What Just Happened To Netflix?

| About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX) has just released its quarterly earnings and it is currently down over 15% in afterhours trading. A few hours ago, I released a pre-earnings brief that recommended looking past subscriber counts and focusing on revenue and quick coverage of the rapidly expanding accounts payable. I recommended that the aggressive speculator should buy 1w otm puts, advice that I followed at the $60 strike. It remains to be seen what level of profit will be made from these options, I am obviously hoping for an open similar to Q3-11, when the stock dropped another 15-20%. More importantly: why is the market reacting negatively to the Netflix report and what should you focus on?

The Results

Netflix's Q3-12 results (letter & financials) included record revenue of $906M, a narrow miss, and EPS of 13c, which was a beat of 9c. Netflix added a total of 1.78M paying streamers (1.11M domestic and 0.67M international) and lost 680k DVD subscribers. The y/y revenue increase is 10.1% and the y/y streaming sub increase is 27.86%. On the surface the result appear decent, so why is the stock down over 15%, and more importantly, why is Netflix doomed to a liquidity crisis if the trend continues?

Subscriber Disappointment

While the streaming sub y/y increase is very impressive, the related revenue gains are disappointing. This is the result of a massive bleed in DVD paid subscriptions (38.67% y/y). With the pure-streaming subs bringing in a lower monthly rate than combination subscriptions, NFLX has posted its lowest revenue/subscriber in company history at $30.30. In addition, NFLX has only added 3.65M subs in the first 3Q, far shy of the originally predicted 7M. Analysts had expected 1-1.8M additions for this Q (vs. result of 1.11M).

Rocky International Expansion

Netflix continues to blame poor profitability on international expansion, especially troubles in Latin America. International losses are expected to increase in Q4-12 due to the Nordic expansion. Although citing troubles with payment options and declines in Latin America, NFLX still expects to achieve profitability in the future.

Cash Flow Negative

Although posting a paper profit, NFLX spent a net $20M in free cash flow, placing its cash and STI balance at $798M vs 1y accounts payable (and content liabilities) of $1.37B. This coverage ratio of 0.58 is the second lowest in company history (the record was 0.49 in Q3-11, 1 month before $400M in debt and equity offerings).

Massive Liabilities

The 10Q will not be posted for several days, so it's unclear how the off balance sheet liabilities have changed, but as of last quarter's 10Q (30 June 12), there was 2.05B due within one year. According to NFLX's shareholder letter "…the $5.0 billion represents the known minimum obligation amounts, but does not include obligations that we cannot quantify but could be significant." In other words, the $2B is the "best case" scenario. Please note that the quick coverage ratio of 0.58 above only accounts for the 1.37B that is include on the balance sheet. The total liabilities due within 1 year are currently unknown, but are likely to be around $2.2B. This changes the coverage ratio to 0.36.

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Increase in Competition

This is a minor issue compared to international expansion losses and liquidity struggles; however, NFLX faces significant competition compared to the 2010-2011 environment. Netflix glosses over the potential threat of Amazon's (NASDAQ:AMZN) Prime expansion and Hulu's attempts at growth, and fails to mention to a potential Redbox (NASDAQ:CSTR) digital venture with Verizon (NYSE:VZ). Although these competitors have been lagging Netflix, they have gained significant ground since launching, and if Redbox develops set-top box capabilities (GTV, Xbox, PS3, SmartTV, etc) with competitive pricing, NFLX will face significant pressure.

Summary of Metrics

I track Netflix each quarter on a variety of metrics. Those I find the most critical are posted below, the worst three quarters are in red and the best three quarters are in green. Please note the plummeting profit/sub and the dangerously low coverage of revenue (annualized rate) and quick liquidity to accounts payable. Assuming $2.2B in 1y liabilities and a constant revenue run-rate of $905M, the coverage drops further to 1.65. If this trend continues (flat-lining revenue or new content obligations), Netflix will be forced to issue additional debt and equity similar to the November 2011 issuance.

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Trading Recommendation

It is clearly too late to trade based on expected earnings (as I suggested a few hours ago); however, this news clarifies that Netflix is an extremely dangerous investment. Almost every quarter, like clockwork, NFLX bounces back on hyped news. The expectations in terms of subscribers and profit are fairly low for Q4-12, so I don't expect the stock to trend much lower than $50/share unless the big-name analysts pick up on the liquidity issue that several Seeking Alpha authors have been covering for the past year. Overall, a few long-term otm puts represent my favorite play, but I prefer to stay away after closing my earnings position until NFLX either rebounds or the liquidity position worsens.

Disclosure: I am short NFLX, AMZN. 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.

Additional disclosure: I am short NFLX via 1w $60 puts.