Netflix (NFLX) is one of my favorite companies. I want to come right out and say I am a Bull on Netflix. A lot of the things I am going to discuss in this article are going to make it seem like I'm a Bear, hence the name of the article. I see some short-term difficulties for the stock for the rest of this year and maybe the first part of 2014 due to the market being irrationally negative on the stock. This will test the resolve of long-term investors but I am confident if you can hold strong Netflix will reward your patience with strong stock price appreciation over the next three years.
The Netflix service has disrupted the entire movie industry. First Netflix revolutionized the video rental industry from the large retail establishments and the constant late fees to home delivery of movies for as long as I care to keep them. This home delivery model cutting out the trip to the closest Blockbuster (DISH) not only made renting movies more convenient for the subscriber but also significantly less capital intense for Netflix. The ability to cut out the expensive retail space to allow renters to shop for the movies they want and replace it with less expensive fulfillment centers and warehouses allows for a greater profit margin. Ultimately, Netflix changed the business model for the video industry permanently. Now Netflix is leading the charge on Internet streaming allowing me to watch movies with almost any Internet connected device I own. The world is also becoming more and more connected to the Internet. Smartphones, tablets, video game consoles, and televisions are all connecting to the Internet adding more and more potential devices to stream Netflix from.
Now let's get to the point of the article and discuss the issues Netflix faces that will put negative pressure on the stock price in the short term. The last two quarters Netflix has posted extremely strong results. The fourth quarter of 2012 Netflix surprised analysts by adding almost four million global subscribers in the quarter helping Netflix avoid a loss and instead it posted earnings of 13 cents a share. The first quarter in 2013 was just as strong adding another two million U.S. subscribers and posting earnings of 31 cents per share after excluding one-time debt-related charges. But now we are moving into the part of the year that is slow for Netflix subscriber growth. The company has released guidance for adding between 230,000 - 880,000 U.S. subscribers for next quarter and we can expect the third quarter to be approximately the same since these two quarters are the weakest for Netflix. The problem I see here is while the subscriber growth will slow the need to purchase content will not. This will squeeze margins for these two quarters. I believe this is normal in the regular course of business for this company but I also believe the market will punish Netflix anyway and the bears will come out hard on the company. Clamoring how the content costs are growing too fast to be sustainable.
Netflix has over a billion dollars in cash and cash equivalents, which is a strong cash position in my eyes. I do see the cash burn increasing during these next two quarters as Netflix content obligations increase quicker than its subscriber base. The last quarter Netflix had a $42 million shortfall and it was a stellar quarter for the company. The number of original series coming out will increase the amount of cash being used in the short term while adding tremendous value in the long term.
"Orange is the New Black" is set to debut in July; Netflix is partnering with DreamWorks Animation (DWA) to produce a TV show with Turbo the racing snail, and will continue to develop more seasons of "House of Cards," "Lilyhammer" and "Hemlock Grove." The reported cost of "House of Cards" was $100 million so the number of original programming projects will increase the cash burn rate for the company. If you look at the last 10-K you will also notice a very substantial growth in accounts payable for 2012, from $925 million to $1.45 billion, approximately 50% growth in this liability account, which also quadrupled from 2010 to 2011. Ultimately these original programs will differentiate Netflix from the competitors but I expect the market to focus on the negative cash flow instead of the long-term impact of increasing the company's moat.
Netflix is also planning the expansion into more international markets at the end of 2013 or beginning of 2014. With the last two quarters of solid earnings, the recent cash injection from restructuring the company's long-term debt, increasing cash and cash equivalents to over a billion dollars, I believe Netflix will launch into new markets this year. Again, while the expansion into new markets will lead to more subscribers the short-term impact is negative earnings. The need to add content for the new market before earning a subscriber base to support those expenditures requires Netflix to sustain a loss in that market before slowly gaining subscribers and becoming profitable. In the last couple of markets Netflix expanded into it sustained losses of over $400 million. This will bring the bears out again jumping and yelling to anyone that will listen that Netflix is broken and is going bankrupt.
The company will have to weather the storm of being punished irrationally by the market as it executes the business strategy that will keep Netflix at the leading edge of Internet streaming. The weak quarters for the next two quarters, a natural cycle for Netflix, will cause negative stock price pressures pulling the stock price down. The expansion into new international markets, while the right decision, will cause additional negative price pressure as losses grow in those new markets, pulling earnings down for the company as a whole. I think the smoke will clear in the first quarter of 2014 and the strong subscriber growth will outweigh the losses in the new markets and allow the stock price to rise again. Netflix is a fabulous service that is seeing amazing growth and Mr. Hastings is holding off on raising the service price to maximize growth in the subscriber base, but it is the ace up his sleeve. It is my opinion that Netflix will see some stock price weakness for the next six-eight months but over the next three years may be able to surpass the $300 mark it hit in 2011. In a previous article I wrote on Netflix back in early March, I predicted Netflix would be able to bring the total subscriber base up to approximately 50 million domestic subscribers by the end of 2018. At the current level of 29.2 million, adding another 2.8 million for 2013 is fairly reasonable, giving Netflix 32 million. Adding 5 million a year through 2018 would reach that ambitious number, which would mean sustaining its current growth of subscribers but a falling percentage.
The slowing growth rate shown in the table above still brings Netflix to over 50 million U.S. subscribers and the international growth will be even more explosive as Netflix moves into more and more markets. The short-term weakness I see for Netflix will eventually give way as Netflix proves to the bears that its ability to grow subscribers will give it the base it needs to grow earnings in the long term. I agree with the bears that eventually Netflix will raise its prices but not for a long time as the company is focused on maximizing the growth of subscribers. But once the major number of subscribers is reached I expect a small increase, which will magnify profits for Netflix and is the real earnings power for the company. Imagine with 50 million subscribers increasing the monthly rate by $.50, a miniscule increase that I believe will not materially impact the churn rate but go straight to the bottom line for the company. Even if we assume only half of the increase goes to the bottom line that small increase would amount to $150 million or $2.67 more in earnings per share. This is the power of Netflix's massive subscriber base and the reason management is rightly pursuing subscriber growth over short-term profits.