Why We're Steering Clear Of Netflix

Oct.26.12 | About: Netflix, Inc. (NFLX)

Maligned DVD rental and video content streaming service Netflix (NASDAQ:NFLX) reported third quarter results that were a little better than expected, but overall, not incredibly strong. Revenue grew 10% year-over-year to $905 million, roughly in-line with consensus estimates. Earnings tumbled, falling 89% year-over-year to $0.13 per share-significantly higher than consensus estimates but still not a great number, in our view. To read about how using a discounted cash-flow process could have saved you big bucks in Netflix, please click here.

While we enjoyed CEO Reed Hastings candid letter to shareholders with regards to the business outlook, he pointed out several weaknesses. Domestic streaming subscriber additions are estimated to be 4.7 million-5.4 million, much lighter than the firm's previous guidance of 7 million. Hastings pointed to several metrics, including 30%+ growth in per-member viewing that suggests consumers love the product, which is hard to debate. However, increasing competition from HBO GO, Amazon Prime (NASDAQ:AMZN), but mainly Hulu, are preventing subscriber growth acceleration. Netflix continues to boast an excellent TV lineup, but viewers seem more fixated on watching recent content via on-demand services and Hulu than older shows, in our view.

Exclusive original content, specifically Arrested Development, could provide some acceleration in 2013, though the development costs will likely weigh on profits and cash flow generation. The firm reported negative free cash flow of $20 million during the quarter, and it expects similar levels of cash drain for the next several quarters. While the firm faces furious domestic competition, it also plans to enter several international markets, which we expect will lose money for several quarters. Though net paid subscribers have grown 270% during the past year, losses ballooned to $92 million from $23 million during the same period a year ago.

The domestic streaming business accounts for 61% of revenue at this juncture, but its 16.4% profit contribution margin significantly trails the domestic DVD rental business. Subscribers in the segment fell 39% year-over-year, but profit contribution margins of 48.2% remain the firm's overall driver. According to Hastings, declines in the rental business have moderated, so the company should continue to generate some cash to offset content acquisitions costs and investments in its international streaming business (at least in part).

Even though Netflix's growth rate isn't nearly as high as it once was, we believe shares are fairly valued. Barriers to entry in the content streaming business are not incredibly high, but we think the firm has some brand strength and is fairly well positioned to add subscribers due to the incredibly low price of its service. Yet, with the price of the service incredibly low, we suspect the firm's cash flow generation will remain unsatisfactory and think the company will struggle to generate excess returns on invested capital. Content costs are simply too high. We think the service is far superior to its competitors--Coinstar (NASDAQ:CSTR) thanks to the variety of avenues for access, but we won't be adding shares to our Best Ideas Newsletter any time soon.

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.