Netflix: Post-Earnings Questions Answered

|
 |  About: Netflix, Inc. (NFLX)
by: Bill Maurer

Last week, we got first quarter results from Netflix (NASDAQ:NFLX). Overall, the first quarter was decent, but Q2 subscriber numbers were less than most were hoping for. That sent shares lower, and they have continued downwards since then. Since the earnings report and conference call, some additional information has come out, including the company's 10-Q filing.

Also, in my post-earnings analysis, I mentioned that Netflix had answered my question on their conference call. However, after reading over their answer again, I still was not sure what they meant, so I e-mailed the company for further clarification, and did get a response. So today, I'm going to break down some information from the 10-Q, and cover additional information I have received from the company since.

First, I had sent in a question for their conference call regarding the convertible debt deal the company entered late last year. The $200 million in money raised was convertible at approximately $85.80, so I asked them about the deal and if they expected the conversion to occur during Q2. Given that this conversion would add an additional 2.33 million estimated shares to the outstanding count, I felt it was quite important to ask about, regarding further dilution. I received the following answer during the call.

Yes. So the first convertible, 6 months after its issuance which was November, which places us in May, the company has the option of converting those shares at 30% over the conversion price, which is about $111. And the earliest we could do that would be July if the stocks had stayed above that price for 50 of the prior 65 trading days.

The last sentence bugged me, since I wasn't sure what "price" they were referring to. I e-mailed their investor relations folks, and they got back to me within half an hour. That spurred another question, and they responded the next business day. Their investor relations people were very prompt and friendly, and even apologized for the confusing answer on the call. So here is how the deal breaks down, and there are a few pieces:

First, the initial conversion rate is 11.6553 shares per $1,000 of bonds, implying a conversion price of $85.80. Holders of the bonds can convert at any time prior to the closing of the last business day before maturity. It appears that holders can convert at any time, although initially the wording in the deal made it seem like holders needed to wait 6 months.

Either way, since $200 million of convertible debt was on the balance sheet at the end of the quarter, nobody has converted yet. Now, these are zero-coupon notes, so holders are not receiving interest, and with the latest fall in the stock, shares are below the conversion price, so conversion seems unlikely for now.

Now, there are two ways Netflix can force a conversion of the bonds. The first method can occur after the six month anniversary of the closing of the deal, which occurs sometime in late May. If after that date, Netflix shares trade at a 30% premium to the conversion price for a period of 50 out of 65 trading days, Netflix can convert the bonds. It would be July at the absolute earliest. That means Netflix would have to trade above the $111 or so for at least 10 full trading weeks out of 13, which right now, doesn't seem like it will happen anytime soon.

The second way the notes are converted is if the following occurs:

Upon the occurrence of a change of control, as defined in the Indenture, each holder of the Notes will have the right to require the Company to repurchase some or all of such holder's Notes at a purchase price in cash equal to 120% of the principal amount thereof.

So if a change of control in the company takes place, holders can force a conversion at 120% of the principal amount. There are also other clauses that could speed up the maturity of the notes. There are a number of them, so if you want to see every exact detail, click on the convertible debt deal link I provided above. Right now, it appears that conversion of the bonds is unlikely, until the stock gets above $85.80. Once that occurs, shareholders could face further dilution.

Now onto the 10-Q report. First, something I've heard discussed recently. A few investors and traders have expressed concern over Netflix's cash and equivalents pile on the balance sheen declining from $508 million to $396 million. Netflix has been known for poor cash flow, so this seems like a concern on the face of it. However, their short-term investments account increased from $290 million to $408 million. If you combine the two, the decrease is only about $7 million, or about a 1% decline. They just moved some of their cash into short-term investments. It is not a big deal.

One of the biggest questions investors always have is in regards to Netflix's off-balance sheet obligations. Because some of Netflix's assets do meet certain criteria, Netflix cannot put these assets on the balance sheet, and thus, the liabilities associated with them cannot go on the balance sheet. As such, Netflix has always had a huge amount of obligations related to streaming content not reflected on the balance sheet. In Q1, some of those were transferred to the balance sheet, so the value of off-balance sheet streaming content obligations actually declined to under $3.7 billion, as seen below.

Streaming Content Obligations 12/31/2011 3/31/2012
Less Than One year $797,649 $729,628
One to Three Years $2,384,373 $2,374,734
Three to Five Years $650,480 $505,553
More Than Five Years $74,696 $74,155
Total $3,907,198 $3,684,070
Click to enlarge

Those aren't the only obligations Netflix has due in the future, but streaming content obligations are approximately 80% of their total obligations, and they don't appear on the balance sheet. Netflix's other obligations include things like the convertible debt, long-term debt, and lease obligations from their headquarters (building lease). Mostly thanks to the decline in streaming obligations during Q1, Netflix's total obligations declined from $4.751 billion at the end of 2011 to $4.528 billion at the end of the first quarter.

So what else has changed since the earnings came out? Well, thanks to Netflix's first quarter beat on earnings per share, analysts have increased their estimates for Netflix. Estimates for Q2 have risen from a loss of 18 cents to a three cent profit. For Q3, analysts are now expecting an 11 cent profit, compared to a two cent loss prior. For the full year 2012, analysts are now expecting an 8 cent profit from Netflix. The prior forecast was for a 28 cent loss.

Netflix looks like it should make money this year, unless it decides to enter a new market in Q4, which probably would then result in another loss. The average analyst has a "hold" recommendation on Netflix shares, with the average price target at $93. Netflix is trading at 37 times expected 2013 earnings, which seems a bit steep for a company with revenue growth in the mid teens, percentage wise, and razor thin profit margins.

So what should investors do? Well, I think this is still a good long-term short candidate. Netflix killed off their DVD unit and that is completely changing the face of this company. Going to a streaming business model will result in lower margins in the future, and Netflix has not been able to prove it can keep costs in check. Current earnings per share for 2013 are estimated to be half of what they were in 2011. Also, Netflix does not have enough financial flexibility to buy back stock (which it was doing well above $200 last year), which means further share dilution from executive options. Oh, and don't forget the 2.33 million shares of further dilution from the convertible bonds.

If Netflix trades above $86 roughly, holders of the bonds may wish to convert. Netflix could also convert at some point, but that would require the stock to be at a much higher level, and a conversion by Netflix could cost them an extra 20% or 30% of par, meaning another $40 or $60 million. The notes don't mature until 2018, so I figure the holders will either convert, or Netflix will just pay them back when they mature. I don't see a reason for the company to force a conversion and spend the extra money.

Netflix has fallen about $20 since earnings, so it might not be the best idea to short at current levels. You may want to wait for the next pop higher. After Netflix's decent Q1, any fears of the firm going out of business this year have been calmed, so don't expect this to go to $0 anytime soon. The company still has enough customers to get by for a while, but I don't see the stock back at $200 or $300 anytime soon.

While this is a good short candidate, you have to pay close attention to it, and if you end up with a quick gain of a few dollars, you might just want to take your profits and look elsewhere.

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