Netflix (NFLX) reported third quarter 2012 earnings in late October, and the company reported its second consecutive quarterly income. This surely means that Netflix is back on the right track, correct? Not so fast. Netflix did generate $8M in income this quarter but is predicting net income/(loss) in the range of ($13M) to $2M for the following quarter. I have been very bearish on Netflix since September 2011 when the stock was still trading at $136 per share. The stock tumbled immediately after earnings but has climbed above $80 after Carl Icahn's investment. I wanted to let the dust settle after earnings and Mr. Icahn's announcement before performing a deep dive into the quarter. The company continues to face difficulty in a challenging marketplace. Competition is increasing but many of Netflix's wounds are self-inflicted.
(Source: Yahoo! Finance)
As I have stated in the past, Netflix can be summarized quite easily: domestic streaming is growing at a steady rate, domestic DVDs are cash cows, and international streaming will be what causes the company to fail. The domestic streaming business is not the problem for Netflix. Growth is frustratingly unpredictable at times and the margins are lower than expected, but the business is fundamentally appealing. The success of the US market and quality of the service in the States often gives potential investors rose colored glasses. The attractiveness of the market is not lost on competitors such as Amazon (AMZN) and Time Warner's (TWX) HBO who are aggressively entering the arena. Fortunately for Netflix, I believe that the impending competition will not materially harm the company in the short-term but is always important to monitor. I put a two-year clock on Netflix in August as it is forecasted to have lost the majority of its DVD customers who are effectively providing the cash for Netflix to stay in business. Any number of factors can cause the window to close sooner: competition growing more hostile, international break-even taking longer to achieve, or exclusive content failing to attract new customers.
My largest complaint with Netflix as an investor relates to management and its headstrong desire to expand globally with disregard for the near-term financial implications. This has been a tremendous drag on profitability and the situation appears to be growing worse. Since this is such a critical area of Netflix's success or failure, it is necessary to dive deeper here when analyzing the company. For this reason, I dedicate this article to examining Netflix's four current global operations to provide actionable advice for investors.
Nordics (Denmark, Finland, Norway, and Sweden):
Netflix entered the Nordics earlier this month and this is Netflix's fourth and latest launch. The launch fell outside of the third quarter so there is minimal disclosed about the performance in the region. Netflix is forecasting an overall fourth quarter loss based largely on anticipated losses in the region thus this is extremely critical area. There are currently only ten million broadband households in the region. Based upon Netflix's current approximate US adoption rate (20% assuming 115M US households), it is puzzling that Netflix would enter a region with such little upside potential given the risk. Lastly, the Nordics are generally still facing economic contraction and I question Netflix's ability to sell a new leisure product in this environment. To explain the trouble the Nordic regions are in, one simply has to look at Sweden. Sweden is one of the European countries in better shape but it still faces seven percent unemployment! I am still scratching my head at management's decision to enter this market.
U.K. and Ireland:
This is a very challenging market due to the continuing European unrest/recession, expensive content, and extreme competition. Management's choice to enter this area with such an intricate economic climate further reduces my confidence in its ability to accurately forecast profitable growth opportunities. In fact, management disclosed, "as we expect the U.K./Ireland market will take materially longer than Canada to get to profitability, given the high level of competition and the continued expansion of our content." It is clear that Netflix is dedicated to this expansion so now investors need to focus on the European situation - an unwelcome surprise for most tech investors.
Latin America represents another emerging market opportunity for Netflix but also faces substantial hurdles. The primary challenges relate to the economic health of the region and the sophistication of the payment systems. Customers in this geographic area "are leery of, or unable to, provide debit/credit cards that can be accepted over the Internet" according to Netflix. This is a cultural issue that management should have picked up on before entering the region. David Wells, Netflix's CFO, listed a variety of reasons in May why Latin America is failing to perform. Virtually all of these issues should have been foreseeable by management before embarking on such a costly gamble. Furthermore, if you read between the lines of the earnings letter, there are involuntary churn issues in the market, so I seriously question if/when Netflix will be successful in Latin America.
Unsurprisingly this is Netflix's only profitable international market as it has economics similar to the United States. I bet management wishes that all international markets were this easy to succeed in.
In summation, this was generally a lackluster quarter and I expected the company to retest its 52-week low, independent of Mr. Icahn's investment. After last quarter, the stock declined approximately 25% the following day but this quarter the stock fell 'only' twelve percent. Investors were very quick to ignore the poor performance and hope that Mr. Icahn would save the day. The stock should not be trading at such a high multiple given its continuing struggles. Will Netflix emerge successfully with its original content and global expansion initiatives? That is the multi-billion dollar question that I unfortunately cannot answer. I foresee the situation getting materially worse for Netflix in the short term and I am not willing to take on the risk of going long anytime soon. The consensus here at Seeking Alpha tends to tilt toward the bear side with the occasional bulls appearing.
Before I close, I want to briefly touch upon the continual Netflix takeover rumors that popup every few months when the stock declines. Netflix's only real asset is its brand equity which is of questionable value. A simple review of the balance sheet reveals that most of Netflix's assets relate to content deals that a potential acquirer would be able to strike independently. I cannot fathom anyone paying a substantial premium for Netflix; therefore, investors should not be counting on getting bailed out of their investment with gains via an acquisition. Mr. Icahn is a very smart man and certainly understands what he is getting into. The only logical solution is to hope that he can achieve sometime a corporate restructuring (whether it is divesting international operations or selling the company). Mr. Icahn has stated that he plans to "go to war" over Netflix. I prefer to stand on the sidelines. The Netflix bears should keep their pitchforks sheathed as the stock should enjoy the Icahn halo for at least the next quarter but after six months, all bets are off.