Why Netflix Is a Short

Netflix (NFLX) has been a favorite short target of Stone Fox for a while. Luckily we've never engaged in more than short term short positions on this stock as it's been one of the bright performers during this recession. The recession and high gas prices have in fact likely helped business as consumers have migrated to the cheapest forms of entertainment - DVD rentals via mail. It saves gas and eliminates late fees, all for a low monthly subscription fee.

Getting DVDs via the mail is clearly a doomed business as even highlighted by the CEO in this Wall Street Journal interview. It's actually pretty incredible that the business model as done so well considering the huge competition in the DVD rental space and the fact that renting by mail was actually seen as a step back for that market. After all, why wait days for a item via the mail when you could just stop at the local store and pick up whatever you wanted and the price of $2-4 per rental didn't seem overly costly? That's where the catch for the current and future business models comes in.

Current model: Netflix is able to provide a huge catalog of 100K+ titles that far exceeds anything that you can get at stores like Blockbuster (BBI). NFLX was able to obtain these movies whether the studios would license the titles to them or not. They could just go buy the movies at Wal-Mart (WMT) if needed. Plus, cost conscious customers could save money and via planning ahead have that desired movie in time for watching on the weekend. This gave NFLX an advantage with the access to unlimited titles.

Mr. Hastings's biggest challenge in reorienting Netflix is getting Hollywood to go along for the ride. Netflix's selection of more than 100,000 DVD rental titles is made possible by the "first-sale doctrine" of U.S. copyright law, which permits buyers of DVDs to lend them out without studios' consent.

In Netflix's early days, its buying team would sometimes purchase DVDs at local Wal-Marts or Best Buys if it couldn't get copies through studios, says Ted Sarandos, Netflix's chief content officer.

Future model: Providing on demand streaming video of movies is definitely the future of the movie rental business. Instant and cheap access to movies is exactly what the consumer wants. This sector will probably have more competition then video stores because of the barrier to entry is low assuming you can get rights to movies. It doesn't take a huge infrastructure to provide the service like it did with physical stores. You've also got to deal with Video on Demand provided by cable operators and so on. The issue really comes back to the amount of titles. According to the WSJ article, the internet streaming division only has 12K titles, far smaller then the 100K for the mail rental side of the business. In this case, the studios have been balking at NFLX having access to their movies. Likely a desire to use their own outlets instead and even a desire to keep DVD sales higher to keep that profitable business going.

In contrast, to deliver movies and television shows over the Internet, Netflix has to license them from studios. So far, it has gotten only about 12,000 titles, a hodgepodge of older films such as "Diehard," episodes of popular TV shows including "30 Rock" and a smattering of new releases.

The main reason: Netflix must compete with television subscription services like Time Warner's HBO, Viacom Inc.'s Showtime and others that gain exclusive rights to show studio movies on cable channels or through on-demand systems. These pay channels have bigger audiences than Netflix and a longer history of hashing out complicated licensing agreements to secure movie rights. Their lucrative deals can prevent Netflix from getting Internet rights for movies until years after they're released on DVD.

Mr. Hastings says he plans to stick to what he knows, software and online services. On the Internet, he is certain to face more powerful competitors than he has in the DVD-rental business, as Netflix competes for consumers with video services from the likes of Apple (AAPL), Amazon (AMZN), Google Inc. (GOOG) and Hulu, a joint venture of media companies including News Corp., owner of Dow Jones & Co., which publishes The Wall Street Journal.

"As a capitalist, I'd rather have Blockbuster as my primary competitor than all those Internet companies," Mr. Hastings says.

The shift in the ability to re-sale the movies via the internet is a huge issue for NFLX. Not to mention that movie rental $$$ will likely be in decline for a long time. It's difficult to bet against NFLX as they clearly recognize the importance to move beyond mail rentals, but it doesn't appear to be in their control. The movie studios clearly want a bigger piece of the pie which likely will leave NFLX out. They may likely grab a decent share of the old movie pie, but I don't see them getting new releases at a price that is reasonable enough for their service. VOD will likely dominate in that sector as the movie studios get a lot more money out of that deal.

For now the stock price is technically still strong as NFLX will likely continue to shine for awhile. After that though, they will likely begin to fade away as a company like an AOL. Until then, we'll continue to watch for the correct time to enter. This might be a stock we can ride down for a long time. The balance sheet is just ok having $250M in cash but making it difficult to compete with much bigger pockets like Apple or cable companies.

Disclosure: No position at this time.

Comments

[viewfromnyc:]

The larger question is in a video on demand via internet world, why does anyone need NetFlix as an intermediary? They are not a technology company so they lack any potential competitive advantage in whatever consumer device, cable set top box, video game console, internet ready television, may be necessary to access on demand content. They are not a content creator so they have no advantage as a supplier. The best NetFlix can do is to be an aggregator of content, competing directly with cable video on demand service and the content providers themselves. That competition will simply lead to lower prices to consumers and lower margins. Cable companies simply are not going to cede their lucrative content delivery market to the internet. In a world on internet ready televisions, content providers can simply create their own a la carte subscription services either directly with an internet based delivery system or in partnership with cable companies based on the On Demand model. I predict that the core business of the company will die faster than the CEO estimates and NetFlix will be disintermediated in the next phase.

Disclosure: short NFLX for a while

Jul 10 08:54 AM

[frugalandpu...:]

Wrong. Only tekkie/PC geeks want internet streaming. The other 90% of people simply use an LCD TV with a DVD player. You are out of touch with reality

Jul 10 09:47 AM

[fishluvrain:]

I agree. In the past when I had netflix I tried to view the free movie capability. Rarely had a bad disc but I know the frustration of BUFFERING. I think the Netflix model might be around for a while. Not everyone lives close to their server and not everyone wants to be trapped to the p c/notebook monitor.

Jul 10 10:06 AM

[Paul Zimbardo:]

@Stone Fox Capital

Sound analysis but you missed what I believe is the most important point and the reason why Netflix will continue to thrive – it’s partnership with Microsoft and Xbox Live. One of the biggest complaints surrounding digital distribution and internet media is that you have to sit in front of your computer and watch it. While this may be acceptable for watching a quick video on YouTube, this is often not ideal for watching a movie in a family setting. By partnering with Microsoft to stream Netflix over Xbox Live, Netflix instantly gains access to over thirty million customers in the comfort of their living room. Instantly.

In addition, Netflix has extremely loyal customers for its services. As the transition continues to digital distribution, the more risk-adverse and traditional consumers will at the very least look toward an established company that they know rather than a start-up venture.

As you pointed out, all is not rosy for Netflix as Apple and the major cable companies are going to try and dominate digital distribution but I do not see Netflix exiting the growth stage of its business cycle in the near future.

@frugalandpuzzled

You are wrong that “Only tekkie/PC geeks want internet streaming”. Your quote could easily mimic the sentiments of those who thought CDs would never defeat cassettes or that DVDs could never defeat VHS tapes. This is just the next step in content distribution. For proof, just look at services such as YouTube and iTunes that are exposing the mainstream to the benefits of digital distribution. With powerhouses including Microsoft, Apple, Amazon, and Google all pushing digital distribution, the question is not “if”, but “when” digital distribution will become the standard.

Jul 10 10:12 AM

[Stone Fox C...:]

The title was suppose to be 'Future Short: Netflix'. NFLX just isn't going to get access to the movies they need to dominate the movies on deman/streaming segment. If that was to change, then i'd probably not short NFLX. Otherwise, NFLX is a big time short down the road as the economy recovers.

Jul 10 11:01 AM

[jkk:]

netflix is a cheap alternative to premium channels with an occasional new release here and there - that plus the streaming for an added bonus at a very low price. I just dumped my premiums channels and saving $41 a month - the three out plans is less than half that and I get the movies I want to watch not what HBO is showing and watch when I want to. HBO and showtime have a lock now under agreement but they could lose this going into the future and netflix streaming, with its loyal sub base, brand recognition and ever increasing scale, could easily become the go to company for the release windows that the premium channels currently occupy-also at current rate of growth netflix could double its subs and income in 2-3 years, and still move up from there. Plus with USPS in dire straights, they will continue to work in partnership with netflix to push up sub levels and bring more mail to service. You should be considering riding this one up and not waiting 5-10 years in the hopes of riding it down.

Jul 10 11:16 AM

[DaY:]

Why hasn't/can't Netflix add video games onto their platform?? Either for discs or online delivery?? Would seem the most logical thing to do?

Jul 10 11:19 AM

[jkk:]

this write up is clearly coming from a big short that expects good numbers from netflix but wants to try to stifle the stock price advance. one that really wanted to take a future short position, would be silent, watch the stock price advance and short at the higher levels

Jul 10 12:22 PM

[Nom De Plum:]

NFLX's competitve advantage was its low cost OFFLINE delivery model. This advantage disappears ONLINE. The key differentiation online will be user interface...so far MVSN and TIVO have a stronghold here.

Jul 10 03:04 PM

[Stone Fox C...:]

Sure buddy. That would be illegal and your crazy to think I have any sort of following that this article would impact the price.


On Jul 10 12:22 PM jkk wrote:

> this write up is clearly coming from a big short that expects good
> numbers from netflix but wants to try to stifle the stock price advance.
> one that really wanted to take a future short position, would be
> silent, watch the stock price advance and short at the higher levels

Jul 10 04:11 PM

[stan2001:]

Netflix is history after the recession , The stock will fall fast . movies are impulse move ( on demand ) Time to sell, remember buy low sell high. Providing on demand streaming video of movies is definitely the future of the movie rental business.

Jul 11 03:20 PM

[Punter Patel:]

I am not a Netflix subscriber as I can't speak with 100% confidence about the user-experience but I have spoken with two users in past tow days and both praised the service and one of them was very proud of being their customer for more than four years. (I have been cable subscriber for more than 13 years but only because I don't want to spend time looking for alternatives and learn to operate on a new remote control). Never the less, having lived through the hyper-growth years of mobile phone providers and on-line service providers and have witnessed what happens to stock market valuations once subscriptions reach saturation point, Netflix will become a short at some point. Netflix might not be a short candidate yet though.

Positives:
* 11 million subscribers with average subscriber growth up over 35% annually since 2005. So far they have managed growth very well. With 100k+ titles and 12k titles available for streaming in NFLX library and 55 million DVDs. Technology to manage the process works! 600,000 USPS are ready to deliver.
* EPS growth despite of tough economic conditions. FY07 - $0.97, FY08 - $1.23. Tougher economic conditions have helped NFLX as consumers have found DVD rental as a substitute to other expensive means of movie watching. These consumers will continue to remain subscribers once economic conditions improve. (if one can afford them in bad times, they can certainly afford them in good times!)
* It took a decade for DVDs to replace video tapes and will take decade for Blu-ray to replace DVD. DVDs provide longivity of product for Studios so they have become core of studio's profits so they will continue to support movie-rental businesses. in 2007, 28% of studio film revenues came from theatrical versus 54% from home video (VOD 4%, Premium TV 8%, TV 6%)
* NFLX is growing at the expenses of traditional rental outlets. Blockbuster/Movie Gallery/Hollywood revenue growth is flat for past five years while NFLX has grown from $0.3 billion to $1.36 billion with could reach $1.6 billion in FY09. Video stores are closing across America. Mom-n-pop video rental stores are almost dead!
* Potential market size is huge. Home video market is a $24 billion large. DVD rentals is ~$8 billion out of this. Video on demand is picking up and already at $1.6 billion and NFLX will be a beneficiary of this growth as well as it scales up online streaming.
* Streaming opportunity is equally promising if not even more promising. Over 99 mm HH pay for TV and 60 mm HH has broadband and 30 mm+ pay for HBO and 73 M HH have a dvd player and internet access. Streaming market is much larger than DVD rental. Ecommerce growth, comfort with the using technology, improving VOD/DVR from cable/satellite/teco is training new sets of potential customer.
* Studios will keep what NFLX spends for postage and handling so they will support success of NFLX. Content availability is growing. TV networks are comfortable giving newer content to NFLX.
* Company is working well with consumer electronics companies to come up with solutions to bring video viewing from PCs to TVs. Netflix receivers or TV sets ready-to-receive streaming will make VOD easier. Higher the share of VOD, lower the churn and DVD usage for NFLX. This is a win-win situation for electronics companies as they can promote their products to NFLX's large subscriber base and provide differentiation.
* 20 million subscribers have used it and company claims that most cancelling subs say they will return. Subscriber acquisition cost (SAC) will drops as the brand has become a household name.

Negatives:
* Blockbuster will not walk away without giving a fight. BBI has $2 bn os sales and it won't walk away easily (even if it means money-losing fight). This is a widlcard! It is possible that BBI could become a leaner "kiosk" type of company with low-price point and also scale up streaming.
* Kiosks are growing to $500-600 million in FY09 and expected to grow at $1 billion by 2011 as per Adams Media research.
* Pirate Bay, Apple, Amazon, YouTube, Hulu and Studios themselves are scaling up online and offline distribution. Improving VOD/DVR from telco cable/satellite/telco. Comcast, Apple, HBO or Amazon entering internet movie streaming.
* Departments stores like Walmart has set up a DVD rental kiosk and charge $1/day. Limited service kiosks are picking up. Too early to tell if they will survive but kiosks are already clocking $200 million+ in revenues.
* DVD shipments to peak in 2013-2018 and VOD and online streaming will become the standard. If the company is not able to fight internet companies with deep pockets and studios themselves go direct to the consumers, NFLX could lose out.
* NFLX will need to allocate large capex to install streaming capabilities, add more streaming content, manage DVD substitution, retention and fight off well established cable/telco companies who could become much fierce competitor (unlike BBI in DVD rental business)
* Streaming spend will certainly pressure P&L, causing near-term lower growth in EPS. Automation drives efficiency in DVD rental and 60% of the process is automated but can further improvement possible?
* 97% of the subs are serviced in 1 Business Day. Company claims that it can not do better than this but also can not drop the expectations either so distribution costs will not go down further.
* With the budget deficit of the US growing, expect further hile in USPS First Class Rate is all but certain. Jan-06 +5%, Jan 07 up +5%, Jan-08 up +2%


Economies of scale working and business model is becoming more stable but growth comes with price and streaming is not same as mail-order rental!
* Marketing expense as a %age of Total Revenue dropped from 24% in Q1'05 to 17% in Q1'08. Recurring revenue grows faster than marketing expense. However keep in mind that churn is natural. The current churn rate of 4%/month will require marketing costs to remain at the current levels. in 2008, Gross subs were atr 6.8 mm and cancellations were at 4.9 mm, net subs at 1.9 mm. management defines marketing as variable expense. I disagree. In this business model, it is a fixed expense. To stay in business and even to retain its subscribers, marketing expense is required evil. Fixed costs are going to remain at 27-20% of the sales. (Fulfillment expenses are at 12% and content cost is at 60%). (See the IR website for data)
* Subscriber profitability grows with the length of membership. More than 50%of the subs are greater have been Netflix subscriber for more than a year. 3/4th of the revenues coming from old subscriber versus current year subscriber in FY08
* Streaming initiative could drag margins. Digital streaming is free to subscribers resulting in new layer of fixed costs. (IF streaming is not provided than NFLX can lose business to new competition) If a subscriber watches the same movie twice, NFLX pays to the content owner twice but revenues does not go up. There are no library nebefits as content providers need to get paid at every click or for certain duration and once the time expires, NFLX has to renew the agreement.
* Streaming offering for newer titles are less compelling than cable/satellite. Newer content will cost more to NFLX.
* 35% historic growth can't sustain as the high-base effect will be seen going forward. 20% growth will equate to 7-8% EBITDA growth. Will ARPU decrease or stay stable will determine the revenue growth as subscriber growth can not come in double digit as saturation will be reached within next five years.
* NLFX gets "internet business" P/E but it's capes-sales of 17% in 2008 is well above typical internet companies and no different than Blockbuster. NLFX is a capital intensive business as it needs to maintain and replenish the DVD library.
Lifetime Value of subscriber
* Return on Capital invested is at 30% and higher than NLFX's cost of capital.
* If NLFX grows at 20% yoy, it will need to grow subscribers at 23-25% (lower ARPU by 1-2%). If EBITDA margins remain stable at 11%, then EPS would be at $1.7 in FY09 (up 27% yoy).

Valuation - for every buyer - there is a seller and vice versa. I hate to say what is the maximum price or target price but looking at the current run-rate, NFLX trades at 12x EV/EBITDA. It's peak was 18 x EV/EBITDA in 2007. The forward P/E us at 24x (which is in line with its historic avg P/E of 26x). Will market continue to assign the growth company P/E multiples if revenue growth starts to drop is the question. Also, as the economy starts to recover, the "earnings growth" premium should go down.
* Average life time of a subscriber = 1 / 4.2% = 24.1 months ( where 4.2% is the churn rate for Dec qtr) (Since 2005 average life of subscriber has ranged from 20-26 months)
* Net Present Value of current subscriber (I calculated this with help of Credit Suisse analyst who cover this stock but I find the number reasonable)
EBITDA = (ARPU * Months * EBITDA %) = 13.53*12*25.6% = $41.6
EBIT = $41.6 -D&A of $24.1 = $17.5
Unlevered Cash Flow = EBIT - Tax - Capex per sub = $17.5 - (40%*17.5) - $3.9 + D&A of $24.1 = $30.7 per sub

PV of Yr1 at 9% cost of capital = 28.3
PV of Yr2 at 9% cost of capital = 23.3 (taking two years as the life time if 24.1 months)
NPV per subscriber = $51.6
NFLX Enterprise Value = $51.6 * 11.4 mm subs = $588.8 mm (for the current 20% market share)

* Market Implied EV and subscriber market share
Enterprise Value = $2,394.2 mm mcap - Cash $275.6 mm = $2,118.6
Enterprise Value / NPV per subscriber = $2118.6/51.6 = 41.1 mm subscribers
41.1 mm subs / Total US TV HHs 115 = 35.7%
In other words, market assigns value of NFLX at 36% market share which is possible for the company to achieve but not easy without burning $200-$300 mm per year in capex.

OR other way of looking at this is, to calculate payback period for acquirer if someone was to acquire NFLX at current mcap

Cash flow per subscriber/year * number of subscribers = $30.7 * 11.4 million = $350 million per year
Assuming zero growth it will take $2118 mm/$350 mm = 6 years.

I don't think it very expensive at 6 years payback for possible acquirer but it is not cheap either. Of course I am assuming that the company will not spend any cash for capex in this scenario which is not the reality! If we look at the valuation in terms of P/FCF perspective then this is trading at 20x P/FCF and 24x P/E.

Risks to shorting -
* Higher ARPU growth - unlikely! ARPUs have faller $17.46 in 2005 to $13.79 in 2008. (Subscribers have choice of plans raning from $5 - $48 per month)
* Higher subscriber growth - possible. It is the subscriber growth rather than average revenue per user that has driven the top-line growth.
* Success in streaming video business - it will reduce fulfillment and subscription costs and could improve operating margins
* Acquisition target - capital is scarce in capital market but NFLX could become an acquisition target for a larger internet company like Yahoo, Amazon, or Ebay or media company interested in it's 11 million subscriber base and solid management team.

I will wait until the price moves up to PEG of 1.25 or higher before shorting this. NOT very inexpensive but not a short yet!

DISCLAIMER: Do not have any position and bias is toward shorts.

Jul 13 03:35 AM

[viewfromnyc:]

Churn baby, churn. NetFlix can't keep 'em. After a bad experience who is going to go back and resubscribe.

Jul 13 03:53 PM

[Stone Fox C...:]

Might get the chance sooner then I thought, but I'm concerned that NFLX might ride with the market for awhile... still watching

Jul 14 11:45 AM

[WhoisJohnGalt:]

Wonder if you got a short position in yesterday, NFLX's earnings were not that bad but the market did not like what they saw nevertheless. Looks like people are starting to sober up.

Jul 24 09:28 AM