Netflix To Face An Uphill Battle In Beating Expectations

| About: Netflix, Inc. (NFLX)

I like Netflix (NASDAQ:NFLX). I have been a subscriber for over 6 years. But I question the business' corporate governance, sustainability, and market expectations.

The media company lost nearly a fifth of its value on the news that the number of subscribers by the end of 3Q 2011 is expected to be 1M less than previous guidance numbers. Whereas management had anticipated 25M by the end of 3Q 2011, they now are expecting 24M. This is largely a result of their as much as 60% price hike on customers. Below is a depiction of the revision contained within a press release.

In the press release, Netflix tried to make the argument that its strategy to split online streaming and renting services was partly "to create a dedicated DVD rental division that takes pride in great execution and maximizes the opportunity for disc rental over the coming decade". Does that same DVD rental division also take pride in retroactively shutting down customer's access to supplemental free online streaming?

The problem with Netflix's decision to hike prices on subscribers was not that it was a sincere plan to increase the bottom line (which is reasonable), but that it was done in one of the most unprofessional ways I have seen from a company. Netflix has continually attempted, and failed, to cloak the fact that they skyrocketed prices. Customers are angry, because they feel that they have been cheated. In a digital age where video piracy is (to put it frankly) easy and media is becoming cheap to free, Netflix's behavior is anachronistic.

This action is particularly damaging, because having a brand name is crucial in the competitive media industry where there are few barriers to entry. In addition to upsetting customers, Netflix has poor corporate governance. Their board is classified, shareholder can not act by written consents, shareholders cannot call for a special meeting, the same person serves as both the CEO and Chairman, there are supermajority voting requirements for changing board size and removing directors, and there are golden parachutes to discourage takeover activity that could maximize shareholder value. A 67%+ vote, for example, is required to remove a director with cause. As one Seeking Alpha contributor wrote earlier, a shareholder proposal was made in 2011 to require a majority vote instead of supermajority vote. Non-abstaining stockholders supported the non-binding proposal on a nearly 2.7:1 margin. Management can either follow the will of shareholders or continue to be thought of as unaccountable. Based on how they treated the representative of the proposal at the meeting, my guess is that they will opt for the latter.

With a PE ratio of 42.9, a forward PE ratio of 24.3, no dividends, and a management explicitly critical of short sellers, Netflix needs to prove its fundamentals are worthy of the pricey valuation. Consensus estimates for EPS are that it will grow by 57.4% to $4.66 in 2011 and then by 48.3% and 36.2% for the next two years. I forecast growth going much slower than expectations due to declining subscriber interest and higher costs from content providers.

In short, I question the direction and sustainability of Netflix. It appears to be neither customer-friendly nor shareholder-friendly. While I believe that Chairman & CEO Reed Hastings is a genius in media and technology, I find that the company will struggle to meet expectations in an increasingly competitive and cheap market. I even think that the company's refusal to renew their contract with Starz (LSTZA) was a smart decision, as the content provider of Disney (NYSE:DIS) and Sony (NYSE:SNE) only made up 8% of total Netflix streaming and was not necessary for customer satisfaction. Netflix has a large library, but unless the company finds a way to reduce its costs and increase customer loyalty and demand, I would remain hesitant about investing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.