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Netflix Inc. (NFLX) has struggled since its ill-fated and short-lived decision to separate into two companies. Since that time, subscribers fled and the stock collapsed. However, starting again in the last quarter of 2011, NFLX was adding subscribers. I first commented on NFLX in October of 2010. Since that time, I've been very bearish on the company, often citing the impending growth challenges, enormous off-balance-sheet liabilities, and misguided stock buy-back decisions. The purpose of this article is to assess the current state of NFLX against these three considerations.

NFLX recently closed at $55.44 per share giving it a market capitalization of just over $3 billion. This is down from a 52-week high of $133.43 and just above the 52-week low. More astounding is that NFLX closed at $298.73 per share in mid-July 2011, making its recent price a collapse of over 80%.

NFLX continues to grow its subscriber base

Back in better times, part of the NFLX story was unrelenting and accelerating growth. There seemed to be no stopping the growth trajectory which was increasing every quarter. However, a series of missteps on separating the DVD business from the streaming business sent subscribers fleeing. The following table shows a recap of total subscriber numbers.

Total Domestic Unique Subscribers
Period EndPeriod End Total Subscribers (Millions)Net New Subscribers (Millions)Gross New SubscribersQ on Q growthY on Y growth
12/31/20089.40.71.28%26%
3/31/200910.30.92.410%25%
6/30/200910.60.31.93%26%
9/30/200911.10.52.35%28%
12/31/200912.31.22.810%31%
3/31/201014.01.73.514%35%
6/30/201015.01.03.17%42%
9/30/201016.81.84.112%51%
12/31/201019.52.75.116%59%
3/31/201122.83.36.317%63%
6/30/201124.61.85.38%64%
9/30/201123.8-0.84.7-3%42%
12/31/201124.40.64.43%25%
3/31/201226.11.75.67%14%
6/30/201226.50.44.62%8%

Source: Netflix website, author estimates and calculations. Note that Gross subscribers added for the last four quarters reflect my estimates.

This shows a worrisome domestic trend of declining growth. One can see the actual net decline in subscribers in Q3 2011 caused by management missteps. On the brighter side, NFLX still has positive growth. This domestic picture excludes international subscribers which now total over 3.6 million and perhaps more importantly added more net subscribers in Q2 2012 than the domestic business. On the negative side, these figures also include non-paying domestic subscribers. Free subscribers accounted for less than 3% of all subscribes in early 2010 but now account for around 5% of total domestic subscribers.

Off-Balance-Sheet Content Obligations Continue to Grow

NFLX provides streaming content services to its users. This content is often secured through long term content agreements and recorded as off balance sheet obligations. As of March 31, 2011, NFLX had over $1.6 billion in obligations. This is an especially large figure when considering that at the time NFLX had only about $1.1 billion in assets. However, since that time the off balance sheet obligations have swelled to an impressive $5.0 billion at June 30, 2012. in comparison to about $3.5 billion of on balance sheet assets. The only good news is that this represents just a modest increase of 2011 year-end figure of $4.8 billion. These off balance sheet assets boost an already high leverage rate from 5x ($3,478 million in assets to just $688 in book equity) to over 12x (~$8.5 billion in assets to ~$0.7 billion in equity).

Elimination of stock repurchases

NFLX also had a surprising history of repurchasing stock despite being a rapidly growing company. In fact, NFLX devoted a larger percentage of its operating cash flow to stock buy backs than mature technology companies like Intel Corporation (INTC) and Microsoft Corporation (MSFT). NFLX repurchased $324 million of shares and $210 million of shares in 2009 and 2010, respectively. However, in 2011, NFLX shifted to being a net issuer of stock with a $200 million issuance of common stock at $70 per share in late 2011. NFLX also raised $200 million in convertible notes from Technology Crossover Ventures. This more conservative approach to liquidity has provided NFLX with over $800 million in cash, cash equivalents and short term investments on its balance sheet. It appears that NFLX has sufficient liquidity.

Challenges lie ahead for NFLX

NFLX faces an increasing competitive market for its subscribers entertainment dollars and time. Consumers have an array of choices from cable TV to Redbox to Hulu.com to apps from Apple Inc.'s (AAPL) iPhone to pass their free time. The same issues that I have discussed before largely remain issues for NFLX. At least, NFLX is trying to conserve capital. With almost 29% of its outstanding shares being short as of September 14, 2012, I'm not alone in my bearish sentiment. Analyst estimates suggest a 2013 EPS of $0.91. This gives NFLX a forward PE ratio of about 60, not exactly a bargain price. However, NFLX is still growing and has promise international markets. I would continue to watch this company; now is not the time to go long. With the third quarter closed, the upcoming NFLX 10-Q should provide additional insights on these key topics. Perhaps most telling will be whether there is solid subscriber growth and the expansion of the off balance sheet obligations.

Source: Growth Challenges Continue To Plague Netflix