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  • Where do you stand on the great Netflix debate?

    Where do you stand on the great Netflix (NASDAQ:NFLX) debate? Sensibly-valued miracle share or short-of-the-century?

    I've read Whitney Tilson's article, part analysis, part mea-culpa, and now Netflix CEO Reed Hastings has issued a rebuttal, possibly the politest rebuttal of all time, but a rebuttal none the less.

    Its worth recalling both entrants in this "who is going to be proved correct" contest have an interest in talking their own books. A significant interest in both cases.

    Time for the obligatory disclosure: personally I've been long and short Netflix, although I should confess to a currently (small) short position. Having said that lets take a look at the arguments, and more importantly lets’ summarise and fish out a few facts amongst the conjecture.

    I would characterise Whitney's position (based on his article) as follows: Netflix doesn't have the business model or resources to go against its new supersize competitors (Apple, Google and Amazon etc).

    He characterises thusly: "In short, Netflix is moving from a business in which it was competing against smaller, dying, heavily-indebted companies with inferior business models to some of the largest, most powerful, aggressive and deep-pocketed companies in the world, which have big competitive advantages over Netflix."

    He then goes on to suggest the content is weak, and will remain so unless big money is paid to content providers. Interestingly he points out customer "churn" is high. He states quite unequivocally he doesn't believe the company will be able to find another 47 million subscribers (from which Netflix's loyal band of 16.9m subscribers have emerged).

    He finally points out that there are potential expensive upheavals with changes in the way ISP's could charge by-the-byte and potential changes in legal rental usage of DVD's.

    This is all prefaced by a moving few words on how he's doing this analysis, not apparently to convince others, but effectively to convince himself. Now lets turn to the "spirited defense" of Netflix by its CEO Reed Hastings. Reed, bless him, starts with several paragraphs confirming his mutual respect for Whitney, so much so frankly I'm almost embarrased to be between these two philanthropists.

    But on to more substantial stuff and Reed goes to town on why his CFO has left, implying a largely believable story about how he really wants to run his own company, although its interesting to compare his use of words with Whitney’s. It was either a “huge fight” with “hand to hand combat” with Blockbuster, or according to Whitney “competing against smaller, dying, heavily-indebted companies”. Must have looked different to our two writers. All very martial however, so lets dodge some more bullets…”. Reed then pulls back his claws a little and coughs to the FCF values not being quite as brilliant as he'd like, but then again, his new CFO is "all over" this particular task and he suggests "On a long term basis, FCF should track net income reasonably closely". Would it be churlish even pointing out this is an aspiration, a goal, not a guarantee or a "fact"?

    Interestingly he states that his Amazon computing costs are all opex. Lets hope that the relationship between Amazon and Netflix remains cordial, especially if Amazon decides to compete hard with a streaming service of their own. I'm sure he wouldn't want to see a apple-iphone-and-adobe-flash type situation developing. (Former allies can be sooo mean).

    Despite my short position I'm minded towards Reeds' argument regarding internet costs, and technological advances. Years at the IT code-face have demonstrated that capacity, speed and cost improvements are significant, and that Moore's law seems to apply to a host of IT related tech, thus I'd look askance at claims that we're going to be charged more for data, certainly within a short or medium time span, although I feel it should be pointed out that it would only need the “cloud” on the horizon to affect the share price, if not the trading of the company.

    More revealing is the way Reed tackles the thorny issue of saturation: "Since we expanded into streaming, Netflix net subscriber additions have been 1.9m in 2008, 2.9m in 2009, and over 7m this year (estimated)." Hmmm.... What was that word Reed? "net", does that mean the folks who stumped up, the folks who didn't churn, the folks who didn't walk after trial periods ended? Does that imply that those folks who didn't sign up are unlikely to sign up in the near future, so the market isn't actually the entire US, less the folks already signed up, but the entire US less the folks who have already rejected it, less the folks that actually signed up.? A question is being begged here: what was the gross figure? What was that Whitney? Did you say the real figure is 47 million out of which they retained 16.9 million. It’s interesting to note that the good Mr Hastings hasn't addressed this set of figures directly with anything like the same vigour he tackled the CFO issue. Maybe one issue is more easily explainable than the other. "Listen to what people don't say" is a useful maxim in many areas of life, not least corporate management missives.

    Interestingly Reed is at pains to point out that they're going not for growth but for margin maintenance, which is entirely laudable, given that he has to steer his company through not just 2011 and 2012 but beyond. Thing is it would rather make a mockery of the analysts figures which, at their most naive seem to indicate there will be more nextflix subscribers than residents of the US in the not too distant future.

    Even more interestingly this seems to the first time I've heard this "not growth, but margins" mantra from the CEO. Maybe we'll be hearing more of this in the future. Can't help wondering what it'll do to market and analysts expectations of growth etc, one of the pillars of the share price. This could be a way of saying they’re getting their content from the bargain bin, or then again, it could be a way of saying they haven’t really got a content funding model that works at $8.99.  

    In summary, lets look at what Whitney doesn’t say, and also what Reed has left unsaid. Firstly Whitney hasn’t really addressed the issue of calling the top. It could be overvalued at 60x p/e, then again it could manage 80x or more p/e, it’s a speculators share. Whitney’s silent of the mechanics of a short squeeze, and the ironic fact that a share that’s shorted so much actually benefits from those shares being taken out of circulation, even if only temporarily. It certainly did for Porsche when they tried it on with VW. I'd suggest the internet data costs bogeyman can be ignored, probably along with the DVD legal issues. (although don't forget it doesn't have to affect Netflix's trading in 2011, just the spectre of it affecting the share price).

    Reeds doesn’t talk about the costs of his deals “We try not to comment on specific deals, like the Starz renewal, as that rarely helps us get deals done.” Very convenient, Reed. I can’t help feeling there’s a position in Washington should you want it. And most tellingly he doesn’t face the net-and-gross churn subscribers figures issue. But he does raise the possibility of “margins-not-growth”. Lets hope he’s not getting his excuses in early.

    As I said, I’m a doubter: for my money I would suggest that the crunch will come with growth figures that are unsustainable, and this may well be the straw that does for this particular camels back. Anything less than stellar results will affect the share price, given its "religious" p/e ratio (are you a believer?).

    I'm sure they could tackle the weak content and growth issues, but they're stuck between the rock of the $8.99 subscription and the hard place of better content at substantially more cost. How happy would the subscribers be if the subscription realigned itself at $19.99 but the content was up from weak to average. Or $39.99 with competitive content. And there's the nagging question of the novelty value, yes its great now, but once you've watched Family Guy what else is there... oh yeah, last years "Lost".

    My ideal shorting preference? Play $200-netflix-whac-a-mole, every time the sp pops up over that figure.



    Disclosure: I am short NFLX.
    Dec 20 10:22 PM | Link | Comment!
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