Is It Possible That We Are Too Bearish On Netflix?

Jan. 4.12 | About: Netflix, Inc. (NFLX)

We all know that Netflix NFLX was one of the biggest disappointments of 2011. The company, on a great track for growth, shot itself in the foot when it raised prices. Customers left or downgraded plans, forcing the company to twice lower subscription numbers. Netflix was forced to halt stock buybacks and stop international expansion plans after the UK and Ireland. The company also announced it would be losing money starting in Q1 of 2012.

Netflix has fallen from nearly $305 to close Wednesday at $80.45. There was an 11% rally in the stock after more M&A chatter involving the company and customer usage rates. The company's customer satisfaction ratings have taken a beating, and the company has had additional flops in public relations, including the spinoff of its DVD business that was ultimately scrapped. There have been many bears that have come out against this name, and analysts even have price targets as low as $45 on the name. With all the calls for this name to never be profitable again, and for the stock to be at $0 eventually, I am beginning to wonder, are we too bearish on Netflix? Let's look at each side of the argument:

The Bear Side:

Netflix bears believe that the company, once it starts losing money in the first quarter of 2012, may never get back to profitability as they have lost too many subscribers and content costs increase. This camp believes that Netflix's business model cannot succeed. Here are their main points.

Eroding Customer Base:

This is what Netflix said when it released its second quarter earnings:

  • We expect 25 million total US subscriptions at the end of the third quarter. 10mil streaming, 3mil DVD only, 12mil both.
  • In Q4, the company expects strong US performance, a return to year over year subscription growth, and the possibility of our first Billion Dollar revenue quarter.

In September, the company warned regarding subscription guidance domestically. They lowered their estimates for the quarter to 9.8mil streaming, 2.2mil DVD, and 12mil both.

That equates to 21.8mil streaming and 14.2mil DVD. But that was too optimistic. When they reported third quarter numbers, they only had 21.45mil streaming and 13.93mil DVD.

Furthermore, they lowered guidance again for domestic subscriptions at the end of Q4:

  • 20.0 to 21.5mil streaming.
  • 10.3 to 11.3mil DVD.

The company did not realize how much the price hike would have on its customers. The company is realizing quickly that customers don't want and don't need to pay extra money to receive DVDs if they have the ability to stream. Netflix derives a large chunk of its profits from the DVD business, and given the potential for more subscription losses in this segment, the future does not look good.

Financial Results:

I said above that Netflix believed that they could have a billion dollar revenue quarter in Q4. That's not going to happen. When Netflix announced its third quarter results, the midpoint of its revenue guidance was $858 million, exactly where analyst estimates are currently. They were at $920 million before the Q3 report. Current expectations still would be a 44% year over year gain, but much less than the 68% gain they were hoping for two quarters ago. Netflix is currently expected to show 47% revenue growth in 2011, but 2012 growth is expected to be just 13.6%.

In terms of earnings per share, Netflix guided to a range of $0.36 to $0.70. Analysts at that time were at $1.09. They are now at $0.57. Since Netflix said it would lose money in Q1, analysts currently project a $0.24 loss, down from the $1.35 or so they were hoping for. For the full year in 2012, estimates have come down from about $6.50 to just 14 cents. They could be forecasting a loss if Netflix guides down again.

In terms of profitability for the international business, the company has said that it takes one to three years to become profitable for a country. They said Canada will be profitable in one year, a great success. The company is entering the UK and Ireland soon, and if it takes 3 years to be profitable, you are looking at 2014 or 2015. Does Netflix have that much time to wait?

Cash Flow:

Netflix believed it was in such financial strength in Q3 that it bought back nearly $40 million of stock at an average price of $218. The company then announced a halt of buybacks and further international expansion plans to save cash. They said that they had an adequate amount of cash on hand to run the business.

However, just a month ago, they entered a convertible debt deal to raise $400 million, an effort to "ease supplier concerns that they wouldn't be able to pay". If converted, the capital raise would equal a stock sale at $85. They shouldn't buy stock at $218 and sell at $85.


Netflix had a good partnership with Starz going, but the two were unable to come to an extension, which ends early in 2012. Thus, Netflix decided to trash Starz in their Q3 report, saying that Starz was only a small portion of their business, and that more than 90% of their viewing hours come from non-Starz content. Do I sense a little bitterness here? Of course I do.

In early December, Netflix provided an update at the UBS Media Conference. For a great overview, I'll defer to my colleague Rocco Pendola, who has a great summary on their update.

In June, CEO Reed Hastings said the following about HBO:

"HBO won't take our checks yet, because they're not big enough."

But when asked at the UBS conference about how many Netflix subscribers had HBO, he stated:

"The last time we checked was a couple years ago. It was about a third."

HBO isn't big enough, but potentially a third of subscribers also have it?

At the UBS conference, Hastings said that Time Warner's TWX HBO GO is their most prevalent competition. Netflix has continued to fight off the notion that Amazon's AMZN Prime is a legitimate competitor, and they've also said Hulu Plus is a complementary service, not a competitor. They've also batted down concerns that a new Verizon VZ service can compete, or that something like XFinity on Demand from Comcast CMCSA could take away market share. Netflix and Hastings have said that you need to spend hundreds of millions, perhaps billions on content just to compete with Netflix, and they believe that nobody can do that profitably right now.

What the company, and Hastings, fail to realize, is that all of these services are online or available on your TV. Netflix will be further forced to focus on its streaming business, not the DVD business that accounts for a large share of its profits. That in turn will bleed into the nearly 14 million DVD customers they had at the end of Q3, and however many less they will have at the end of Q4.

The Bull Case:

Netflix bulls believe the company has taken its beating, but that the bottom is coming. They will lose money in early 2012, but will make it up in the second half of the year. Domestic subscriber losses will level off and start rising again, and international growth will start to take off as they enter two new markets. Buying the stock at $72 is a great opportunity because it will be back at $200 in a year or two. Here are some main points of the bulls:

Netflix was extremely conservative with guidance after last quarter and will do better than expected.

Bulls believe that the company, which took guidance down a second time, were actually too negative on the guidance. Netflix was extremely bearish on the DVD guidance with a range of 10.3mil to 11.3mil, down from the 13.93mil at the end of Q3. Will they really lose roughly 25% in one quarter? It does seem unlikely to some.

Netflix has beaten analyst estimates in the past four quarters. In fact, despite missing on both the DVD and streaming subscription guidance in Q3, Netflix actually beat on both the top and bottom line. Netflix guided to a midpoint of $0.53, and analysts are currently at $0.57. However, Netflix has beaten by an average of 15.55% over the past four quarters, which currently would imply about $0.66.

The news out on Wednesday about Netflix usage data was extremely positive. The question is, are current customers streaming more, or are they actually holding onto more subscribers than we thought? Bulls would tell you they are, while bears say the rally was too much and you should keep shorting.

International Subscription Growth is just starting to take off.

While the international business is losing money at the moment, it is early in its growth. At the beginning of 2011, Netflix had just half a million international subscribers. At the end of Q3, they were up to about 1.5 million. They forecasted 1.6 million to 2.0 million at the end of Q4, but that number could easily be beat. Looking forward, expansion into the UK and Ireland will add new markets. Netflix could easily double or triple their international subscriber base in 2012.

Expectations are not coming down anymore currently.

This is a strange point, but true in some respects. However, it could easily be destroyed by the next bull point. In the past 30 days, analyst expectations for Q4 2011 and Q1 2012 have stayed the same. There have not been any more downward revisions. In fact, estimates for the full year 2011 have increased by 2 cents over that time.

Netflix could have a huge loss in Q1 or Q2 but recover afterwards.

Netflix might just be able to pull this off. The company said that it would lose money early in 2012 as they expand into the UK and Ireland. Current estimates call for a loss of 24 cents. For the year, analysts are expecting a gain of 14 cents, meaning that they will make up 38 cents after Q1.

I think Netflix could try to throw all its losses into Q1, a "one-time" issue, then return to nice profits in Q2 and beyond. It certainly is an interesting strategy. Could the company lose $2, $3, even $4 in the first quarter? It's possible. The question is can they make it up the rest of the year? Bulls say yes.

This type of strategy could lead to a huge downward revision when they report Q4, and would certainly send the stock much lower. If they can throw all of their losses into one quarter and return to profitability afterwards, wouldn't it make the perfect buying opportunity?

Conclusion/My Opinion:

Before I get into my personal take, I must disclose that in my theoretical short portfolio I maintain on this site, I am short Netflix.

That being said, what is my view of Netflix? I'm glad you asked.

Netflix right now is in poor shape, and that comes from a lack of strategy and management oversight. Netflix has failed its shareholders and been a flop in the press. Just in 2011 alone, they've said that they would have a dedicated leader/team to focus on the DVD business, planned a spinoff then took it back, then said at the UBS conference that "DVD will do what it does". Netflix also did not take its price hike seriously, and did not see the effects it would have on their customers. The stock buyback/sale issue shows that tremendously. They also have a high view of themselves, saying that nobody can compete with them and shrugging off anyone that's a potential contender. I've said that Netflix has to fix its management before it can fix its business, which is why one of my 2012 predictions was that CEO Reed Hastings will not have his position at the end of the year.

So what do I see happening going forward? Well, if Netflix does do the nightmare scenario, coming out and just destroying Q1, the stock will tank after earnings. Netflix's DVD business will continue to lose customers, and given the profitability of that segment, the company cannot succeed financially based off of a streaming only business. Netflix should have raised streaming plans to $9.99, and maybe put a combo plan at say $11.99 or so, to keep some of the DVD customers. Netflix has the potential for international subscriber growth, but as they've noted, profitability remains several quarters away.

As for the stock, I see the potential for a bottom in 2012 if the company fixes its flaws. They could easily see a return to subscriber growth later in the year, and international growth could help. A return to profitability is not out of the question. As for a buyout, we've heard rumors that someone like an Apple AAPL or Google GOOG has the financial position to do so, but I don't see it currently. Ask me again if the stock is at $25 and I might have another opinion.

Netflix was a big disappointment in 2011 and certainly has flaws. It could certainly be dead money. It could also make a tremendous comeback. Netflix has the potential to do great things in the future, but what's great now may only be about half of what would have been considered great 6 months ago. Companies sometimes fail because their business environment is too challenging while others like Netflix fail when they shoot themselves in the foot. Netflix has the ability for a dramatic comeback, but I think there's more pain to be had first. Wednesday's huge rally gives shorts new ammunition, and while we might see another day or two of gains, this name should be back to $75 within no time.

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