Len Brecken's Netflix Short Case, Part 2: Sub-$5 Stock or Bankrupt by the End of 2012?

| About: Netflix, Inc. (NFLX)

In part one of my interview with Len Brecken of Brecken Capital, the hedge fund manager laid out his short case for Netflix (NASDAQ:NFLX), focusing on the numbers. In part two, Brecken discusses Netflix's international expansion plans, competition, and his projection for NFLX shares going forward.

You can read part one of my interview with Brecken, as well as Brecken's bio, here.

Rocco Pendola: In a recent article, I wrote: "Netflix expects us to believe that Canada will swing from a $10 to $14 million loss at the end of Q2 to profitability at the end of Q3. Netflix also tells us that a market that generates a $50 to $70 million loss in the second part of 2011 can fuel expansion into another market in early 2012." Your thoughts?

Len Brecken: Canada is a complete failure and will continue to be so. Firstly, sub adds declined in 1Q11 sequentially, indicating failure. I think that results from a weak content library and bandwidth caps implemented there. So what did NFLX do in response to this? It reduced the content quality to less than VCR quality to get around the bandwidth charges that are being levied on NFLX subscribers by using the service. NFLX announced a three-tiered streaming quality option to Canadian subs. Each tier has a different video quality assigned to it so that the subscriber can modify the bandwidth used to save data charges.

The problem is that, based on the bandwidth used by each tier, it does not come close to the 720p offering typically found here in the States. I estimate that for 720p video quality using MPEG4, the same compression used up in Canada would require 18G/hr (5Mbit/s) vs. NFLX’s “Best” quality which uses 1G/hr. Does this imply that even NFLX’s best quality in Canada would result in 18X lower quality versus what is found here in the States? At the very least it’s much much lower.

If true, then how can streaming become that popular? NFLX’s Canadian default quality setting, dubbed “good,” is well below VCR quality and by no means can be viewed on standard TV, never mind PCs except in tiny windows without visible artifacts. So why is management using non-standard video quality methodology like “good," “better” and “best” versus using standards like 480P or 720p like everyone else other than to hide the fact that it's inferior?

Now as far as other markets, they have nowhere near the 80-100M broadband subs necessary to provide NFLX any critical mass in the near-term. In international markets, latency issues are more pervasive and many users are not served by cable broadband, but instead DSL. Further, DSL rates typically range from 256 Kb/s to 40 Mbit/s -- nowhere near what is necessary for streaming video. Take Brazil: It has 15M broadband subs but over half are using DSL. Furthermore, only 25% of those 15M are serviced with cable broadband. To me, this is just another gimmick by management to distract investors from the fact that domestically subs are slowing to raise hope it can still grow.

RP: What do you think about Netflix's conference call format?

LB: Simply put, it’s a joke. It tells me NFLX management wants to shine the light on the good, but not the bad. No public company should be allowed to conduct calls without taking live calls that are unscreened.

RP: Broadly speaking and company-specific, what and who do you see as Netflix's stiffest competition?

LB: As I mentioned earlier, by year’s end cable MSOs will be offering the same content in HD versus NFLX SD streaming. Starz (except thru Verizon (NYSE:VZ)) is the only movie channel that does not offer their content through cable streaming in HD; even EPIX, NFLX's so-called exclusive, is offered in HD. Thus, cable will soon be on equal footing with NFLX on their streaming content offering. Hollywood is in the process of reordering the streaming content it is offering NFLX and the rest of the over-the-top competitors such as Google (NASDAQ:GOOG) and Amazon.com (NASDAQ:AMZN).

I believe much of the older content found on NFLX will be offered via free ad-supported sites with the newer offered in some pay-per-view manner. There's also ample evidence Hollywood is repricing premium content to be more in line with cable, which is many times more that NFLX is paying (as a benchmark, STAZ NFLX paid $30M and it will likely cost 5-10X that amount). GOOG will likely launch a PPV and an ad-supported site by summer, while AMZN [could follow] soon after with a subscription-based plan.

Formidable, yes, but cable MSOs appear to be better positioned content-wise, as neither GOOG nor AMZN will attempt to replicate the reckless content spending undertaken by NFLX.

RP: Where do you see the stock by year's end and into 2012?

LB: Subscriber adds will begin to slow this quarter and continue through 2011, especially domestically. As this occurs, and amortization expense accelerates (unless management continues its accounting gimmicks through under-amortization), it will create negative leverage on earnings, causing [them] to decline. With over $10/share in off-balance sheet expenses for the next three years to hit earnings [at] $3.00/shr in 2010, you figure out what will occur.

Ultimately, the accounting will catch up and the entire streaming effort will be labeled a ruse and the stock will be under $5 per share or bankrupt by the end of 2012. In my view, NFLX will not be able to meet its obligations to Hollywood, as by 2012, I expect the combination of churn and competition will result in negative cash flow and declining subs.

RP: Specifically, what would your trading or investment strategy be with Netflix? What type of position do you hold as of this writing?

LB: I am currently short the stock. But for the average retail investor or those who can’t borrow the stock using the inflated call premiums by selling, long-dated calls make the most sense. Put premiums are just as expensive, thus unless you are buying deep in the money puts or leaps, [they] may be too risky for the average investor.

RP: I have not heard analysts with bullish ratings on the stock refute your claims. Why do you think this has been the case?

LB: I think they are breaching their fiduciary responsibility to investigate all views, short or long, on a stock. I have put these issues in front of virtually every sell-side analyst and all but a few have even debated them. None have challenged them, which is most concerning. All of them, except for Wedbush, have ignored the accounting issues in their formal research. When I have brought it up with them, [they] have requested that I stop sending my research to them. The environment is reminiscent of the 1999 bubble, when sell-side analysts turned their backs to the negatives while only portraying the positives.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in NFLX over the next 72 hours.