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Netflix (NASDAQ:NFLX) reported fourth quarter 2012 earnings and full year end results recently, and frankly, as I expected, it was a lackluster performance at best.

Granted, there was a little excitement back on January 14th when Turner Broadcasting Systems and The Warner Brothers Television Group (WBTVG) announced that they were entering into a licensing agreement with Netflix. This agreement allows Netflix subscribers with access to Turner Broadcasting and Warner Bros. seasons of animated and live action programming. However, this access was on a limited basis for a limited number of shows. What we do not know and what is not readily available to the public is this, what were the acquisition costs? Estimates are that Netflix is now spending over $1 billion for content.

I believe Netflix will continue to see losses going forward.

  • First, there are continuing high costs being incurred by Netflix for its content. Some of these costs are a direct result of international expansion. However, I do not expect massive new subscribers, but a moderate gain. The reason is simple; there are just too many players in the industry now.
  • Here is a small list of Netflix's direct competitors: Amazon's (NASDAQ:AMZN) Prime, Microsoft's (NASDAQ:MSFT) Xbox Video and Comcast's (NASDAQ:CMCSA) Xfinity.

Competition Eroding Market Share

Back in 2002, when Netflix was just a blip on the radar, the company revolutionized how consumers were renting DVDs, and current trends are showing a declining market in DVD rentals: case in point, the implosion of Blockbuster Video.

Blockbuster was such a behemoth that it did not think it needed to adjust for market trends. It was not until 2004 that the company realized its mistake, and by then it was too late. Netflix was turning a profit, Redbox was launching into the market, and as a result, Blockbuster was done.

Netflix is following in those inglorious footsteps, and the rise of competition from all sides is eating away at Netflix's subscriber base. Even worse for Netflix is that all the new competition is increasing the costs of acquiring new content.

Amazon

Amazon has redefined and revolutionized every industry it has entered. With its announcement of Amazon Prime, Amazon has already taken the first swing at Netflix. With the advent of Amazon's instant video service (AIS), it is delivering a crippling blow.

Amazon Prime is only $79 per year while Netflix streaming is $8 per month or $96 per year. Therefore, there is a cost factor to consider. However, the crippling blow comes from AIS when you consider that AIS has a better availability of newer and better movies than Netflix. Despite the $8 price point, many consumers will leave Netflix for lack of having the titles they want to watch when they want to watch them. Investors should keep a close eye on Amazon to see if the company continues to take swipes at Netflix's market share.

Microsoft

Microsoft also joined the fray with Xbox video. Launched on October 16, 2012, it is still too early to make a call on its performance. But it is likely that Microsoft will steal some customers away from Netflix as well.

Comcast

Comcast's "Xfinity" is also taking a shot at Netflix. Comcast has approximately 22,525,000 customers. Out of that group, just over 14 million have digital cable. That is one heck of a captured target market and begs the question: why would they want to join Netflix when they already have Xfinity? When you also consider the billions of dollars Comcast spends on improving infrastructure and to either purchase or create new technologies, I expect Comcast to really take a large market share. In order to have Netflix, you have to have high-speed internet, and according to Comcast, the company serves over 40% of all internet customers nationwide. I foresee most customers asking themselves why they should pay an extra $8 per month for Netflix when Comcast is already providing the streaming service with a better selection.

Raising Prices Does Not Always Raise Profits

Anyone that has a Netflix account will tell you that Netflix's streaming movie content for new releases is lackluster at best, and Netflix didn't do itself any favors with its strategy decisions back in 2011.

First, Netflix announced that it would be charging separately for its streaming video service as opposed to keeping it as part of a package deal with DVD rentals. This in effect doubled the cost to the consumer. This resulted in almost one million loyal Netflix customers dropping the service.

Then, Netflix announced that it would be splitting its services entirely, and that those consumers who wished to continue its DVD rentals would have to create an entirely new account at the newly created "Qwikster," which resulted in another round of lost subscribers.

The Cost of International Business

While I do expect Netflix will see a modest increase in its subscriber base due in large part to its expansion overseas, I also see rising costs on the horizon.

Netflix is currently in the United Kingdom, and it is continuing its expansion into the Nordic countries of Denmark, Sweden, Norway and Finland. With a combined population of just under 25 million people, there is the potential for a market share of up to 8 to 9 million subscribers. If they can come close to capturing 20% of that market, which I believe to be unlikely due to the competition from Amazon as well as local players, Netflix can expect approximately 1 to 1.5 million new subscribers. While this, on the surface, seems like a win, we must remember there is a cost associated with providing high quality content to these new subscribers. The costs associated with obtaining new content are outpacing the revenues generated by new subscribers, and that will lead to a decline in Netflix's profitability.

Acquisition costs for new content, as a percentage of revenue, have almost doubled in just one year from 22% in 2011 to almost 44% in 2012. These costs are going to continue to eat away at Netflix's earnings for quite some time.

Netflix still, to date, cannot answer this looming question:

How are they going to stay ahead of their competitors as they expand into international markets where the technological environment is constantly changing?

Competitors in Canada include Zip. Competitors in Europe include Lovefilm.com. Competitors in Asia include Cinesprite.com, iVideo.com.tw and Movieflys.com.

One advantage Zip.ca has over Netflix in Canada is that it offers "kiosk" rentals, based on the Redbox business model, as well as DVD by mail. Now, here is the catch, Zip.ca does not yet have streaming video. Expect major market share changes when zip.ca starts streaming in Canada.

Here is another scary part to that equation: Lovefilm.com and Amazon.com entered into a business arrangement in 2008 with Amazon EU SARL completing the acquisition of Lovefilm in 2011. Lovefilm.com starts at only $7.86 per month, close to half of the cost of Netflix.

Why the Large Purchase of Shares?

This is the question that is nagging at me. On November 19, 2012, a record number of 13D schedules were registered with the Security and Exchange Commission wherein it was reported that millions of shares of Netflix were purchased by institutional investors. Why?

The following table shows all transactions with respect to shares affected since November 5, 2012, the date of the last schedule 13D. Except as otherwise noted below, all such transactions were purchases of shares affected in the open market, and the table includes commissions paid in per share prices.

Name of Reporting Person

Date of Transaction

Amount of Securities

Price Per Share

High River LP

11/19/2012

858,213(1)

21.94(2)

Icahn Partners LP

11/19/2012

1,313,380(1)

21.98(2)

Icahn Partners Master Fund LP

11/19/2012

1,339,769(1)

21.89(2)

Icahn Partners Master Fund II L.P.

11/19/2012

541,248(1)

21.94(2)

Icahn Partners Master Fund III L.P.

11/19/2012

238,456(1)

21.94(2)

Pursuant to the filing, these were call options set to expire in September. The call options were exercised at the price of $36.05 per share when Netflix was trading at just around $75 per share. With an exercise price of $36.05 per share and with over a year still left on the options, why exercise them now? Is this representative of the proverbial "rats" leaving the sinking ship?

Netflix, in its fourth quarter report, says "The U.S. Postal Service is under financial stress, but we don't foresee service changes this year that have a material negative impact upon us or our members.

Really? You don't believe that even a modest increase in the price it costs you to ship DVDs will not impact your business? According to Netflix's own filings, the company currently has over 8 million DVD rental customers. Just assume for a moment that each customer only rents one DVD per week. Given that the U.S. Postal Service just announced an increase in postage to 46 cents, that would equate to an $80,000 a week in increased expenses or $4,160,000 a year. Yet Netflix would have us believe that there will be no negative impact.

Global Profitability: Q4 Results & Q1 Outlook

Consolidated Q4 net income of $8 million ($0.13 EPS) exceeded our guidance due to contribution profit out-performance primarily in our domestic and international streaming segments. Net income was flat quarter-over-quarter, as increased domestic streaming contribution profit (up $18 million) more than offset a $3 million decline of DVD contribution profit, and a $12 million increase in international losses (driven by the launch of the Nordics market), while global operating expenses were flat sequentially. We anticipate net income will be relatively flat quarter-over-quarter in Q1, as improvements in both domestic and international streaming profits will be offset by a decline in DVD contribution profit and increases in global operating expenses.

Let me reiterate that: Netflix has point blank said that they expect no increase in revenue for the upcoming quarter (Q1). Add in the fact that new postal rates went in to effect on January 27, 2013 and their reported $8 million in revenue is cut in half.

The Final analysis

Competition is increasing for Netflix, and cost for acquiring content is on the rise. I would expect these costs to increase even further as bidding wars are sure to break out between Netflix and its competitors.

Case in point:

"As we shared on our last earnings call, our original programming will require more up-front cash payments than most other content licensing agreements, raising this ratio (of cash to P&L for content) to as high as 120% in certain quarters with material originals payments."

Furthermore, by the company's own admission:

"Consolidated Q4 net income of $8 million ($0.13 EPS) exceeded our guidance due to contribution profit out-performance primarily in our domestic and international streaming segments. Net income was flat quarter-over-quarter, as increased domestic streaming contribution profit (up $18 million) more than offset a $3 million decline of DVD contribution profit, and a $12 million increase in international losses (driven by the launch of the Nordics market), while global operating expenses were flat sequentially. We anticipate net income will be relatively flat quarter-over-quarter in Q1, as improvements in both domestic and international streaming profits will be offset by a decline in DVD contribution profit and increases in global operating expenses."

With that being said, and based on past actions by Mr. Reed Hastings, I would suspect that there is something we are not being told, much like the time we were not told about Netflix facing a $9 million lawsuit back in February of 2012.

According to the 8-K filing (January 2013), Netflix showed a $105 million loss in its international business for the fourth quarter, on top of the $92 million loss in the third quarter as well as $51 million negative cash flow. Total revenue for the fourth quarter was a paltry $8 million compared to last year's $35 million.

Furthermore, Netflix has $200 million in outstanding notes and it specifically talks about wanting to raise additional cash flow through "new" debt financing?

How exactly Netflix shot up overnight from $103 to $143 defies comprehension to anyone that is reading the 8-K filings. The company was short $51 million in operational capital and made only $8 million and is floating over $200 million in debt, and it is talking about borrowing more.

If you are looking to invest in Netflix, now is not the time. If you already hold stock look at exiting at a good profit point; if not, continue to hold your position and wait for Q1 earnings around April to see if these trends continue.

Source: Netflix: Don't Let The Rally Fool You