3 Choices for Netfix Investors: Book Profits, Short the Stock or Go Long Faith in Hastings

Jul.26.11 | About: Netflix, Inc. (NFLX)

In the seminal "Backstreets," Bruce Springsteen speaks of "Catching rides to the outskirts" and "tying faith between our teeth." That epic line applies to what Netflix's (NASDAQ:NFLX) Q2 letter to shareholders and its is it live or is it Memorex conference call boils down to.

It's tough to put a positive spin on the company's results or its guidance: For all intents and purposes, they stink across the board.

While Netflix beat Q2 EPS, it came in below analyst expectations on revenue and guided down both Q3 EPS and revenues. Net subscriber additions totaled 1.8 million domestically -- the worst showing since Q3 2010 -- while the company added just 160,000 net subscribers in Canada. As many bears have long anticipated, Netflix has hit the wall on subscriber growth.

The following excerpt from the above-linked shareholder letter sums up Netflix's message: Q3 will be rough, but we'll be back leaner and meaner than ever come Q4.

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I refuse to hold my breath. And because I do not have the same type of confidence in Netflix CEO Reed Hastings that I have in Sirius XM (NASDAQ:SIRI) top dog Mel Karmazin or Amazon.com (NASDAQ:AMZN) leader Jeff Bezos, for instance, I cannot bank a long play on the man's own self-confidence. As far as I am concerned -- and, granted, that's not very far in Hastings' mind -- the unraveling many of us have anticipated begins now, in earnest.

Hastings wants us to believe that his company has a handle on what the price increase will do to the business. Some observers believe Hastings has access to rich data that allows him to make predictions with startling accuracy. I simply don't buy the second part of that sentence. I don't think Netflix has any idea what to expect. Rising content costs and Hollywood studios forced the company into an abrupt decision that will make or break its future on a dime.

In the Q2 letter to shareholders, here's what Netflix had to say about the DVD business:

Because we believe we can best generate profits and satisfaction by keeping DVD by mail as a division, we have no intention of selling it. In Q4, we’ll also return to marketing our DVD by mail service, something we haven’t done for many quarters. Our goal is to keep DVD as healthy as possible for as many years as possible.

First, it was nice to get an indirect response to my thesis that Netflix will spin-off its DVD business down the line. I simply cannot see any good reason to reemphasize the DVD side other than to appease the studios and attempt to score sweeter terms on streaming content. Why else would the company go from treating DVDs as an afterthought to keeping it "as healthy as possible" going forward? Hastings blew off the notion that any connection exists, noting that the studios keep digital and DVD as separate business segments.

In any event, Netflix paints a lopsided picture of its subscriber mix come Q3 -- 10 million streaming only and 3 million DVD only. If more people than Netflix expects opt for DVD only, it could shoot the entire model in the foot. From a quality of service standpoint, I cannot see how just 3 million subscribers go DVD only. That side of the business not only offers more content, but fresher content, relative to streaming. Simply put, at the moment, DVD trumps streaming; and, if consumers choose between the two, more will go for the former than Netflix and most pundits predict.

Netflix has entered uncharted territory. Hastings is asking investors to have faith that the company's subdued Q3 outlook will morph into record revenue in Q4 as the company rides, awkwardly, on the outskirts. As Hastings and Wells noted on the call, off-balance sheet streaming content costs continue to rise markedly as do the streaming content-related expenses that are hitting the income statement. If Hastings' subscriber data does not provide him with the crystal ball others think it does, the company could face massive misses on its own guidance and on actual results over the course of the second half of the year.

Given that nothing has changed other than Netfix's entire business model (rising content costs, larger international losses and increased competition still roll on), I have very little confidence that the company can pull off record revenues of $1 billion in Q4 while growing profits at the same time. The record revenue assumes the price increase will not backfire; instead it anticipates subscribers pumping up revenues by dishing out $16 a month, which, in turn, will allow the company to keep pace with mounting expenses.

I cannot get on board with that overly optimistic forecast. As Springsteen concluded in "Backstreets," I guess I'm "Just another tramp of hearts crying tears of faithlessness."

Disclosure: I am long SIRI. I am short NFLX via long position in NFLX put options.