As Netflix (NFLX) soared to over $300 per share, I kept tabs on Wedbush analyst Michael Pachter's reports on the stock. Over the years, Pachter has been right about Netflix more often than he's been wrong. But, more importantly, he provides the type of clear-headed analysis you just don't get from the parade of bulls who got it all wrong.
As the dust settles around Netflix's disastrous Q3 report, I think it proves instructive to see what Pachter said shortly after the latest implosion. In a report where he called Netflix A Riddle Wrapped Up In An Enigma, Pachter wrote the following:
Investors have come to rely upon company management to deliver sustainable subscriber growth while delivering consistently higher earnings, with earnings growth of 25% or more having been the norm for the last several years ...
While Netflix will once again likely grow earnings in 2011, company management has made the affirmative decision to forego earnings for “a few quarters” in 2012 while the company aggressively invests in International expansion. This strategy is at odds with the company’s previously stated strategy of growing earnings first, and investing “excess” earnings in its expansion ...
We view yesterday’s announcement as an act of desperation. Netflix management appears frenzied to grow at all costs, and the company’s shares dropped precipitously from already low levels, as investors in the after-market voted by selling. We are at a loss to explain the company’s zeal to expand without regard to profitability, especially when the decision is at odds with the company’s “winning” formula of the last few years. It appears that Netflix management is in a race with itself to establish global dominance, apparently believing that a much larger, if unprofitable company has greater value. We disagree. In our view, Netflix attained its lofty share price earlier this year because investors viewed the company’s phenomenal subscriber growth as a proxy for the phenomenal earnings growth that they thought was certain to follow ...
As usual, Pachter cogently sets the scene. As NFLX wages a near-term battle with $90, it's important to put things in perspective and consider the magnitude of what has happened here.
This company is about to lose money. The one reason why investors tagged it with such a lofty premium is because it always put profits first. Now, as Pachter discusses, the company intends to do the opposite by sacrificing profits in favor of international expansion and content spending that cloaks the future in uncertainty.
As I watch the stock refuse to break support around $90, I can't help but wonder when one of the next several shoes will drop. Netflix does not report Q4 earnings until the end of January. I have no confidence whatsoever in management's subscriber forecast for the quarter. In fact, I fully expect that the company will need to issue downside or upside subscriber guidance before the end of the year, much like it did ahead of Q3.
That could be shoe number one. Shoe number two comes with the Q4 report. Any ounce of positive news with either event could send the stock back toward and possibly past $100. Given the number of defenders who have come out of the woodwork at this stage, I would not be surprised by any level of upside the stock shows, no matter how big.
The color Netflix provides for 2012, however, holds the key to the company's future. So far, management has only told us that it expects Netflix to lose money beginning in Q1 2012. The size of that loss and how long the company expects to be in the red will dictate how much lower the stock goes.
Remember this -- off-balance sheet obligations related to streaming content acquisition grew by about $1 billion between Q2 and Q3. As Netflix continues to spruce up the bottom lines of companies like CBS (CBS) and sign more content deals, expect that number to continue to grow exponentially. Save a handful of bears, it's pretty much been left unsaid that even if management never erred, Netflix never stood a chance of covering those costs while maintaining profitability on the back of even solid domestic subscriber growth.
As such, the focus now shifts to international subscriber growth. Like Pachter explains, Netflix, having abandoned profitability, now puts all of its eggs in one basket - it desperately needs unprecedented success internationally to survive. (And, in the words of Jerry Seinfeld, "There's no precedent, baby!").
For Q4, the company only expects to grow its international base by between 120,000 and 520,000 subscribers. If it hits the top end of that range that's a paltry 1.96% increase in international net additions between Q3 and Q4. Of course, if it comes in anywhere below the high point of its guidance, it will actually show a percentage decrease in net additions between quarters. From Q2 to Q3, international net additions increased by 52.6%. Talk about a soft launch.
Clearly, Netflix expects Latin America and U.K./Ireland to do better than Canada. But it does not expect considerable adoption to happen in the early stages of this expansion. The notion that Canada has been a success is little more than wishful thinking. Up until last quarter, Netflix saw international net additions decline in the periods Q4 2010 to Q1 2011 and Q1 2011 to Q2 2011.* If Netflix's new international markets follow the same trajectory as Canada, the experiment does not stand a chance.
Just as I asked you to do the math several times throughout April, May and June with regard to Netflix's rising content costs, I ask you to do the math here in relation to international growth. Simply put, Netflix can do nothing less than take Latin America, the U.K. and Ireland by storm if it expects to turn the predicted, but still-to-be-determined 2012 losses into meaningful 2013 profits. Yet again, the numbers just do not add up.
I predicted that Netflix would lower guidance and eventually report EPS losses back in July:
If Netflix does not miss this quarter, I believe it will report EPS to the low end of its range. I fully expect an earnings miss - or further significant downside guidance - over the next several quarters (emphasis added).
And now, put me down for another prediction. Netflix will pull out of one or more international markets by the end of 2012 as it struggles to avoid insolvency and remain a going concern.