The New Netflix: Do You Believe In Smoke And Mirrors?
Shares of Netflix (NFLX) rose sharply on Thursday after its earnings report on Wednesday afternoon, sending shares back to their pre-Q3 earnings levels and well off their 52-week low of $62.37. Netflix's stock has been off to the races, with most of the gains coming in the new year. After the report, it seemed that most people were jumping for joy and celebrated Netflix being back from the dead. I wrote recently about why Netflix's report was not as rosy as it seemed, but today, I am here to question the company going forward.
Everyone now says Netflix is back from the dead. This couldn't be more false. Netflix is not back from the dead, because it never was dead to start. We are just dealing with a much different company than we were a handful of months ago. Netflix didn't die and come back. This is just a new version of the company. I'm welcoming you to the New Netflix, and I ask if you believe in the smoke and mirrors. Here's why.
The New, low-margin business:
Netflix is apparently trying to emulate Amazon (AMZN), a company it may find as a legit contender going forward, whether or not it believes it is a true competitor. Just look at Amazon's net margins over some periods in time.
Amazon's net margins have declined over time, instead relying on sales growth to boost net income. Is this a winning strategy? Well, Netflix is going to find out. Now look at Netflix's margins. As a point of reference, in calendar Q4 of 2011, Apple (AAPL) had gross margins of 44.68%, while operating margins were at 37.42% and net margins were 28.20%. Netflix will never see those numbers.
|Margins||3Q 2010||4Q 2010||1Q 2011||2Q 2011||3Q 2011||4Q 2011|
Netflix is going to a low-margin business, and we know that at least in Q1 and for a couple of quarters, net margins will be negative. Netflix is going to lose money. For the full year, Netflix's net margin declined from 7.44% in 2010 to 7.23%. It might not seem like much, but that number will be negative for the full year in 2012 if things happen as expected. So why are shares up so much? Good question.
Now there have been some articles on this site that touched on my next point, but it is clearly worth mentioning here too. Netflix streaming customers provide $2.40 per subscriber of contribution margin, while DVD customers provide $17.37. In Q1, using the midpoints given, streaming customers will provide $2.45, and DVD users $15.10. Netflix is focusing on a much smaller margin segment, and if the DVD business goes away, where will the profits come from?
Netflix already lost 2.76 million DVD subscriptions in Q4 of 2011. If they lose only 3 million more in 2012, a conservative number based on the 1.5 million they expect to lose in Q1 alone, they would need to add 15-20 million streaming subscribers to make up for the lost contribution margin. That's 60-80% growth, and it isn't happening this year.
Share Buybacks and Count:
The following is a quote from Netflix's 2010 2nd quarter earnings results and management commentary:
We continued to repurchase Netflix shares in the second quarter, even at record high prices.
In the first three quarters of 2011, Netflix bought back 900,000 shares for $200 million. In Q4, they went out and raised money, $400 million. $200 million of that was through equity, selling 2.86 million shares at $70 each. So that has a zero impact on cash and cash flow, yet nearly 2 million additional shares added to the balance. Great work, folks.
In addition, the second $200 million came from a zero coupon convertible debt offering. That debt is convertible at about $85.80 per share, meaning another 2.33 million shares could be added to the balance, as early as mid-2012 (starting late May it looks like, depending on when the deal actually closed).
Also, executives had more than 2.6 million shares available on option grants at the end of the 3rd quarter, with an average price of $65 roughly. That's even more shares to add to the pile.
Netflix is not buying back stock currently, and probably won't for the indefinite future. So its share count, which was under 54 million at the end of Q3, could easily rise over 60 million in 2012, and that's if they don't need any more funds.
That $400 million they raised at near rock-bottom prices, Netflix just said "we have no intentions on using it, it's just a safety net". Great, that makes me feel so much better.
The following table shows some key balance sheet data at the end of Q3, what it would look like after the $400 million raise, and how it ended up looking at the end of Q4.
|Financials||End Q3||Cap Raise||End Q4|
While the numbers get better from Q3 to Q4, they actually are getting weaker internally. It's great that the money is there, but if it is just going to sit there, it won't do any good.
Oh, and remember I was talking about the second $200 million. Once it gets converted, the liabilities to assets ratio will cosmically improve because $200 million will shift from liabilities to equities. However, they are zero coupon notes, so it won't help reduce interest costs or anything. It will just increase the share count and make things appear better than they really are. Yes, the company's current ratio, working capital, and debt ratio improved from Q3 to Q4, but only because of the money raised. Are they going to do that every single quarter?
Reporting Consistency and Transparency:
These are the past six quarterly releases of Netflix's earnings:
- 2010 Q3 Earnings Release and Management Commentary.
- 2010 Q4 Letter to Shareholders and Financial Results.
- 2011 Q1 Letter to Shareholders.
- 2011 Q2 Letter to Shareholders.
- 2011 Q3 Letter to Shareholders.
- 2011 Q4 Letter to Shareholders.
Why do I share all of these? Because Netflix changes its reporting every quarter, which makes it hard to compare actual results from one time period to another without doing some serious work. Now, I know Netflix is a growing and evolving company, but this is how they've changed things just in the last six quarters.
- 2010 Q3 earnings release and management commentary were in separate parts.
- 2010 Q4 earnings release combined into one statement. Company now reports Operating Income and Net Subscriber Additions as headline numbers.
- 2011 Q1 earnings release now contains new sections for international data and segment reporting.
- 2011 Q2 earnings release now contains new headline category for contribution profit.
- 2011 Q3 earnings release now contains new headline category splitting DVD and streaming subscriber total numbers.
- 2011 Q4 earnings release now splits DVD and streaming business, reporting each segment's financial data in own segment, but does not provide any financial data for segments prior to Q4. Operating income no longer reported as headline number.
Also in Q4, company announces that all guidance going forward will contain numbers for paid subscribers per segment and total subscribers. Also, going forward, company will not report gross additions, churn, or SAC numbers.
Some may argue that Netflix was doing better here because they were giving more information. However, I will take the opposite side. Netflix is giving different information each quarter, which makes it hard to compare their results to prior periods, especially when they don't give numbers for prior periods. Also, going forward, they will not provide some key numbers they have always given, including gross additions and churn, two very important numbers that investors watch.
How will Netflix report its quarter three months from now? I have no idea, but I do know this, it won't look the same as this quarter's, or last quarter's, or any of the quarters' before that. Some consistency in reporting would be nice.
I've read a bunch of material on Netflix, both on Seeking Alpha and plenty of other sites. I also have gone through the above mentioned earnings reports and management commentaries. Did anyone ever mention that Netflix is under investigation by the IRS and the state of California regarding its taxes? The IRS is currently looking at 2008 and 2009 returns, with 2010 subject to examination. The State of California is looking at 2006 and 2007, with 1997 to 2005 and 2008 to 2010 subject to examination.
Why do I mention this? Look at the following statement found in their 10-Q filed after the 3rd quarter.
Our effective tax rate for the three months ended September 30, 2011 as compared to the three months ended June 30, 2011 was primarily attributable to the expiration of a statute of limitations for years 1997 through 2007, resulting in a discrete benefit of $3.5 million.
So because the statute of limitations expired, Netflix had a $3.5 million gain in the third quarter. That ended up being 5.6% of net profits. Maybe they should add this as a headline number to their quarterly reports. It seems important to me.
Why do I mention taxes? Well, because of their heavy operations in the US currently, Netflix is paying a very high tax rate. They only paid 33.3% in the third , thanks to the above mentioned quarter, but were at 38% in the 2nd and 4th quarters, and have been above 40% in prior periods. Apple is paying like 24-25%. Netflix is paying close to 40%. That makes a huge difference on the bottom line.
I've never heard anyone mention tax investigations when it comes to Netflix, but it seems rather important. If the company is forced to pay fines, that's even more money that they don't have. Just an extra $4 million in taxes or fines in the 4th quarter would have wiped out 10% of profits.
Success Will Lead to Failure:
There are two things Netflix cannot do in 2012. It cannot have a terrible year, and it cannot have a great year. I think the former speaks for itself, but let's examine the latter. If Netflix does have success moving to a streaming only business model, it will set itself up for tons of competition moving forward. Amazon already has pieces competing in the US and UK, and we know that Time Warner's (TWC) HBO Go is the main competitor currently, according to Netflix. We've also heard rumors that Verizon (VZ) might try to enter the space, and Comcast's (CMCSA) XFinity on Demand could be expanded. Of course, Apple could also enter the mix, but I think the low-margin aspect might prevent them from doing so. Netflix cannot win a war with these heavyweights.
If Netflix does too well, content providers online will jack up their content costs even further, and new competitors will emerge. Netflix needs to have a good year in 2012, but that's it. A bad year will definitely destroy them, but a great year could do so as well.
The Analysts' Take:
Let's just say analysts have changed their minds in a hurry. On Thursday morning, the average price target for Netflix was $82 and the median was $80. On Sunday morning, the average was above $102 and the median was $107.50. Everyone that was quickly to throw the company away is now back on the bandwagon. However, I must caution you that analysts right now think Netflix can only make $2.59 in 2013. What does that mean? Well, even given 62 million shares, which may be too high an estimate at this moment, that only implies a profit margin of 3.8% for the company. Even in the disappointing 2011 year, the company managed net profit margins of 7.22%. That tells you how much this streaming business is going to hurt.
My Take and Conclusion:
Everyone is back on the bandwagon after what wasn't really a great report, and that may send shares back to $150 or $175 or maybe even $200. I don't think people realize how much trouble this company is in. Their balance sheet is getting worse, unless they raise new capital every quarter. Margins are going down, and content costs are shooting higher. Oh, and at the end of Q3, they had over $3 billion in off-balance sheet liabilities that were coming due in the next few years, mostly relating to content costs.
Good luck paying those bills. I don't think people realize that this business model cannot sustain itself in the long term, and we'll need another report like the Q3 one for that to occur. I wouldn't call this a short currently because of the irrationality that exists in this marketplace, but it is a short idea candidate. There will be a time when the bubble will burst again, and it is coming soon. Netflix cannot survive in this way forever.