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Recently, Whitney Tilson, chairman of Value Investor Insight and Value Investing Congress, wrote about why he was long Netflix (NASDAQ:NFLX) and why it was “downright cheap” since it had fallen 75% from its peak in less than four months. I provided a rebuttal to his bullish thesis earlier. However, instead of just refuting his thesis, I felt it would be more constructive to show how a real value investor would evaluate Netflix at this time. To do so, I will evaluate the economics and value of each of its business segments: DVD, Streaming, and International.

What Is Netflix?

Netflix CEO Reed Hastings has tried desperately to portray the company as the wave of the future by transforming the company from a DVD-by-mail business into a futuristic company that streams video over the Internet. In the process, it has lost its competitive advantage, which was its delivery system and the ability to resell the same fixed-cost content over and over. The recent release of guidance for the fourth quarter and disclosures in their 10-Q for the 9/30/11 period provide additional information to value each of the business separately. The following shows NFLX's guidance for the fourth quarter:

DVD

Streaming

International

Beginning Subscribers

13.93

21.45

1.48

End of Period Subs

10.80

20.75

1.80

Revenues

361

470

28

Contribution Profit *

185

36

-65

Ave Revenue per Sub per Month (ARPU)

$9.75

$7.99

$8.19

Average Number of Paying Subs

12.34

19.61

1.12

(*) Contribution Profit as defined by Netflix is revenues less cost of revenues and marketing expenses.

Contribution Profit is a measure that is prior to the allocation of any Technology & Development expenses or any General & Administrative expenses, which are currently running about $100 million per quarter. Arguably, one would assume that most of the T&D expenses would be due to the Streaming business, rather than the DVD. However, assuming these expenses are allocated equally based solely on the number of average subscribers for each division for the quarter, the entire income statement by division would be as follows:

DVD

Streaming

International

Contribution Profit

185.0

36.0

(65.0)

Allocation of T&D and G&A

39.5

62.7

3.6

Operating Profit

145.5

(26.7)

(68.6)

Interest Expense

(4.0)

Pre-Tax Profit / (Loss)

141.5

(26.7)

(68.6)

Tax Rate

38%

38%

38%

Net Income

87.7

(16.6)

(42.5)

Shares Outstanding

53.0

53.0

53.0

Earnings Per Share

$1.66

($0.31)

($0.80)

(*) It is unclear whether the International division losses would create a tax benefit for the company.

With this guidance by division for the fourth quarter, and other recent financial disclosures, it is clear that economically speaking, Netflix is merely a dwindling DVD business that is subsidizing the money losing streaming business both domestically and internationally.

Valuing Netflix Based on the Economics of Each Division

As a real value investor, I evaluate the economics of the business, estimate the sustainability of the cash flows of that business, and determine what rate of return I would require if I were to own the entire business. Then I evaluate how management allocates the cash flows generated by the business to determine whether they are creating or destroying value for shareholders. In true Graham and Dodd sense, the goal is to create a margin of safety between the price paid for the stock and the value of the business without having to make significant assumptions about the future of the business.

DVD

The DVD business is the only one that is currently profitable. However, on the recent conference call, CEO Reed Hastings described DVDs as “something like AOL dialup from 2002 to today.” AOL’s U.S. subscribers peaked in 2002 at 26.7 million and are practically non-existent today. Here is the trend of Netflix’s DVD subscribers this year after splitting the DVD plans from streaming in July:

1Q 2011

2Q 2011

3Q 2011

4Q 2011 est

Number of DVD Subscribers

19,052

18,856

13,135

10,800

The trajectory of DVD subscribers over the last year looks more like AOL from Q4 2005, when it had 19.5 million subscribers to Q2 2007, when it had just 10.9 million subscribers. Netflix also said on its conference call that only 7% of new subscribers are opting for the DVD plan. Even if Netflix gets 5 million gross subscriber additions per quarter, and the DVD churn rate is only 2% per month (well below the overall company average, but these are more mature subs that typically have lower churn rates), the number of DVD subscribers would shrink to 9.6 million at the end of 2012. Assuming it is able to keep the Contribution Margin steady at 51% even with the declining subscriber base (best case), the DVD business could earn $5.46 per share in 2012.

What is this declining DVD business worth? A declining business can provide a discrete set of future cash flows that can be discounted back to the present value. Obviously, the value depends significantly on assumptions multiple years in the future, but in trying to make a best-case scenario, we could use the following optimistic assumptions: 1) Subscribers decline to 9.6 mm at the end of 2012 and decline 200,000 per quarter thereafter (which is a much slower decline rate than AOL U.S. sub rate decline from the same starting point); 2) Contribution Margin remains constant at 51% even with the declining subs; 3) cash flow equals earnings. Using these assumptions and a 10-year run-off time horizon for this business, a discount rate of 15% yields a value of around $20 per share and a 12% discount rate yields a value of around $22 per share.

Streaming

The company first gave separate subscriber details regarding the streaming business in its 2Q/11 financial releases. Based on that information, I was able to estimate a churn rate for the streaming business of 8.6% per month, or an average life of just under one year. The total profitability of a streaming subscriber over its lifetime was calculated at just $9. Unfortunately, these statistics were muddled due to the split up of the streaming and DVD plans this quarter, and are not available for this quarter. They may never be available again, as Netflix plans to eliminate providing these valuable subscriber metrics next year.

One area where it is still required to provide disclosure about streaming customers is Content Costs. While it doesn't break down content obligations between domestic and international, I have assumed that content costs per subscriber are the same for both.

At the end of 2Q/11, Content Costs, both on- and off-balance-sheet for the next year, were $47 per ending paying sub. After the split of the DVD and streaming businesses and loss of those subscribers on a streaming plan, this number has increased to over $67 per subscriber at the end of Q3/11, and even if content obligations are flat to the end of the fourth quarter, would be $79.46 per ending paying sub.

Q4/10

Q1/11

Q2/11

Q3/11

Q4/11 est

Current Content Library

$181,006

$265,933

$499,434

$705,398

Content Obligations due within 1 Year

$530,878

$642,898

$625,000

$740,800

Total Content Obligations within 1 Year

$711,884

$908,831

$1,124,434

$1,446,198

$1,446,198

Ending Paying Streaming Subscribers (1)

18,269

22,078

24,120

21,500

18,200

Content Per Sub over Next Year

$38.97

$41.16

$46.62

$67.27

$79.46

(1) The number of Streaming Subscribers fell off dramatically in the third quarter due to the separation of the streaming and DVD plans (prior to that everyone had access to streaming and were counted as a streaming subscriber to calculate content per sub). The fall-off to the fourth quarter is based on Netflix midpoint guidance, and estimates of free subscribers at year-end that are consistent with the prior year, since Netflix's fourth-quarter gross additions guidance is modeled from prior year’s performance.

At $7.99 per month, annual revenues per streaming subscriber are only $96 a year, all other costs before marketing are approximately $18, and minimum content obligations per current subscriber will be close to $80 at year-end. So even before marketing expenses, a streaming subscriber is not profitable with current content obligations and subscriber levels.

At this point, a value investor should either assume no value or perhaps even a negative value to the streaming business, since it has not proven that it is capable of earning a positive return. Rarely will a value investor pay for future growth of a company, unless that growth has a protected franchise, which is certainly not the case with Netflix.

International

The International story helped propel the stock skyward on the way up as the engine that would propel never-ending subscriber growth around the world. Unfortunately, these were just dreams of Reed Hastings and the bulls. Here is the reality: Total International losses have been $56 million since it entered Canada in Q3/10, and that is before allocating any technology and development expenses or G&A. I suppose it was able to magically stream videos to Canada and Latin America without any technology or development, and there was no corporate time dedicated to entering 44 new countries?! On second thought, perhaps that is why international is such a disaster...

Canada allegedly had a slightly positive contribution profit in Q3/11 (before those other pesky expenses), but will not be positive for the next year as it re-invests in the business. Subscriber growth in Canada after a year has slowed to a crawl, and total estimated subscribers of 1.1 million don’t even cover a single month of churn in the U.S. Not exactly an engine of growth there.

Latin America was the next savior for future growth. The $23 million of international losses in Q3/11 was attributed to entry into this area, and an additional $60-$70 million of losses in the fourth quarter are expected. Even though Reed Hastings proclaimed that the company is usually profitable when it enters new geographic area within one or two years (despite having no previous experience entering new countries), a mere two months after entering Latin America, it is now not sure whether it can become profitable within two years. The initial subscriber trajectory is similar to that in Canada, where they had 510,000 subscribers (176,000 free) at the end of 2010. However, losses in Canada in the 4Q/10 were only $9 million, and will be 6 to 7 times that in Latin America in 4Q/11. Next up, similar type quarterly losses to enter the U.K. and Ireland, even though there are already entrenched competitors in those markets.

In the 9/30/11 10Q, Netflix states, “As a result of the flat consolidated revenues and the increasing investment in our International segment, we expect to incur consolidated net losses in 2012.” For international to wipe out all the domestic profitability in 2012, international losses will likely be at a minimum $280 million in 2012 and some portion of that for 2013.

Netflix’s streaming business isn’t profitable in the United States, even with an established brand name and around 20 million subscribers. Given the losses over the next two years being racked up to launch into new countries and the uncertainty of ever having a profitable business model internationally, a value investor would need to assign a liability to their international business. With at least $280 million of losses and 53 million shares outstanding, the negative value assigned to the international business would be $5 per share at a minimum.

Management Allocation of Cash Flows

One of the most important considerations for a value investor is how management allocates the cash flows that the company generates on behalf of its shareholders. How has Netflix done on this item? Since the beginning of 2010, Netflix has used a significant portion of its free cash flow repurchasing its own shares. While share repurchases can be a value enhancing activity, Netflix has essentially used repurchases to simply offset additional share issuance through options exercises. The following shows how effective Netflix’s share repurchases have been since 2010:

In '00s

Since 2010

Share Repurchases

$409,745

Proceeds from Issuance of Shares

$68,365

Net Investment in Share Repurchase

$341,380

Net Income Before Stock Comp Expense

$396,112

% of Net Income Used on Share Repurchase

86.2%

Beginning Shares plus Average Dilution

54,878

Ending Shares plus Average Dilution

53,862

Change in Ending Shares plus Average Dilution

1,016

Reduction in Shares Outstanding

1.9%

Effective Price of Repurchasing Stock

$ 336.00

Average Trading Price of Shares

$ 165.00

Difference

$ 171.00

Value Lost

$173,740

% of Net Income Before Stock Comp Expense

43.9%

It took Netflix over 86% of its net income since the beginning of 2010 to reduce the share count by only 1.9%. Because of its heavy reliance on stock options to compensate employees, the effective price of repurchasing shares over this time period was $336, significantly above the $165 average trading price. While the historical allocation of cash flows to repurchases has been value destroying, future allocation of cash flows to questionable international expansion may be even worse.

Conclusion

To a value investor, Netflix is a DVD business worth $20-$22 in an optimistic case of discounting future cash flows as the business runs off, a streaming business that has not proven that it can generate any profitability, and an international business that will create significant losses for at least two years with no guarantee of profitability in the future. To declare the company “cheap” simply because it has fallen 75% from its peak or because it is valued at $175 per subscriber is ludicrous. Based on a thorough analysis of the economics, and valuation of each of the business lines, no serious value investor could be convinced of any margin of safety with Netflix at $75 or above. The Value Investing Congress needs to have a recall vote of its chairman.

Disclosure: I am short NFLX.

Source: How A Real Value Investor Evaluates Netflix