With all the Amazon-Netflix chatter I thought I'd explain why AMZN would be really stupid if they bought NFLX. I'd title my piece "Has Bezos been spending too much time in his rocket depriving his brain of much needed oxygen?"
At the current price ($24.8) Netflix has a $1.76 billion valuation. The mid-range of their EPS guidance is $.80, so with 71 million shares outstanding that equates to GAAP net income of $56.8 million. Add back the taxes paid at a 40% rate and you have pretax of $94.7 million. Now add back pretax stock based comp of $11.2 million and depreciation of $18.4 million and you get EBITD of $124.3, so the multiple to 2007 cash flow is currently 14.2 times.
The Bulls point out that Internet companies are worth 15 times cash flow. Yahoo (NASDAQ:YHOO) trades at 14.7 times cash flow. But Yahoo has true Internet margins, with Net margins (when stock based comp is added back) of over 11% versus Netflix's 5%. Why would anyone pay the same multiple for less than half the net income?
But if Amazon owns them they can cut back on the marketing budget the Bulls say? They are already doing that hard to get to the 2007 numbers. Each of the last two quarters of the year, NFLX is projecting net earnings of $.22 which is 57% above the recently reported Q1 of $.14. This despite a headwind of $.03 per quarter in increased postal expense due to the postal rate increase of $.02 on May 14th. That means pre-tax earnings will need to grow $13 million each quarter. With NFLX already fine tuned, the only place for that to come is from marketing. In Q1 NFLX spent $72 million on marketing. That should drop to $60 million each of the last two quarters to get to the projected EPS.
There is a serious disconnect between the EPS guidance for the last half of the year and the subscriber guidance. As I just showed, marketing spend should be down dramatically, but somehow subscribers are expected to grow by 750,000 during the last two quarters. The real wild card here is the June quarter we are currently in.
During the June quarter, NFLX projects EPS of $.21 with zero subscriber growth and with 1/2 quarter of the postal increase. That implies that EPS will improve $.085 from Q1. At 71 million shares and a tax rate of 40%, pretax will need to grow $10 million. If all of that came out of marketing and the subscriber acquisition cost was the same as in Q1, that would mean that gross subscriber additions would be 1.3 million and subscriber losses an equal 1.3 million.
So their marketing spend of $62 million in Q2 yields no net additions, but spending only $60 million each of the last two quarters generates 375,000 net additions each quarter. That makes no sense.
Q2 will be a disaster either in terms of SAC or churn. If the company signs up and loses the 1.3 million customers, the churn rockets to 5.4% from 4.4% in Q1. Conversely, if the company only signs up and loses 1 million subscribers, the SAC skyrockets to $60 from $47.5 in Q1. Either metric should raise serious questions about the sustainability of NFLX model.
But the real wild card is Blockbuster (BBI), because according to NFLX management, all of their recent problems have been caused by their pricing a product below their costs. (Ironically, the $4.99 plan at NFLX loses money when one considers the cost of acquiring subscribers.) How many successful companies have their fortunes dependent on their competitors actions? What if BBI doesn't raise prices? What if BBI raises the Total Access price (with store visits) but lowers Internet only prices?
The other huge issue to AMZN would be the tax ramifications to their customers. Amazon currently only charges sales tax in 4 states where they have a physical presence. The total population of those 4 states is less than 14 million. Buying NFLX would increase the number of potential customers who would need to pay taxes by over 270 million people! Of course they could close a ton of distribution centers, but the famous NFLX service isn't so attractive when customers need to wait an extra day or two to get their DVD's. That just makes the Blockbuster Total Access plan that much more attractive.