix stock as a long-term investment. As I also wrote here, NFLX will never have a cash hoard or generate free cash flow of any significance because it will never be able to meet its content obligations. Furthermore, this problem comes as its high-margin business declines, replaced by a lower-margin domestic business that will require a price increase … and as its international business is still losing money.

The Bottom Line for NFLX Stock

Ultimately, NFLX stock is a risky bet because it’s based on a perpetually cash-hungry business with eternal obligations that will never be met. If you ask me, Netflix stock will inevitably implode … although it still has that intrinsic value as distributor. In the end, I expect someone will purchase it — probably a content provider.

But that doesn’t necessarily affect where NFLX stock stands as of today. As of now, Netflix stock is set to open at almost $390, giving it a market cap of around $23 billion. Just so we are all clear, Netflix earnings for the full-year showed, once again, operating cash flow of $112 million. Do people really think NFLX stock is worth over 200 times operating cash flow? I sure don't think so. Not even close.

Of course, Netflix is a momentum stock, so it's completely irrational. But eventually the market will come to its senses and price NFLX stock accordingly. When that happens, I hope I'm short.

Lawrence Meyers does not hold any position in NFLX stock as of this writing.  Just prior, he held 50 shares short at $333, and was long 1 Jan 31 $350 call. Those trades were closed prior to writing this article.

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