The Curious Case of the Economics of Netflix

| About: Netflix, Inc. (NFLX)

Being short a stock that rises incessantly is not an enjoyable experience, but does offer the opportunity to continuously reevaluate one's thesis.

In spending more time thinking about Netflix (NASDAQ:NFLX), I came to a pretty simple conclusion. At the highest level, the company has a subscription-based model (offering the potential for recurring revenue) that requires significant ongoing capital expenditures. No one can debate either of those points. Based on that description, I immediately thought of a large group of companies exhibiting the same characteristics. On a monthly basis, these companies receive payment from their customers for providing a service. This service requires a lot of equipment that wears out, which thus requires substantial capital each and every year. The companies providing this service go by the names of Waste Management (NYSE:WM), Republic, and Waste Connections, among others.

This comparison I'm sure will invite ridicule, and in many ways these businesses are highly dissimilar. Take the notion of recurring revenue, for example. Waste haulers have one of the most captive audiences imaginable - once a new household or a new business is formed in Waste Management's service area, it's highly likely that WM now has a new customer that (1) needs their service, (2) has no alternative service providers and (3) will pay them to provide this service each and every month. Netflix, on the other hand, provides a service that (1) is not needed, (2) has numerous alternative service providers and (3) is easily turned off at the click of a link. Another large source of dissimilarity is growth potential, which of course is at the heart of every NFLX bull argument attempting to justify current valuations. Waste Management, for example, can't simply move into adjacent markets where they do not have the required permits to provide their service, whereas Netflix is free to offer their service to any and all willing customers in the United States and Canada. Because of the difficulties described above in making revenue truly recur, however, Netflix faces what Jim Pyke has referred to as the "Churn Challenge," whereby in the last three fiscal years, on average NFLX loses nearly 70% of the subscriber base it had at the beginning of the year. Until now this challenge has been more than offset by new subscribers, many of which undoubtedly have previously cancelled their service. Thus, it is quite difficult to truly gauge what is a steady-state market for Netflix's service, but it is quite clear that although NFLX has strong brand equity, they do not have loyal (and certainly not captive) customers.

The similarities in the economics of these seemingly disparate business models becomes more striking when looking graphically. The below chart compares the three-year average margins for Waste Management and Netflix. At a gross, EBITDA and free cash flow level, the margins these companies generate are nearly identical.

(Click to enlarge)

For bulls who counter that comparing three-year average margins hides the wonderful new world of streaming economics, consider these points. First, NFLX management continuously and explicitly states that they look at content acquisition with an eye towards managing a 14% domestic operating margin. In FY2010, Waste Management had a 16.3% operating margin. Further, after incessantly talking about the future of NFLX as a streaming business, recent comments from NFLX management indicate they are considering reemphasizing their traditional DVD business. Finally, existing content deals are finite and need to be renewed in the future, and the need to find and license new content will not end. These points do not support a drastically different future for the economics of NFLX's business.

I have spent no time talking about valuation, but as you might expect, Netflix is valued slightly more richly than public waste businesses. Once Netflix's growth stops, you have a business that resembles a waste collector without a captive customer base. That's a scary thought.

Disclosure: I am short NFLX.