Netflix: A Broken Company, Not Simply A Broken Stock

Nov.30.11 | About: Netflix, Inc. (NFLX)

When a company’s stock loses a large amount of value in a relatively short time, investors should always ask whether this is a case of a broken stock or that of a broken company. If a company’s stock suffers a setback for temporary reasons but its business model remains strong and its competitive advantages remain intact, we can consider it a (temporarily) broken stock and it usually makes for a good investment opportunity. However, if the causes for the stock’s decline can be found in a flawed business model, the loss of its competitive advantage, an overall shift in the company’s industry, or any other serious, long-term adverse effects, then we can generally refer to it as a broken company.

Investing in a broken stock can often lead to outsized returns for the patient investor who is able to wait for the company’s return to normal and the accompanying stock price correction. Investing in a broken company, however, is a surefire way to significant losses.

Where does Netflix belong?

For several years, Netflix (NASDAQ:NFLX) was a darling of the investment world. The company consistently showed stellar growth, its business model was as simple as it was genius, and its CEO Reed Hastings was hailed as a superstar who could do no wrong. The company’s shares traded around $20 in late 2008, doubled to about $40 by summer 2009, reached $100 in May 2010, touched $200 in November 2010, and then continued all the way to a peak of $300 in July of 2011. The company’s share price rose more than tenfold in the span of less than 3 years!

What many investors missed, however, was that while Netflix’s share price continued to rocket skyward, a major shift in the company’s industry was in full swing.

Netflix's early success was based on their very successful business model of renting DVDs via mail delivery. The business model was as simple as it was brilliant, and Netflix had the first-mover advantage. People did not want to drive to a physical store (i.e. Blockbuster (OTC:BLOAQ)), fill out a membership card, wait in line, or even find out that the movie they wanted to see was once again unavailable. Hence, they embraced the convenience of Netflix and Blockbuster eventually filed for chapter 11 bankruptcy.

The Netflix business model largely worked because the even more convenient way of renting a movie, instant streaming via the internet, was still not a viable option for most people due to limited broadband speeds. As long as it took hours to download a movie or streaming was only possible in lower quality and/or with frequent buffering throughout, renting DVDs through the mail with Netflix was by far the best option.

However, with the advent of ever-faster broadband connections, both at home and on the road (via 3G/4G/WiFi), the market underwent a drastic change in the past 2-3 years. Most consumers in the developed world and especially in the US, Netflix’s home market, now enjoy broadband speeds fast enough to allow instant and seamless streaming of movies. This means that all of a sudden the Netflix DVD model has been replaced by an even faster and more convenient option. Why wait a few days until your DVDs arrive in the mail when you can instantly stream a movie right now? Why worry about having to care for physical DVDs and eventually sending them back to Netflix when you can instead just click a button? Netflix’s original business model had been rendered largely irrelevant. It became a victim of the technology industry’s ever-faster replacement cycles.

“But,” you will say, “Netflix and its CEO Reed Hastings of course knew that this was coming and prepared the company for a shift into streaming video!” and you would be absolutely correct. But foreseeing and preparing does not always equal success. A coastal resident who sees a hurricane coming and battens down the hatches does not automatically guarantee that his home will survive the storm. If the house wasn’t built to withstand a hurricane, it may get destroyed no matter how much its owner has prepared.

Streaming Video – A Tough Industry

By doing a quick industry analysis, we can see that Netflix’s problems with the streaming business model are numerous. Netflix no longer enjoys a competitive advantage. Their way of streaming content into its customers’ homes is no different from any other company offering streaming service. Barriers of entry are relatively low, at least considering that most of Netflix’s current and potential competitors in this space are huge companies (Comcast (NASDAQ:CMCSA), Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), and the like) who can easily afford to pay for content and set up a streaming business targeting their already large customer bases.

Since everybody is essentially providing the same streaming content, substitutes are everywhere and Netflix is unable to differentiate its products from those of its competitors. Buyer power is high since customers are not locked into long-term contracts and can easily switch from one provider to the next based on better prices or content, both of which are completely transparent and easily accessible. Supplier power is also quite high since there is usually only one supplier for each movie or show, and this supplier (the studio/production company) can charge high prices as long as their product is in high demand.

To sum it all up, the streaming video industry is an extremely competitive landscape where Netflix enjoys no significant competitive advantage against its much bigger rivals.

CEO Reed Hastings - Superstar no more!

Back in the days when Netflix’s stock was skyrocketing, its founder and CEO Reed Hastings was often cited as a visionary leader who could do no wrong. While only a few months ago, those days seemed long gone. Recently, it seems, Netflix’s leadership has stumbled from one poor decision to the next, destroying confidence in the company and loads of shareholder value along the way.

In order to finance the push into streaming, along with overpaying heavily for streaming content, the company in July 2011 decided to raise prices of their traditional DVD-by-mail delivery by 60%. Needless to say, this sudden move did not exactly get a warm reception from its subscriber base and it seriously affected the company’s image in the public eye. In an instant, Netflix went from the cool, must-have company providing cheap DVD rentals to a despicable corporation trying to squeeze its existing customers in order to cash in on its recent successes. The stock responded by dropping back to the low $200s by mid-August.

It was a terrible move, but it proved to only be the start of a series of poor decisions that brought the company into the position it currently finds itself.

Shortly after the pricing fiasco, in September 2011, the company announced that it would split its DVD rental business from its streaming business and call the new division “Qwikster”. Customers who wanted streaming content but also DVDs in the mail now had to visit two different websites and manage two different user accounts in order to do so. To this day, I still cannot understand how such a poor decision was made. Not only did it throw away the Netflix brand value for half of its business, but it also caused major inconveniences to millions of customers and seriously impeded the user experience. After another major public outcry by Netflix users, the company decided to abandon the decision less than a month later. By then, investor confidence was badly tarnished and the stock had dropped to about $110.

As if to confirm the company’s poor decision making over the past few months, the company posted miserable third quarter results in October, including the loss of about 800,000 subscribers and a weak outlook for the coming quarters. The stock responded by dropping to $77 and has continued its downward trend from there. If you happened to have bought in near the peak, you had by now lost a horrific 74% of your investment.

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(Source: Yahoo! Finance)

I believe it is important to note that all of the above decisions were caused by Netflix’s perceived need to quickly move towards a streaming business model, regardless of the costs. The company felt that it had to move quickly and decisively into the streaming space in order to stay ahead of its competition. While this assessment is probably true, the company’s implementation of these moves was horrendous and clearly shows that Netflix’s management is not infallible.

The fact that there was huge insider selling going on throughout 2011 (Finviz currently shows a -43.46% change in insider ownership over the past 6 months) and the company’s CFO suddenly resigning in December 2010 also does not inspire trust in the company’s management.

Netflix Accounting Issues – Fraud or Desperation? Either way, it’s not good.

As if the difficult industry environment and poor management decisions were not enough, there are now also questions regarding Netflix’s accounting policies which have cropped up over the past few months. The complaints raised by various analysts generally focused on two specific areas:

Throughout its push into streaming content, Netflix has gradually prolonged the time period over which it amortizes costs related to content acquisition. This is done to defer costs into the future while artificially increasing the company’s earnings in the present. This led to an increasing divergence between reported earnings and actual cash flows, a trend that can often act as an indication that a company is using “fishy” accounting practices. If costs had been amortized at a more normalized rate, similar to the days when Netflix was primarily a DVD-by-mail business, its adjusted net income would actually have been negative starting in late 2010.

Another red flag about Netflix’s accounting was recently raised focusing on the way the company classifies its content acquisition expenses within its cash flow statement. As accurately pointed out in an excellent article by fellow contributor Shmulik Karpf here on November 13, 2011, Netflix records its massive content purchases as assets on the balance sheet, but fails to record the associated expenses as an operating cash expenditure under cash flow from operating activities. Instead, Netflix pushes these costs a bit further down on its cash flow statement and classifies them as cash flow from investing activities.

As Shmulik correctly pointed out,

This accounting decision does not correspond with the proper discretion that management is obligated to exercise: Investing activities refer to expenditures on such things as plant and equipment, and not on the purchase of standard inventory that is later sold to consumers.

However, there is an obvious (if dubious) reason for this decision by Netflix. Analysts tend to focus more on the top part of the cash flow statement (cash flow from operating activities), and less on the lower parts (investing & financing activities). By “hiding” these huge expenses ($1.34 bn in 2011) further down, Netflix artificially inflates its cash flow from operating activities and net cash position which are figures closely watched by most analysts. How bad is this inflation? A correct classification in the last quarterly report would have decreased Netflix’s net cash position by 40%. Quite significant if you ask me!

If we don’t want to go as far as accusing Netflix of purposely misleading investors with the help of creative accounting methods, we must at least acknowledge that the company is desperately trying to portray itself in a better financial position than reality might suggest. All of this has the distinct smell of a company that has experienced such rapid growth in the past that it simply cannot keep up with future expectations but is now desperately managing its books to at least give the impression of continued growth. These types of managed earnings in order to satisfy growth expectations can quickly lead to disaster. The name Enron certainly comes to mind, even if that comparison is still a bit far-fetched and I would certainly not accuse Netflix of actual accounting fraud at this time. What Netflix is doing can only be described as creative accounting – but that in itself should be a big red flag for investors.

You probably guessed it by now: Netflix is a broken company.

Considering all of the issues outlined above, I think it is safe to argue that Netflix by now is a broken company, not simply a broken stock. Its competitive position in the industry has been eroded, its image is tarnished, its leadership has not managed to properly reinvent the company and has even contributed to its downfall, and the company is resorting to creative accounting practices to desperately hang on to the image of success. As the industry is moving away from DVDs and towards streaming-only business models, Netflix will find it increasingly difficult to compete against its huge rivals, and, I am afraid, Netflix’s original business model will soon become obsolete.

Don’t get fooled by the perceived value of a $70 stock that was once a $300 stock. If the underlying business is broken, the current price may not signify a great value, but may instead only be a temporary stop on its way to oblivion. This worst-case scenario may not happen in the end, but it is worth remembering that tech companies frequently become obsolete and have very little tangible value, so there is no real “bottom price” and a stock can indeed fall to $0.

(In the spirit of full disclosure, I was long NFLX during part of this run up. I had bought at $31 and sold at $165.)

On a side note, I believe that the Netflix story will soon make for a great strategy case study in many business schools around the world!

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