Netflix: A Glass Half Empty

| About: Netflix, Inc. (NFLX)

In a classic episode of Seinfeld, George Costanza loses his much needed glasses. Yet despite having impaired vision, he insists he spots best friend Jerry's girlfriend cheating on him with his cousin. Jerry expresses his skepticism that George could see anything until he proves his keen eyesight by spotting a dime laying on the floor across the room. However, later in the scene, George mistakes an onion for an apple and takes a huge bite of the pungent bulb.

An exasperated Jerry proclaims, "You're spotting dimes, you're eating onions. I don't know what to believe!"

Spotting Dimes, or Eating Onions?

To perplexed investors, Netflix Inc. (NASDAQ:NFLX) is both spotting dimes and eating onions. Some don't know what to believe about the company that helped run video rental stores out of business but is now defending its dominant position in the streaming content game.

Those who focus on the company's dime-spotting had their eyes widened when the company posted a $0.13 per share profit for the fourth quarter of 2012 after earlier warning of a likely loss during the period. The gain was fueled by the addition of 4 million subscribers in the U.S. and abroad during the holiday season, and Netflix anticipates another 2 million new members during the first quarter of 2013. This despite facing increasing competition from the likes of Hulu, Amazon (NASDAQ:AMZN) and even Red Box, which has partnered with Verizon Wireless to launch a streaming video service.

In addition to new subscribers, Netflix's earnings were buoyed by better cost management, including a 12% decline in administrative expenses from the year before.

The news propelled the company's stock price to climb 35% on the day of its earnings release, and was trading as high as $184 in early February, nearly double from where it started the year and more than triple from its 52-week low.

More good news for Netflix: It recently launched original programming with 13 episodes of "House of Cards," starring Kevin Spacey. More original content is on the way, including season 4 of the cult hit "Arrested Development." Netflix also just added classic hits from Disney (NYSE:DIS) and signed an exclusive rights deal for new Disney movies beginning in 2016. Disney content equates to potentially more families signing up to have content to keep the kids entertained while taking a nap or folding laundry.

Netflix bears see the company eating onions. They point to a business taking on more debt and burning through cash to stave off competition from rivals who have established themselves in complementary industries and that have the resources and reputation to steal market share.

The bears point out the company's management effectiveness ratios (Return on Assets and Return on Investments) have declined considerably when compared with its industry peers. While Netflix's five-year average returns in these categories are far superior to the industry average, the last 12-month's ratios lag the industry.

The Competition

Companies such as Amazon, Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) have an advantage because they can use their piles of cash generated from their strong core businesses to invest in a digital media business. Netflix's only revenue source is subscriptions. Fewer subscriptions means less revenue, which makes it more difficult to invest in content to grow its subscription base. Meanwhile, the aforementioned companies with additional revenue sources can use their excess cash to either outbid Netflix for premium content, or undersell the company's monthly subscription fee -- maybe even both. Those diversified competitors also have more financial resources to dedicate to marketing and promotion, or even producing more and better original content.

Put another way, compare the cash positions of Amazon and Netflix. Amazon started 2012 with $5.3 billion in cash (billion with a b) and ended it with $8.1 billion, a 53% increase. Netflix opened the year with $508 million in cash (million with an m) and finished with $290 million, a 43% decrease. If this was a game of Risk (another classic scene from Seinfeld), Amazon's armies would far outnumber those of Netflix, and it could be biding its time before launching an all-out offensive. The attack may have already begun: Amazon recently nabbed the exclusive rights of future seasons of the popular PBS drama, "Downtown Abbey."

All this doesn't even take into account the possibility of competition from pay-TV channels such as HBO, Showtime and Starz. It's conceivable that some of these networks may eventually migrate from cable-TV and sell their content directly to consumers, a la Netflix. HBO is heading in that direction with the launch of HBOGo, which is available on Microsoft (NASDAQ:MSFT) Xbox game consoles and soon on Apple TV. When discussing the need to produce its own digital content, a Netflix executive said: "The goal is to become HBO faster than HBO can become us."

The difficulty in trying to outdo HBO is that the cable network has cultivated a reputation for high-quality programming. HBO shows like "The Sopranos," "Sex and the City" and "The Wire" have won a bevy of Emmy awards. Current offerings like "True Blood" and "Game of Thrones" are appointment television. Yet HBO didn't build this reputation overnight, and neither will Netflix. Many see it as a stretch to believe that a handful of new, unproven TV shows will lead directly to new subscribers anytime soon. Furthermore, Netflix spent $100 million on 26 episodes of "House of Cards," about a third of what it plans to invest now in original content. Building a library of its own programming will require it to take on even more debt, without the guarantee that those shows will be successes. After all, think of all the shows that bomb on regular TV.

What The Future Holds…

As it tries to build original programming, Netflix will continue to have to spend heavily on the best content available and compete for it. According to its most recent annual report, Netflix has more than $5.6 billion in content obligations, with $2.3 billion due within the year. Content costs will only increase.

Those in the dime-spotting camp still see a company that sold for $300 a share a few years ago, that has an unexpected influx of cash thanks to an anticipated $0.13 a share loss turning into a $0.13 a share gain, that has by far the largest library of any digital content provider, that is focusing more on digital content and slowly exiting the DVD-by-mail business, that boasts the top market share and is expanding into growth markets internationally.

If only they could watch Seinfeld reruns on Netflix, they would realize that George really was "eating onions." In the end, after a huge gain on one quarter of earnings and an uncertain future, now is probably not the best time to buy Netflix.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was written by an analyst at Catalyst Investments.

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Tagged: , Music & Video Stores, Earnings
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