Short-Term Hiccups Shouldn't Keep You Away From Netflix

Dec.16.12 | About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX) was cited by the SEC for violating fair disclosure rules as a result of Netflix CEO, Reed Hastings, posting on his Facebook (NASDAQ:FB) account in July that Netflix had surpassed 1 billion hours of monthly viewing. According to a Netflix filing referring to the SEC's so-called "Wells Notice", Netflix may be the target for a cease and desist proceeding or a civil injunction. The SEC's action may also result in Netflix having to pay some type of financial penalty.

What the SEC alleges is that Netflix violated rules regarding the release of material information that should be made public to all potential investors at the same time and not just to some by posting in FB the record number of hours streamed by it. Apparently, material information should have been released to the public through a publication or through a SEC filing.

In a letter to shareholders in response to the SEC's charges Hastings maintains that the information was not material and that it was not restricted. It was not material according to Hastings because it was not financial in nature and that already in June he reported that Netflix had come close to 1 billion hours of viewing. Also, the information was not restricted considering that his FB page has over 244,000 subscribers, many of whom are journalists and bloggers.

Analysts point out though that the information was very much material considering that Netflix's stock price jumped from less than $70 to more than $80 the day of the FB posting by CEO Hastings. Hastings argues that the jump came that day before the posting and that it was caused by a research report by Citigroup on Netflix.

It goes without saying, Netflix doesn't need a costly fight against the SEC.

Analysts point out that technology has overtaken the SEC's regulations in this instance. When the pertinent regulation was adopted in 2000 social media did not exist yet so a gray area surrounds whatever news or information is publicized through it and therefore the SEC may not be on such solid footing considering the ambiguous nature of the medium in which Hastings chose to publicize his company's achievement.

Meanwhile Netflix hasn't been standing still. It reached a deal with Disney (NYSE:DIS) whereby Netflix will have exclusive transmission rights for all new releases of Walt Disney Animation Studios, Marvel Studios, Disneynature, and Pixar Animation Studios of both live action films and animations, as well as movies in its catalogue starting in 2016. Moreover, Netflix will not increase its monthly fee of $8 as a result of the deal.

With competitor RedBox entering the streaming market, Netflix is making the right move by not increasing its $8 fee (same as RedBox will charge, supposedly) and to lock up the Disney deal. Any exclusive content Netflix can grab will be an investment into keeping its market share amongst newcomers to streaming video.

Nevertheless, opinions among analysts are divided over this deal. While the amount paid was not released estimates of it were around $350 million. Company officials tout it as a game changer while others think that Netflix overpaid for the exclusive transmission rights. Analysts that think that it was a good move point to the family aspect of the deal. It seems children have an inexhaustible appetite for watching the same films time and time again. Anyone with kids knows this is true.

It was also a major step for internet-provided content as opposed to traditional cable TV because it was the first time such content from a major studio would be provided via internet.

Netflix stock jumped 10% the day the deal was announced - to about $85. In the past week it has remained steady until the last couple of days when it increased to around $90 even after the SEC's charges. It is now about mid point from its low of $52 and high of $133 for the past year. Netflix has been notoriously volatile in its valuation. Nevertheless, the SEC action against Netflix doesn't appear to have affected its valuation, which leads to the conclusion that the SEC action attracted undue attention when compared to the Disney deal.

Netflix's operating and net incomes have deteriorated over the past five quarters even as its revenues have increase by some 10%. Its operating income has gone from $96 million in Q3 2011 to $16 million in Q3 2012, and its net income has decreased from $62 million to $7 million in the same span of time. Both operating income and net income were actually negative in Q1 2012 - $2 million in the former case, 4$ million in the latter - so there was an improvement to the present time.

Although if we look at Netflix's history it looks to be a riskier than average company to invest in, it is hard to bet against a company securing important content and market share. Netflix is a groundbreaker in that respect. So even though its debt has been downgraded by Moody's Corporation (NYSE:MCO), this development is in the short term and transient in nature (as are the SEC charges), while the Disney deal points to a solid bet in the long run.

Disclosure: I am long DIS.

Business relationship disclosure: This article was prepared for Freedonia Freelance by one of our analysts.

Additional disclosure: Eric, the manager of Freedonia Freelance, is long Disney.