Netflix (NFLX) has been on an amazing run recently and the stock has gone from trading in the low $60s to over $165 today. The stock is up almost 185% in the past half year and 173% in the quarter alone. This breakneck performance has been driven by three primary positive catalysts:
(Source: Yahoo! Finance)
Unfortunately for Netflix shareholders, the latter two items may not be as positive as they seem. I have already focused on the Disney deal and now I want to turn my attention to Netflix's fourth quarter 2012 performance, which catapulted the stock up over 70% last week. Most analysts praised Netflix's quarter as they reported a surprise profit for the year but the results were not as strong as they appear. Below I will focus on three areas of Netflix's quarter that give me concern. I have been bearish on Netflix for the last two years and the stock is still down 25% but will it ever regain its lofty heights?
Note all quotations come from previously linked Netflix Q4 2012 Letter to Shareholders.
International Loss Up 250% Year-Over-Year
The spread between domestic streaming contribution margin (+$109M) and international streaming contribution loss (-$105M) is narrowing over prior quarters but the magnitude of the international loss crossed the $100M mark for the first time. Management forecasts that the loss will narrow in the near-term but certainly creates the impression that the company plans to expand further in the future. "We are evaluating several expansion markets for late 2013 or 2014, but have not made any decisions yet. Our launch in the Nordics was very successful, confirming our belief in the large international opportunity for our service." I have primarily been bearish on Netflix due to the company's expensive international expansion and little has changed.
If Netflix had shown ability to profitably capitalize on an international opportunity, aside from Canada, I would be far more willing to give management some leeway. As solid as the domestic operations are, the international business is equally shaky. If the company continues to burn through cash (to be elaborated on below) and pursue questionable long-term ventures, it will remain very vulnerable.
Subscriber Growth Not As Bullish As It Appears
Netflix surpassed earnings and revenue estimates but the short-term up-tick will be difficult to sustain. Netflix added 2.05M net subscribers in the quarter but the percentage of paid subscribers declined one percent from 95%, where it had remained since Q2. The international decline was even more pronounced as the percentage of paid subscribers dropped six percent to 80%. The international paid percentage is more volatile but this is still a very large decline. High growth stocks like Netflix with minimal earnings are often evaluated based upon subscribers or other non-financial metrics so it is critical to dive further into the numbers. The subscriber numbers were also boosted by the increase in involuntary retention related to "improvements in how we process payments and recover those members on payment hold." In fact Netflix is acting like a bank in Latin America and launched a "direct debit consumer payment option". Apparently achieving profitability in Latin America is more difficult than the company initially imagined.
DVD results were strong for the quarter as subscribers slipped far less than expected and margins grew due to "lower than expected DVD usage". I forecast more cancellations in Q1 as more users with low utilization will likely cancel. The DVD margins are at risk of declining further with the USPS $0.02 round-trip cost increase and further increases possible. Even if you are bullish on Netflix I suggest you wait for a pullback rather than buy into the stock after its run.
Cash Flows Trends Are Troubling
Netflix is burning through cash at a blistering rate. Cash dropped $217M in the past year to $290M although the decline was mitigated by a $170M increase in short-term investments. Management dedicated an extended section to the free cash flow:
"In Q4, the gap between free cash flow (negative $51 million) and net income (positive $8 million) widened as a result of payments for the original programs coming to Netflix in 2013. Significant uses of cash in the quarter (relative to net income) were cash payments for both originals and non-originals content (in excess of the P&L expense), cash payments for PP&E (related to the continued rollout of our Open Connect servers), and tax payments."
Cash flows from operating activities were positive by $22.7M; however, the cost associated with acquiring DVDs was classified as an investing activity. As DVDs are still core to Netflix's operations I question the classification, especially since amortization of DVD content library is included in operating activities to the tune of $65.4M. If this $48.3M use of cash was included in operating activities rather than investing, the approximate $20M positive cash flows from operations would have flipped to a similarly negative amount.
The financial position is quite tenuous as the largest asset is the $2.9B content library. These intangible assets lack real value to a potential acquirer or to debt holders. Netflix has substantial operating fixed costs and its leverage is increasing due to new financial leverage. Netflix recently announced a $500M 5.375% 2021 note offering (increased from $400M) to bolster its cash reserves. Approximately 45% of the proceeds will be used to retire debt costing 8.5% and the remainder will likely be used to meet content cost requirements. After considering the benefits of retiring the existing debt, the total interest cost should remain approximately constant. Netflix is increasingly focusing on generating original content and pursuing exclusive content so it will increasingly have to rely on debt to finance operations. Originals are particularly risky as the cash is front-loaded so there is little margin for error if a show flops. Netflix is a few weak quarters away from facing financial difficulty, especially with the "cash cow" DVD business eroding.
Despite these negative trends and catalysts, I cannot recommend that you short Netflix as it is futile to fight the chart right now. The fact that Netflix trades at a 575 P/E is not a secret and you will still need a strong catalyst for a short play to be profitable. The safest way to take a directionally negative bet on Netflix would be via a long-term put. Overall I am still bearish on Netflix because of its fragile financial position and lack of barriers against rivals but shorts must exercise caution as the stock continues to rise. I still believe that Apple (AAPL) or another large rival will come in and significantly curtail Netflix's market opportunity but only time will tell.
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Disclosure: I am long AAPL.
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