econyong's  Instablog

Netflix (NFLX) has a lot of challenges that have been well-documented to the followers of the stock - falling operating margins, lackluster subscriber growth and the low barrier to entry that leaves NFLX vulnerable to competition from bigger fish like Comcast and Amazon, just to name a few. Those reasons alone would motivate short-sellers to target NFLX. Here, I want to throw fuel to the burning house that is Netflix by showing you three company-specific adverse trends that have been developing.

(1) NFLX is bleeding cash

NFLX generates free cash flows. According to the FCF definition employed by the management, NFLX has generated $79.3 mn, $59.5 mn, $13.8 mn and $28.4 mn in FCF in each of the four quarters in 2011. However, what the management is not telling you is that a large portion of the FCF came from net working capital. In other words, the company is not funding its balance sheet expansion, and this trend will have to reverse. Working capital simply cannot be a sustainable source of FCF for a growing company!

If we just strip out the contribution from net working capital to overall FCF, then the respective FCF figures for 2011 are $-55.6 mn, $20.2 mn $21.4 mn and $2.8 mn. The company has lost about $10 mn in FCF in 2011, and this is assuming no funding of balance sheet. Needles to say, there will be a greater cash drain when NFLX will inject cash into net working capital. Alas, the revenue will not grow as fast as costs at least in 2012 - the management projects a loss for whole 2011!! - and there's the true reason for the $400 mn capital raising in Q4 2011.

See how FCF excluding net working capital regularly comes in lower than the FCF figures reported by the management since 2010.

(2) Curious case of content library amortization?

A big chunk of NFLX's subscription costs is due to the amortization of content library. I don't know what method NFLX uses to amortize its content library (if any of the readers knows, please kindly share that information with me). However, it seems only reasonable and indeed prudent that amortization of content library keeps pace with the growth in content library, like in 2008-09. But since 2010, growth in content library has experienced an exponential rise, while the amortization has consistently fallen below.

For a company that purchases contents at a fixed cost for a fixed time period, I cannot think of a reason for the consistently lower growth in amortization of content library. It gives rise to suspicion that the management may have been under-reporting its subscription costs to beautify its income statement or make it look less bad at least.

(3) It's the paid subscribers, stupid!

When NFLX reported its 4Q2011 results, there was a sigh of relief from NFLX longs that the subscriber base resumed its growth again. The subscriber statistics provided by the company show the number of total subscribers grew by approximately 1,000 in 4Q2011 from 3Q2011. However, I believe focus on paid subscribers is what ultimately matters for the company, and a closer look at that data reveals a continued troubling trend in subscriber growth.

NFLX's paid subscribers rose by only about 470, and the growth in international paid subscribers (about 460) accounted for most of the overall rise. The domestic paid subscriber base - both streaming and DVD businesses - actually suffered a decline. The decrease in the number of domestic streaming subscribers, albeit small, is particuarly worrying because that's the area that NFLX has said time and again they are focusing on. I believe the uphill task NFLX faces in growing its subscriber base explains the recent rumor regarding a potential partnership with a cable company.

NFLX, it seems, has a very bumpy road ahead in 2012 and beyond. The biggest risk to the upside in my opinion is a possible take-over by a bigger player like Time Warner. With all the baggages NFLX is carrying, the 24 mn subscriber base alone should be worth something. However, if I were looking to acquire NFLX, I wouldn't pull the trigger at this point in time, especially with all the challenges facing NFLX and knowing that the stock fell to below $70 late last year. In addition, Reed Hastings may not be all that amenable to selling his company (founders are not known to be the most friendly when it comes to being acquired!).

Whatever transpires, 2012 promises to be just as exciting and a roller-coaster ride for NFLX as 2011 was.

Disclosure: I am short NFLX.