Is Netflix On A Suicide Mission?

| About: Netflix, Inc. (NFLX)

Leave it to the great Erick Schonfeld of TechCrunch to sum things up so nicely in the Netflix (NASDAQ:NFLX) post-earnings aftermath:

If you break that down, each streaming subscriber is worth only $2.40 in profit each quarter to Netflix, compared to $17.32 for each DVD subscriber. The old business was very lucrative. The new business kind of sucks.

Throw that one in the hopper for both line of the year and at least somebody gets it awards.

I will get into the "that" which Schonfeld broke down, but first, take a deep breath if you're bearish. We've seen this all before. NFLX stock soars despite the reality that nothing has changed, in fact, things actually went from bad to worse for the company.

I waited a couple of days to post an article on this, simply because I like to let the dust settle. I had this article written, however, in my head after reading Netflix's Q4 letter to shareholders and listening to a replay of its conference call. So many red flags came out of both. What we have here is a momentum stock divorced from its underlying company's reality. And while I have been consistently bearish on NFLX, I have also urged caution because, no matter how "right" the bear case is, it doesn't take much effort to be "wrong" about the trajectory of the stock.

Each red flag I saw received immediate reinforcement after the call. Schonfeld touched on what might be the biggest:

While the streaming business is growing (adding 220 subscribers domestically in the quarter), and the DVD business is shrinking (it lost 2.76 million subscribers domestically), its margins are much worse than the legacy DVD business. The streaming business has an 11% profit margin, compared to a very healthy 52% margin for the DVD business.

Out of Netflix's total $847 million in revenues last quarter, $476 million came from streaming and $370 million came from DVD rentals (the remainder came from international). The streaming business also has twice as many subscribers: 21.7 million versus 11.2 million. But the DVD business contributed the vast majority of Netflix's profit: $194 million versus $52 million.

And investors ran the stock up because...?

What Schonfeld describes is akin to Apple (NASDAQ:AAPL) crushing its burgeoning Mac business because it views tablets as the future. Apple management exudes brilliance, while Reed Hastings continues to display an overconfident arrogance. Granted, he's a big picture thinker - and I love that - but that lofty lens can do grave damage to near-term decisions and business strategy.

If Apple lived in the black and white world that Hastings does, it would be stomping the life out of the Mac, just like Hastings is murdering his company's DVD business. I can't even begin to figure out why Hastings is doing this.

Simplistically speaking, we can equate the Mac at Apple to the DVD at Netflix and streaming at Netflix to iPad at Apple. This assumes that (A) tablet sales cannibalize computer sales to some extent at Apple and industry-wide just as streaming cannibalizes, even if it gets an assist from Hastings, DVDs at Netflix and (B) tablets will become the predominant computing method in the future just as streaming will become the leading delivery system for video entertainment.

The fly in the vaseline in this comparison is that Mac sales grew by 26% and iPad sales grew by 111% in Apple's last quarter. Neither DVD or streaming experienced such robust growth at Netflix, but, between the two, as Schonfeld points out, DVD dwarfs streaming in terms of profitability. So, why kill it? There's not a good answer.

Of course, the company talking point is that streaming is the future. Maybe it is. And tablets might be as well, but you do not see Apple killing the Macbook. By a similar - not the same - but a similar token, Netflix should not kill the DVD. If Apple did nothing to promote Mac sales, it would be little more than a mistake that dings revenue because Apple is stronger than ever. At Netflix, neglecting the DVD and placing almost sole focus on streaming amounts to little more than a suicide mission.

In Netflix's case, outside of more fundraising and perpetual unprofitable quarters, DVD profits actually dictate the future of streaming. Here's a company seemingly in an excellent position; it has a profitable business segment that's not ready to die that can responsibly subsidize the ultimate vision, yet it is killing it. It as misguided as Jerry causing relationship George to kill independent George. Use the DVD, like (NASDAQ:AMZN) uses its core profit-generators, to walk into the future from a position of strength, not a pathetic, cash-raising mess.

That said, streaming can never be as profitable - margin-wise or per subscriber - as DVD. The actual number varies depending on who you talk to, however, one thing is certain - it takes multiple streaming subscribers to replace one DVD customer. Hastings calls that analysis "well-intentioned," but flawed on the call, noting that there are less costs associated with servicing streaming subscribers versus DVD. Direct costs, such as postage and fulfillment maybe, but he's completely ignoring the enormous and exponentially growing digital licensing expenses that must exist to service streamers.

While it's much more difficult to attach direct costs, other than the "credit card fees" Hastings matter of factly cites, to a streaming subscriber than it is to connect postage to a DVD sub, you still must service these people with content. That matters more than anything. Please consider what Schonfeld wrote again:

Out of Netflix's total $847 million in revenues last quarter, $476 million came from streaming and $370 million came from DVD rentals (the remainder came from international). The streaming business also has twice as many subscribers: 21.7 million versus 11.2 million. But the DVD business contributed the vast majority of Netflix's profit: $194 million versus $52 million.

It's gotten to the point where I have to beg for a credible answer as to how the abrupt, forced and premature migration from DVD to streaming will result in anything even close to a workable, let alone profitable business model. Hastings gave anything but a credible answer on Wednesday's call. If he would take a few hours and several beers to punk-slap me with some sound reasoning, I would agree to stop writing about his company.

More color on the subscriber dynamics in a second, but what bothers me more than anything - and should bother investors just as much - is how this company openly contradicts itself over the span of six months and very few members of the media call them on it.

Here's what Netflix had to say about DVD in its Q2 shareholder letter from July:

In addition to separating the plans, we are setting up a dedicated DVD division, led by twelve-year Netflix veteran Andy Rendich, to focus on running a successful DVD by mail service in the U.S. for a long time. Andy and his team will be located nearby in San Jose, and are already planning some great improvements for the DVD service. Because we believe we can best generate profits and satisfaction by keeping DVD by mail as a division, we have no intention of selling it. In Q4, we'll also return to marketing our DVD by mail service, something we haven't done for many quarters. Our goal is to keep DVD as healthy as possible for as many years as possible.

In early December, here's what Hastings had to say:

DVD will do whatever it's going to do. We're not -- we're going to try to not hurt it, but we're not putting a lot of time and energy into doing anything particular around it ...

And then on Wednesday's Q4 call, I turn things over to the Twitter feed of AdAge's Jeanine Poggi, where I first heard the latest:

Think about this. In July, Hastings presumably promotes a "twelve-year Netflix veteran" to head up DVD with "some great improvements" planned. In December, Hastings flat blows DVD off. And then, on Wednesday, he says he has no intention of marketing the DVD segment, even though in July he noted that "In Q4, we'll also return to marketing our DVD by mail service ..." Q4 was a month ago.

Absolutely stunning. And there are people who are actually willing to put their money into this stock on the basis of confidence in its CEO and streaming as the future. Even Rolling Stone notices the contradiction.

In terms of the number the media latched onto post-earnings release - a gain of 220,000 streaming subscribers - fellow Seeking Alpha contributor J Mintzmyer nicely sums up that smoke and mirrors. Bottom line, paid domestic streaming subscribers dropped by 358,000 quarter-to-quarter, while free subs jumped by 581,000. You can dig into the numbers yourself in the above-linked Q4 letter to shareholders. But the "gain" came from a marketing and promotional blitz as well as retention efforts of epic proportion. All you need is a television (it does not even have to be "smart"), an email account and a Twitter feed or a handful of Facebook friends to have figured that out.

All of this said, you're crazy to short this thing. It represents everything that makes the stock market the worst, most corrupt, irrational and mind-boggling endeavor ever at the same time as it reflects so many of the reasons I absolutely love waking up every morning to follow the action. It would not shock me in the least to see NFLX move on air back to $300 a share before its next earnings report. At some point, however, the same thing that happened in 2011 - a full-on implosion - will take shape sooner, rather than later.

Disclosure: I am short NFLX.