Netflix: Jumping Through Hulu Hoops

by: Rocco Pendola

Netflix (NASDAQ:NFLX) has big plans. Not only does the DVD rental turn((ing)) online streaming company want to expand internationally, it also appears to be moving toward an HBO-like model of distributing original content. Goldman Sachs analyst Ingrid Chung contends that losing deals with the Showtimes of the world should not have a "material" impact on Netflix, however, it faces an uphill climb if it intends to produce programming people will actually care to watch going forward.

Uphill climb or insurmountable task? Without a savior in the form of serious network or studio backing, a buyout, or an infusion of cash, I go with the latter. I am not sure Netflix can go global aggressively and generate original content while maintaining significant growth and avoiding unsustainable expenditures. As it stands, without having yet dived into international expansion and content acquisition or creation costs fully, I do not think Netflix is in as strong a financial position as its bulls might have you believe.

As of its last earnings report, Netflix sits on about $350 million in cash alongside approximately $236 million in debt. Accounts payable, which include content fees due within a year, increased from just over $92.5 million in 2009 to nearly $223 million in 2010. The report lists "non-current liabilities," which include fees Netflix owes for content that are due beyond one year, at $69.2 million for 2010, up from almost $16.6 million in 2009. The report provides other disconcerting summaries of Netflix's growing expenses:

Cash provided by operating activities decreased by $48.7 million or 15.0% during the year ended December 31, 2010 as compared to the year ended December 31, 2009 primarily due to increased spending for content acquisition and licensing other than DVD library of $267.8 million. This increase was coupled with increased content delivery expenses of $78.7 million primarily resulting from a 9.7% increase in the number of DVDs mailed to paying subscribers and higher costs associated with our use of third-party delivery networks to deliver streaming content, increased promotional advertising activities and expenses related to our affiliates and consumer electronics partners totaling $33.6 million, increased payroll expenses of $36.2 million due to a 11% increase in employees, increased fulfillment expenses of $33.4 million, and increased current tax provision of $30.5 million.

Granted, it's well-publicized that Netflix expects DVD shipments to decrease as more subscribers take advantage of online streaming, but increased expenses on the streaming side will presumably more than cancel out savings on postage and other costs associated with mailing DVDs. And Netflix has barely even begun its content acquisition, streaming, and international expansion efforts. In another article, I discuss other relevant concerns, including Netflix's decreasing revenue per subscriber and anticipated international operating loss of $50 million in the second half of 2011 alone, despite only having expanded to one new market, Canada. Netflix needs to orchestrate something big if it expects to reach its lofty goals without bleeding red.

Network and Entertainment Industry Backing. The real powers of the entertainment world could seriously hamper Netflix's business tomorrow by either throwing all of their eggs in Hulu's basket, or coming together in force to go it together as opposed to alone. In some fashion, this event has already materialized via, an effort backed by big shots such as News Corp. (NASDAQ:NWSA) and Disney (NYSE:DIS), and independent streaming efforts by everybody from ESPN to CNBC. These entities have far fewer barriers to entry in the streaming content business than Netflix does.

As for Hulu, it provides programming from a veritable who's who of content providers. The success or failure of Hulu seems inconsequential, though. I doubt the old guard is preparing to make things easy for Netflix. Just the opposite likely holds true. Before partnering with what they likely view as a brash and cocky Netflix, I see the major networks -- free, pay, and premium -- coming together, with or without Hulu, to make things next to impossible for Netflix, who will undoubtedly cry "cartel."

Buyout. The other day, Jim Cramer mused on CNBC that Sprint (NYSE:S), Verizon (NYSE:VZ), or AT&T (NYSE:T) should buy Netflix before Apple (NASDAQ:AAPL) does. While anything's possible, I don't see any of the wireless companies pulling this off. Apple, on the other hand, makes some semblance of sense. America's Company could secure the closest thing to a foothold on distributing content to the streaming masses, especially when you consider its aniticipated move to the cloud. That said, Apple, taking on Netflix's full-fledged streaming business, would face the same content-related obstacles as Netflix now faces. Why would Apple, rolling on cylinders, want to take such a risk? I don't include Netflix in the "strategic opportunities" Apple is keeping its powder dry for.

Cash Infusion. Netflix could do several things to fund its growing expenses. It is highly unlikely that it could take the (NASDAQ:AMZN) approach of plowing money back into the business. Netflix simply does not have the financial firepower that Amazon (AMZN), and similarly situated companies have in that regard. And, considering the increased expenses it faces, it's unlikely that its cash flow position will change for the better -- or enough -- anytime soon. Netflix could access or open new lines of credit. It could do a secondary stock or bond offering. It could form some type of strategic partnership whereby another firm shares in its costs. Other than a partnership or a magical increase in cash flow, these options could send a bearish signal to shareholders.

I maintain my conviction that Netflix shares will drop considerably over the next year or two. Of course, betting against NFLX is not for the faint of heart. I don't necessarily recommend it. If you timed it right, you could have taken part in a $50-plus drop in the share price between February 14, 2011, and March 10, 2011. Since then, NFLX has rebounded, closing at $229.06 on Wednesday.

A relatively safe way to make a bearish play on NFLX -- and please take the word "safe" with a grain of salt when discussing NFLX -- involves the use of weekly or monthly call options. Choose a strike price that you do not anticipate NFLX rising above on or before the options expiration date. You can sell a call at that strike and purchase a call with a higher strike, resulting in a net credit. For instance, you could have sold the NFLX March $230 weekly call for $2.90 and purchased the NFLX March $235 weekly call for $0.98, as of Wednesday's close, resulting in a net credit of $192 per spread. If NFLX closes below $230 on options expiration date, both calls expire worthless and you keep the credit. You will need margin available to cover the difference between the strike prices in case NFLX shares rise above $230, triggering the exercise of the call you sold. Your maximum loss equals the difference between the two strikes minus the net credit received plus commissions.

While I suggest using my ideas as nothing more than a starting point for your own research, I would probably go a bit more conservative than the example I outlined. You increase your chances of both calls expiring worthless if you use higher strike prices. Of course, you also lower the net premium you collect. If you used this further OTM strategy and decided to execute multiple spreads, you would also increase your margin requirement.

Disclosure: I am long AAPL.