Netflix's Business Model Isn't Sustainable

| About: Netflix, Inc. (NFLX)

Read through the transcript of Netflix's (NASDAQ:NFLX) most recent conference call and, in terms of keeping things close to the vest, the company makes Apple (NASDAQ:AAPL) look like a firm that provides a live webcast of executive retreats. Netflix offers an endless stream of short answers that are light on specifics. When an analyst dares to "ask" about expenses -- and oddly, few of those types of questions get through -- the response amounts to: No worries, we've got it covered.

As an investor, it concerns me that Netflix conference calls, particularly the last one, tend to be light on, if not void of, talk about the surging expenses the company pays now, puts off to a later date, and can expect to incur going forward.

Even more troubling is Netflix's conference call format. It does not occur in real-time with analysts on board. While other companies use similar methods, Netflix use of a Q&A session only, conducted via email, smacks as curious, at the very least. The protocol appears to give the company the ability to preselect questions and craft ideal answers only to the ones they choose, as opposed to having to answer potentially tough questions exposed and on the fly. Regulators ought to banish this approach, as it provides little value to investors. Netflix's last call amounted to nothing but a dog and pony show.

What's even worse is how they attempt to make what, for all intents and purposes, is a canned Q&A session appear live. In Netflix's earnings press release, the company notes that it "will host a live Q&A session" where VP of Investor Relations, Deborah Crawford, "will read the questions aloud on the call and" CEO Reed Hastings and CFO David Wells will "respond to as many questions as possible." For good measure, the company even throws in the following head fake to feign a "live" call (click to enlarge images):

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As always, I reserve the right to be wrong or off-base. I am not one of these guys who lives and dies with being right. I simply go on the information that's out there and available to me. I could have missed something. I welcome clarification as to how the company conducts its conference calls. From what I can logically glean, it appears that they sift through email questions and then go "live" in a somewhat, if not wholly, rehearsed back and forth between Crawford and Hastings and Wells. Was Reed really talking to Mark in that clip? Or was he picturing Mark as he looked at Deborah from across the room? To blame the new format on saving us from management's "boring" discussion before questions, technical glitches, or noise from a speakerphone insults our collective intelligence.

Why the lack of willingness to delve into the numbers and talk expenses? Alongside revenues, investors certainly care most about the costs a high-growth company like Netflix incurs and will incur at it ramps into its next and, most likely, largest expansion phase. Given the time waste of the company's conference call, the best thing we have to go on is an annual report that consists of crafty bookkeeping, to put it mildly. Any investor who goes the extra mile with their due diligence -- and Netflix surely realizes most, even ones with substantial amounts of capital to invest, don't -- can figure out that Netflix's numbers just don't add up. They'll need a Herculean surge in revenues to keep up with growing expenses.

In its most recent annual report, Netflix explains how it accounts for the costs it incurs to stock its streaming content library (you'll need to click the excerpt to make it bigger):

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Pay close to attention to what Netflix says in that excerpt because it's critically important to the company's ability to maintain such a high valuation. Or, more aptly, to keep up with what will be an exponentially rising valuation over the next several quarters, assuming it's price per share does not plummet. I'll go as far to say it's vital vis-a-vis Netflix's chances to maintain a stock price above $100 going forward. Let's take a look at the numbers associated with each of the area's Netflix's speaks of in the above-referenced excerpt.

Current content library, net. 2009: $37,329M, 2010: $181,006M, Increase: 385%

Acquisition of streaming content library. 2009: ($64,217M), 2010: ($406,210M), Increase: 533%

Amortization of content library. 2009: $219,490M, 2010: $300,596M, Increase: 37%

Accounts payable. 2009: ($1,189M), 2010: $139,983M.

Other non-current liabilities. 2009: $16,583M, 2010: $69,201M, Increase: 317%

Footnote 5 (straight from the 10-K; emphasis added):

The Company had $1,075.2 million and $114.8 million of commitments at December 31, 2010 and December 31, 2009, respectively, related to streaming content license agreements that do not meet content library recognition criteria.

The Company also has entered into certain license agreements that include an unspecified or a maximum number of titles that the Company may or may not receive in the future and /or that include pricing contingent upon certain variables, such as domestic theatrical exhibition receipts for the title. As of the reporting date, it is unknown whether the Company will receive access to these titles or what the ultimate price per title will be. However such amounts are expected to be significant.

Prepaid content. 2009: $26,741M, 2010: $62,217M, Increase: 133%

A look at year-over-year revenue shows an increase that pales in comparison to the rise in costs associated with content acquisition. For instance, total revenues grew from roughly $1.7 billion in 2009 to $2.2 billion in 2010, an increase of 29.4 percent. Net income ticked up by 39 percent, from $115,860M in 2009 to $160,853M in 2010. And to top it off, Netflix's average monthly revenue per paying subscriber declined 8.3 percent, from $13.30 in 2009 to $12.19 in 2010. The company blames this on growth in its lower-priced subscription options.

Bringing it all together, between 2009 and 2010 Netflix saw its cost of subscription revenues rise by a $244.6 million. They jumped from about $909.5 million in 2009 to almost $1.2 billion in 2010. Content acquisition and licensing expenses accounted for nearly $166 million of this growth. And this does not take into account content costs that do not presently "meet content library recognition criteria" (that pesky billion dollars or so referenced above).

What's even more startling about the amount of money Netflix has and will continue to put out in the future relative to revenues is that the preceding discussion about expenses focuses solely on content acquisition costs. I make no mention of the further hole Netflix will dig for itself as it dives into its international expansion plans.

International expansion, particularly the costs associated with it, represents another area of its business Netflix executives don't seem to like to talk about much. One of the few hard numbers they have provided is an expected $50 million international operating loss for the second half of 2011 alone. Outside of this, the company does little more publicly than hinge their international ambitions on an "if" regarding anticipated success in Canada. There's no mention of how much it will cost to secure international content rights and other "infrastructure," conduct marketing activities to build the Netflix brand where it does not yet exist, lease buildings, and hire staff. Just trust them, they'll get it done.

Obviously, I expect items such as accounts payable to increase when looking at a growth company like Netflix. If they did not, I would be concerned. In addition, I understand the transitional growing pains associated with the shift from a DVD-delivery model to a streaming one. These factors, and nothing else that I have heard thus far, do a thing to ease my concerns over Netflix's ability to grow enough to justify expenses. In fact, I expect them to announce a shocking earnings miss within the next year or so or provide unexpected Coinstar (NASDAQ:CSTR)-like guidance.

In the company's most recent letter to shareholders, Netflix anticipates 2011 Q1 revenue to come in on the high-end at $704 million. If we extrapolate that out to $2.8 billion for the year, it represents year-over-year growth of about 27 percent. If Netflix Acquisition of streaming content library line item, for instance, grows by only a fraction of the 533 percent it grew between 2009 and 2010 -- say 100 percent -- that number would fast approach $1 billion. And this does not account for new content expenses that hit the books in 2011, international charges, and other general operating costs.

I don't see any way Netflx can substantially decrease the costs it will incur to acquire content. Content creators certainly aren't in the mood to cut any deals. And if they do, it won't be with the seemingly arrogant, new kid on the block Netflix. As Hastings said himself, in one of the few substantive comments he made on the last conference call, "cable service providers," for example, have little incentive to "help [Netflix] grow."

And with just $350 million in cash on its books for 2010, up from $320 million in 2009, Netflix can ill afford to purchase a programmer such as Discovery Communications (NASDAQ:DISCK) or Scripps Interactive (NYSE:SNI) or a division of a company like Time Warner (NYSE:TWX). Hastings almost brags about being a "$100 million a year customer for Warner Bros.," but he's being taken to the cleaners.

To his credit, Hastings did address the issue of content costs right here at Seeking Alpha when he warned Whitney Tilson to cover his NFLX short. But the CEO's treatment of the issue did not inspire confidence:

Moving on to the widely-discussed issue of increased content costs, it is true that we are paying more for any given piece of content than we were two years ago, and that in two years, we’ll pay more than we pay today. Part of our goal as a business is to make money for content producers and to become one of their largest and best revenue sources. Fortunately, our subscriber base is growing fast enough, and DVD shipments are growing slow enough, that we can afford to pay for the existing streaming content we have, and also get more content. We try not to comment on specific deals, like the Starz renewal, as that rarely helps us get deals done.

Investors sometimes see the content cost threat as an issue around our margins. But we have no intention of overspending relative to our margin structure, and there is no specific content that we “must have” at nearly any cost. In our domestic business we spend 65-70% of revenue on COGS (which is mostly content and postage). So if content costs rose faster than we expected, then in practice we’d have less content than otherwise, rather than less margin. This would ultimately show up in less subscriber growth than we wanted from a not-as-good-as-it-would-otherwise-be service; it would not likely show up as a sudden hit to margins. Management at Netflix largely controls margins, but not growth.

In a nutshell, Hastings said content will continue to get more expensive to acquire, but Netflix will not overspend for content at the expense of their bottom line. If the company adheres to such fiscal responsibility, its product will undoubtedly suffer just as competition from a broad range of players intensifies. Netflix will ultimately face a chicken versus egg dilemma (or is it a double-edged sword?). It needs to secure more and more content to compete, but it cannot survive on the trajectory of its current and necessary shopping spree. While it really cannot afford to cut back strategically and theoretically, it will need to cut back from a financial sustainability standpoint.

As it stands, the Netflix business model of impressive growth combined with mind-boggling expenses that will only go up is simply not sustainable. Sooner rather than later, Netflix will run into a cash flow problem. Netflix has short written all over it. Two years from now, I think we will be talking about one of two things: a sub-$100 NFLX share price or Netflix Streaming by (take your pick of) Apple, Google (NASDAQ:GOOG), Verizon (NYSE:VZ), or AT&T (NYSE:T).

Disclosure: I am long AAPL. I may initiate a short position in NFLX, via options, over the next 72 hours.