Netflix: Game Over

| About: Netflix, Inc. (NFLX)

On April 1, I published an article which advised investors to take short positions in Netflix (NASDAQ:NFLX). The rationale was straight forward: the company was phasing out their high margin DVD-by mail service in favor of their very low margin streaming business. This move (combined with an ill-timed international expansion) was leading the company to the poorhouse -- Netflix's went from earning .73 cents per share in Q4 2011 to losing .08 cents pre share in Q1 2012. The entrance of deep pocketed rivals into the market for streaming content was driving up prices on content licenses which in turn left Netflix to choose between paying higher prices to studios (thereby driving down already paper thin streaming margins) or losing access to quality content. Of course neither of those choices are particularly desirable. Since that article was published shares of Netflix have fallen around 50%.

Although there are surely arguments to be made about obsolescence of the physical DVD and positioning for the future, I prefer to take the admittedly simplistic view that technology companies are no different from any other company regarding their obligation to stockholders and employees to strive at all times to maximize profitability. From this perspective, it is difficult to imagine a worse business decision than that made by Netflix when they decided to phase out their high margin DVD-by mail service in favor of expanding their low margin (or, in the case of the last two quarters, 'no' margin) streaming business.

Note that in Q1, the DVD-by mail segment made up only 38.6% of the company's domestic revenues but accounted for 68.7% of domestic profit. Put more simply, the profit margin on the DVD-by mail segment was 45.7% in Q1 and 45.8% in Q2. By contrast, the profit margin on the domestic streaming segment was 13% in Q1 and 15.6% in Q2. In typical Netflix fashion, the company managed to completely offset the 200-plus basis point gain in domestic streaming margins by racking-up nearly $90 million in international streaming losses resulting in a net loss for the streaming segment of around $6.2 million during the second quarter.

Perhaps the most disconcerting thing about these trends is CEO Reed Hastings' comments regarding the company's results which, quite frankly seem rather delusional. Consider the following statement about the company's domestic businesses:

"Our highly profitable US business, both streaming and DVD, is funding our international expansion."(emphasis mine)

The company made $83 million in profit on $532 million in revenue in its domestic streaming business during the second quarter. While there is certainly something to be said for any company that can make $83 million in just three months on a single business segment, I ask investors to do a quick thought experiment: imagine you made $532 dollars for a day's work. If you only got to keep $83 of that $532, I'm not sure you would describe that venture as "highly profitable".

Relatedly, the international expansion that is being funded by this "highly profitable" U.S. operation is itself highly not profitable. Nonetheless, Hastings cheerfully said the following about the company's international expansion:

"Our international segment now represents 13% of total Netflix streaming members, and slightly over half of the streaming net additions in the quarter."

The company hasn't made a dime of profit internationally this year, so the fact that the international segment represents over half of the company's new streaming customers is nothing to be particularly happy about. As a matter of fact, if this trend continues -- that is if the non- profitable international streaming business continues to make up half of new subscribers at the same time as the highly profitable DVD-by mail segment is phased out -- it is likely that company wide profit margins will fall unless either the international business becomes profitable or the company can somehow expand domestic streaming margins much more quickly than they are expanding currently.

Moving from the theoretical to the concrete, consider the following table that appears under "Contingencies and Liabilities" in the company's 10Q:

As you can see, the company has nearly $5 billion in total streaming content obligations coming due over the next 5 years. Worse, at least $2 billion of these obligations are due in the next twelve months, and given Netflix's cash balance ($402 million as of June 30) and its expected earnings it isn't at all clear how it is going to pay. This subject has received quite a bit of attention as of late and this portion of the company's 10Q has been given some rather scary-sounding names ('shadow debt', 'hidden liabilities', etc). As usual, I prefer to call it just what it is: another example of why the company is unlikely to fulfil its duty to shareholders and employees to remain profitable.

Lastly, I should note that the company's shares fell around 7% Tuesday after Amazon announced a licensing deal with premium content provider Epix which gives users of Amazon's premium service ("Prime") access to such high profile movies as "The Avengers", "The Hunger Games", and more. Previously, Netflix enjoyed exclusivity in its offerings of Epix titles. Epix's parent companies are Paramount, Lion's Gate, and MGM. Ironfire Capital analyst Eric Jackson said the following on CNBC about the implications of the deal for Netflix:

"It just shows that the exclusivity is going away for Netflix, and therefore, what are you left with with Netflix? You're left with just a streaming business where you've got to bid against all these other well-capitalized companies for content."

In the final analysis, Netflix has exactly nothing going its way. It is losing content exclusivity, prices for licenses are rising, it has a mountain of seemingly unfunded commitments coming due, and it is aggressively expanding its most unprofitable business (international streaming) just as it aggressively unwinds its high margin, profit generating DVD-by mail segment. Unless Netflix gets bought out, I personally believe the stock will be in the single digits within twelve months. As such, I recommend taking a short position in Netflix.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.