Netflix: The One Metric Nobody Is Watching

Sep.23.13 | About: Netflix, Inc. (NFLX)

I just ditched Netflix (NASDAQ:NFLX). The system is plagued with technical problems and portions of the library freeze or cannot be accessed. There have been widespread service disruptions and large parts of the repository were recently discontinued (because of license expiration). I'm not the only one. Have a look at recent traffic numbers from the best third party web traffic monitoring services (Quantcast and

Click to enlarge

This graph, exclusive for Seeking Alpha, captures only the sign up domain traffic within The part of the website that must be visited if you want to become a subscriber to the service. You can see that sub growth peaked in Q1 this year (2013) and that sub growth is decelerating. This is a forward indicator of future subs. Other leading 3rd party traffic measure services validate the same trend. Have a look at the Quantcast chart (notice I have Isolated the "sign up" subdomain only).

So why is Netflix at an all time high? Because these are not the metrics analysts are looking at. Street analysts are looking at the 30MM unique visitor number given without digging further. They're looking at the wrong chart, a lagging indicator such as this chart. Which has some seasonality, but modest growth. There still is growth, but it has started to level off. Is this the growth deceleration expected from the Q1 peak of 2MM additional subscribers?

I have used this "sign up" data to accurately pinpoint the last 2 quarters sub growth. This quarter (Q3 2013) expectations on the street are high. The stock just closed at an all time high, which means it's priced for perfection.

Remember, Netflix added 200,000 coupons for the Chromecast deal with Google. This is a subsidized way of getting additional growth. Analysts should question revenue per sub on the call. This aggressive style has been very much in line with other questionable management decisions. In my opinion, the pressure to meet the over 800K to 1.4MM new domestic subs and 2MM total subscribers the street is expecting next ER comes from a fundamental accounting practice that is flawed. Why?

Netflix has been capitalizing the cost of content acquisition as an off balance sheet expense. It amortizes these expenses in a straight line over 2 to 4 years depending on factors like the number of seasons of the show it procured. The accounting guidance they follow is complex, it's the ASC 920, Entertainment - Broadcasters, which provides the accounting framework for licensees of films and TV shows.

The problem is that an entire season of a show like "House of Cards" which, according to Kevin Spacey is a glorified 12 hour movie, is consumed by the Netflix sub base in a matter of days. The yield Netflix gets in terms of engagement is so short compared to the amortization period.

When these rules were written I don't think anyone could understand (or still does) how quickly the benefit of a licensed show can dissipate (the binge viewing experience). This reality is just not captured by Netflix financials. A warning to investors, this amortization schedule can change (and should) at any moment. Look at the IR Q&A section of their website:

"However, we are in the early stages of original content and continue to monitor whether the viewing pattern is significantly higher in the first few months which would indicate a faster initial rate and then continue on a straight line basis for the remainder of the amortization period."

Because the costing is backlogged, it becomes very important for Netflix to hit a commensurate sub growth to stay ahead of these "future" expenses. Sooner or later the expenses will catch up with revenue. In fact, it is doubtful that Netflix can be truly profitable. To date, Netflix has accumulated over $6B to date in off balance sheet expenses. The company would need nearly 70MM subs to break even on gross profit basis, assuming constant content expenses, which are rising rapidly. This cost treatment is the only reason Netflix is slated to achieve over $3 EPS next year. I don't see how this company can grow into its valuation (100 times 2014 earnings) under a more accurate accounting practice. Unless it has less content or hikes prices. Neither will work, 2011 has showed that Netflix customers can leave as quickly as they came. In other words, subs are very tenuous; they are at Netflix because it's easy, cheap and it feeds their hunger for binge viewing; move any one of those and Netflix falls like a house of cards.

This accounting issue is nothing new. In fact, Witney Tilson highlighted the problem a while back. But now, the sub rate has reached the magic 30MM mark, where additional growth will become extremely difficult. I will get into the limitations of this in another article. But to start, there is only 82MM broadband connections in the US. We are about to see several quarters of more modest growth. Starting this, both the data and the research suggests a deceleration of growth from Netflix, more like 6 digit additions when the Street has priced in 7 digits additions.

Most likely the company will need to raise capital to fund more content and dilute investors in the coming weeks. The subsidized deal with Google (NASDAQ:GOOG) is just the beginning. I would not only get out the way on this name, I would short it to front run any further dilution in revenue or even equity.

Disclosure: I am short NFLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.