I released an article yesterday concerning what I considered the "Devil in the Details" of Netflix's (NFLX) projections. However, it appears that Reed Hastings learned his lesson from last summer and decided to downplay projections this time around. Hastings and Co. beat their own expectations, but the profit slippages y/y was ignored under the guise of international expansion. Hastings played up the growth of streaming amidst the death of the DVD business, but as Erick Schonfeld points out in his recent article, NFLX is essentially transferring from a 52% margin business to a 10.9% margin business. Why the bulls are eating this transition up is beyond me. If I were a stockholder, I would be confused regarding NFLX's motivations to essentially abandon an extremely lucrative market.
The reasoning? DVDs are not sexy, they are not Cloud, they are not Web 2.0, they are old news… retail business. Retail prices around 10 P/E in this environment whereas online growth stocks are on fire-P/E ratios can soar out of control-Netflix was priced around 100 P/E less than 6 months ago. Hastings wants to pump the stock price, so he is abandoning the proven retail model in favor of a large multiple "growth" industry.
Stock Buyback Blunder
Several decisions bring Hastings' management and Wells' financial prowess into question. Primarily the buyback blunder- In November 2011, NFLX announced that they were raising an additional amount of capital through convertible bonds and stock offerings; however, their behavior throughout 2011 suggests that this need for funding was unexpected. Either the off-balance sheet liabilities were going to hit harder than expected, or international expansion was proving far more expensive.
Details are below, but in summary, NFLX essentially gave away a net 1.96M shares for free.
In addition, the terms of the convertible zero-coupon bonds allow for conversion of up to 2.33M shares at a price of $85.80 per share. Both of these deals increase net dilution by 4.29M shares y/y, while only contributing a net $200M in cash, essentially a net sale of $46.62/sh.
Q1-11, repurchased 502,000 shares @ $216.48 -- $108.7M
Q2-11, repurchased 216,000 shares @ $238 -- $51.4M
Q3-11, repurchased 182,000 shares @ $218 -- $39.7M
Q4-11, sold 2.86M shares @ $70 for $200M
International Black Hole
I believe that the primary reason for raising additional capital was to both absorb massive content costs in Q1-12 and to provide financing for international moves (the two are not mutually exclusive). While this is similar to what Hastings' has said, he downplays how close NFLX was to the brink on cashflow. After suspending buybacks, NFLX would have entered 2012 with only $110M in cash. With international losses in 1Q-12 pegged at $108-$118M, this alone would eat the cash, let alone additional content payments. Over the past six months, expenses have risen 19.5% while revenues have risen 11%, while this isn't horrible overall, it's not a healthy sign either.
Debt/Obligations vs Cash
At the end of FY2010, NFLX had a current assets/liabilities ratio of 0.92.
At the end of FY2011, NFLX has a current assets/liabilities ratio of 0.76.
Perhaps a better ratio would be quick ratio, which discounts inventory. Netflix's inventory is essentially worthless on market-value since they can't exactly auction off their contracts.
Quick ratio 2010: 0.90 // Quick ratio 2011: 0.65
Quick ratio 2011 without Debt/Equity Offering: 0.33
This points to the necessity of the recent financing. Also, the reported numbers are only current as of December 31, 2011, so they do not include the several UK/Ireland contracts that were inked in January. They also do not include further off-balance sheet liabilities (below Q3-11):
Unfortunately NFLX might not file their updated 10-Q until February (they filed Feb 18 last year), so even this outstanding debt is approximately 4 months outdated. Compare this to the offsheet liabilities of Q3-10:
To be fair, it appears that NFLX is including their "less than 1 year obligations" under content accounts payable in the most recent (Q4-11) shareholder letter. NFLX lists these at $925M, which does NOT include anything signed in January. If the 1-3 years are added in to long-term content liabilities, where they SHOULD belong, NFLX's total liabilities increase by 2.14B, although total long-term assets (intangible goods) could also increase by 2.14B until the contracts are amortized, this changes the aforementioned current assets/liabilities ratio to 0.40 or 0.31 disregarding the "necessary" equity/debt offering.
Please also keep in mind that the 2.14B of liabilities (1-3 years) is approximately 4 months outdated, the number is likely considerably higher by now.
To also be fair, Netflix is NOT going bankrupt anytime soon, but I would not be surprised if the combination of the international black hole and domestic competition from Hulu and Amazon (AMZN) knocks them out by mid-2013.
The Subscribers Game
Finally, let's examine Reed Hastings' (and Netflix PR's) final spin piece that enable NFLX to jump 15% after hours: the subscriber results (note: all data taken from Excel sheets on NFLX IR)
At the end of Q3-11 Netflix had 21.45M streaming subs, 13.93M DVD subs, 1.48M intl subs, for 25.27M total. Here's the rub: NFLX includes free subs in their numbers; Q3-11 actual was 23.82M (989k intl included).
Hastings' NFLX projections for Q4-11 (in Q3-11 letter) were purposefully vague. On subs, one can project that he means "total" (i.e. not free) but there's no clarification. Also, "total global unique" is NOT included. ONLY DVD total, streaming total, and intl total.
The US news is blasting that NFLX gained 220k streaming subs… let's see what REALLY happened: in Q3-11 NFLX had 20.51M PAID streaming subs while in Q4-11 NFLX had 20.15M PAID streaming subs. Wait a minute--- That's a LOSS of 360k PAID streamers in the US.
Meanwhile, the high margin DVD-unit dropped from 13.81M paid subs to 11.04M paid subs -That's a LOSS of 2.77M PAID DVD subs in the US.
The "big" international move that saw losses of $60M in Q4-11? Well, they added 458k subs… Not bad until you figure that's roughly an acquisition cost of $131/sub.
So - NFLX lost 2.77M DVD subs and 360K streaming subs in the US, but still managed to gain a net of 15k paid subs? How is that possible? I'll tell you how: 3.145M subscribers who used to be on a hybrid plan are now on a single plan. That's a revenue loss of 301M annually - revenue that NFLX will NEED to pay the upcoming contractual obligations.
The Spin Zone
Am I a bit biased, and perhaps sharing the negative sides? Sure. That's all part of the online analytical blogosphere. Similar to how several political analysts can watch a debate and come up with different stories.
I analyze companies based on inherent value… and Netflix looks like it is headed for the tubes. I just think it's time that investors stop taking Hastings and NFLX at face value and actually dive into the numbers a little bit.
If all financial analysts had a due diligence level that went beyond reading only the "Letter to Shareholders," I'd be surprised to see NFLX at 50% of its current market value.