I don't think I have to explain much with regard to my position on Netflix (NFLX). Not including this article, I have published 158 Seeking Alpha articles since February that include the ticker symbol. While not every article focused on Netflix, many did.
Even though the bear case came to be, I do think I should provide some color on my continued bearishness, particularly because I opened a "short" position by going long deep out-of-the-money NFLX June put options.
First of all, I cannot stress this enough - Forget about the price increase and the Qwikster still birth. Netflix CEO Reed Hastings wants investors - and consumers - to focus on these two things to ensure that they take their eye off of his company's endemic structural problems or never recognize them in the first place.
He can easily spin these two moves as temporary pain, however, he cannot distort the reality that Netflix is attempting to execute a business model that simply will not work. Fellow Seeking Alpha contributor Michael Verd approached this reality from an interesting angle:
I draw readers' attention to column 3 because I think it shows a relatively consistent level of performance over the last year. Of course, the most recent quarters have been affected by losses, as the quote from Hastings details, but generally Netflix achieved between 2 and 3 converts for each free subscriber over 2010. I assume that this is what he means when he says "our expectations are modeled from (the) prior year's performance."
Table 1: End-of-quarter paid and free subscribers and marketing conversion, 2010 to present
Source: Netflix 10Qs. Marketing conversion defined as Q-on-Q difference in paid subscribers divided by prior-quarter free subscribers. For example, 2.77 in Q2 2010 means that Neflix signed up 2.77 people for each free subscriber in Q1 2010.
Verd's excellent work helps support my thesis that Netflix was getting set to fall apart before Hastings made his two big mistakes. As the CEO's "virtuous cycle" turned vicious, he accelerated content spending and international expansion in an effort to sign up more subscribers because without more subscribers Netflix cannot possibly afford the additional content it needs to bring in more subscribers, which allows it to license more content ... so the story goes.
At this point, we all know that any mention of the "virtuous cycle" is not only moot, but comical. I am just explaining things using the perspective I think Hastings has always attempted to relay. Now he can explain away subscriber losses to the price increase and Qwikster debacles, but the numbers clearly indicate the trend was already in motion.
Just consider how net subscriber additions have been on the decline in terms of year-over-year growth since late last year:
Click to enlarge
Churn also was on the rise prior to the noise Hastings does not want you to ignore:
|Quarter Ending...||Netflix Churn Rate|
Because of the price increase/Qwikster issue the numbers look particularly bad between Q2 and Q3 2011, no doubt. All those two things did, however, was speed up what was already inevitable. And now, Reed Hastings attempts to use them as one part distraction, one part scapegoat.
Additionally, Netflix continues to bleed cash as it not only continues to spend on content, but as pending obligations come due. Compare the statements regarding liquidity the company made in its 10-Q for Q2 with the one just released for Q3.
Although we currently anticipate that cash flows from operations, together with our available funds, will continue to be sufficient to meet our cash needs for the foreseeable future, we may require or choose to obtain additional financing. Our ability to obtain additional financing will depend on, among other things, our development efforts, business plans, operating performance and the condition of the capital markets at the time we seek financing.
As a result of the significant increase in subscriber cancellations resulting in flat consolidated revenue, coupled with increased investments in our International segment, and in International content in particular, we expect consolidated net losses and negative operating cash flows in future periods. Although we currently anticipate that our available funds will be sufficient to meet our cash needs for the foreseeable future, we may require or choose to obtain additional financing. Our ability to obtain additional financing will depend on, among other things, our development efforts, business plans, operating performance, current and projected compliance with our debt covenants, and the condition of the capital markets at the time we seek financing. We may not be able to obtain such financing on terms acceptable to us or at all. If we raise additional funds through the issuance of equity, equity-linked or debt securities, those securities may have rights, preferences or privileges senior to the rights of our common stock, and our stockholders may experience dilution.
It really does not get much more ominous than that. I don't think it's a stretch to claim that Netflix will have to do something to raise cash going forward. In so many words, the company warns of this very real possibility.
I say this with a complete and total straight face, but I would not be shocked to see the SEC require the company to do the same thing it ordered Blockbuster (BLOAQ.PK) to do back in 2009. While the circumstances might not be the same, the message conveyed by something like this from the April 2009 Blockbuster filing is:
The obligation of the lenders to fund the $250 million amended credit facility is subject to the satisfaction of certain conditions, and there can be no assurances that these conditions will be satisfied. Even if the amended credit facility is funded upon the terms contemplated, we may not have sufficient liquidity to finance the ongoing obligations of our business, which raises substantial doubt about our ability to continue as a going concern.
I am not sure how anybody can justify a position other than total implosion in the not-so-long-term. I simply do not see a buyer stepping in to assume what adds up to an unknown amount of debt ($3.5 billion in off-balance sheet streaming content obligations is a good place to start) and a broken brand.
With this in mind, I have opened positions in deep out-of-the-money NFLX put options that expire in June 2012. You simply can't use the value argument here. Before long, this stock will no longer even sport a P/E ratio. In my view, you can chalk up the recent pop and stagnation in Netflix's stock price to short-term bounce traders and investors waiting for the other shoe to drop before they hammer Netflix one last time.
Disclosure: I am short NFLX.