Netflix: The Good, The Bad, The Ugly

| About: Netflix, Inc. (NFLX)
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On Monday afternoon, Netflix (NASDAQ:NFLX) released its much anticipated first quarter earnings report. Results were mostly good, but the less than impressive guidance sent shares plunging in after hours trading. So what happened? Well, let's look at what they reported.

The Good:

Netflix actually did pretty good in Q1, and I've summarized their results versus their guidance (from the Q4 report) in the following table.

Domestic Streaming Guidance Actual
Total Subscriptions 22.8m to 23.6m 23.41m
Paid Subscriptions 21.5m to $22.3m 22.02m
Revenue $496m to $511m $507m
Contribution Profit $50m to $64m $67m
Domestic DVD Guidance Actual
Total Subscriptions 9.4m to 10.0m 10.09m
Paid Subscriptions 9.3m to 9.9m 9.96m
Revenue $308m to $322m $320m
Contribution Profit $139m to $154m $146m
International Streaming Guidance Actual
Total Subscriptions 2.5m to 3.1m 3.07m
Paid Subscriptions 1.9m to 2.45m 2.41m
Revenue $38m to $44m $43m
Contribution Profit ($118m) to ($108m) ($103m)
Consolidated Global Guidance Actual
Revenues $842m to $877m $870m
Net Income ($27m) to ($9m) ($5m)
EPS ($0.46) to ($0.19) ($0.08)

Most of the actual results were at the high end of the ranges, with some actually beating the upper end of the range. Netflix was at the high end of their revenue range, coming in at just under $870 million, slightly ahead of street estimates of $868.6 million. Their earnings per share loss was just 8 cents, much better than their expected range, and much better than the 27 cent loss the street was expecting.

The Bad:

Well, it is not good to lose money, but the issue has become more than just profits or losses. It is a matter of margins. Here is Netflix's three primary margins in recent quarters.

Margins 3Q 2010 4Q 2010 1Q 2011 2Q 2011
Gross 37.73% 34.42% 39.02% 37.87%
Operating 12.56% 13.16% 14.23% 14.60%
Profit 6.86% 7.90% 8.38% 8.65%
Margins 3Q 2011 4Q 2011 1Q 2012
Gross 34.71% 34.31% 28.27%
Operating 11.78% 8.09% -0.22%
Profit 7.60% 4.65% -0.53%

Gross margins were down more than 6 full percentage points over the fourth quarter, but if you look to a year ago, they were down 10.75 percentage points, a huge drop. Now, we expect that operating and profit margins will improve in Q2, perhaps both swinging back to positives, but they probably will still be below the 4th quarter numbers, and that may be a sign of things to come.

What has been the biggest problem? Well, let's look at Netflix's costs. The following table shows their five key income statement expense lines, as a percentage of revenues.

Expenses Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012
Subscription 52.47% 54.30% 57.41% 58.54% 64.84%
Fulfillment expenses 8.51% 7.83% 7.88% 7.15% 6.89%
Marketing 14.51% 12.04% 10.84% 13.05% 15.62%
Technology and development 7.08% 7.34% 8.45% 9.23% 9.52%
General and administrative 3.20% 3.89% 3.63% 3.94% 3.34%
Total 85.77% 85.40% 88.22% 91.91% 100.22%

It's not a good sign when your five costs are more than your revenues. That does not work. Also, subscription expenses are rising quickly. Subscription costs were up 10.03% over the fourth quarter, while revenues were down 0.66% over that time. In comparison to the first quarter of 2011, subscription costs were up 49.61%, while revenues were up just 21.05%. Does anyone think this is a sustainable business model? It doesn't seem that way. It also didn't help that their "interest and other income" line on the income statement, which had been producing between $800,000 and $1.7 million in pre-tax income per quarter, turned to a loss in the fourth quarter and lost them $116,000 this quarter. It doesn't sound like much, but that has costs them a couple of pennies per share in earnings for each quarter lately.

Why have some of these expenses risen? Well, Netflix is facing a ton of competition. When Netflix decided to abandon their very profitable DVD business, Coinstar (NASDAQ:CSTR) was extremely happy. Coinstar, which owns the Redbox movie rental kiosk system, which is available at grocery stores and other locations, has seen Redbox sales soar. A few months ago, Coinstar announced a partnership with Verizon (NYSE:VZ), which will build on the Redbox success, and further plant their dominance in the DVD business. On the flip side, Netflix is letting its DVD business die off. When you have increased competition, your marketing costs are higher, and usually, your technology expenses are too.

Netflix needs to spend more to keep its technology up to date and ahead of the competition, so technology expenses have risen. On the streaming side, Netflix does face some competition from Amazon (NASDAQ:AMZN). Not only does Amazon have Prime, which features several thousand pieces of online content for viewing, but Amazon has a subsidiary called Love Films which competes with Netflix in the UK. Amazon is obviously a huge company, and Coinstar when partnered with Verizon will be a huge force. Netflix, whether it sees the competition or not, will be forced to spend more on marketing, which will keep margins under pressure as well.

The Bad, Part 2:

Netflix's financial flexibility is in question as well. Despite a decent quarter, their financial condition did not really improve. Actually, in some respects, it got worse. Here's how some financial metrics have looked in recent quarters.

Financial Health 4Q 2010 1Q 2011 2Q 2011 3Q 2011 4Q 2011 1Q 2012
Current Ratio 1.65 1.47 1.33 1.23 1.50 1.42
Debt Ratio 70.45% 74.71% 78.73% 80.20% 78.85% 80.94%
Working Capital $252,388 $231,284 $239,230 $222,147 $611,315 $612,075

The current ratio came down a bit in the quarter, and the debt ratio (liabilities to assets) also got worse. Working capital stayed flat. Now, Netflix has greatly increased the size of its balance sheet. A year ago, Netflix had less than $1.1 billion in total assets. As of the end of March, it had $3.48 billion in total assets. Over that time, total liabilities have increased from $814.5 million to $2.817 billion.

Now, I submitted a question to the company for its conference call, asking about their convertible debt. If you go back to November, they raised $400 million. Half of that, $200 million, was purely selling stock. The other $200 million was zero coupon convertible debt, which, if conditions were met, could be converted after 6 months. My question to the company asked if they expected a conversion of that debt, and basically what the terms of the conversion were.

Netflix answered my question during the call with the following:

Yes. So the first convertible, 6 months after its issuance which was November, which places us in May, the company has the option of converting those shares at 30% over the conversion price, which is about $111. And the earliest we could do that would be July if the stocks had stayed above that price for 50 of the prior 65 trading days.

So if those shares are converted, there will be a couple million shares added to the fully diluted count, and I believe the number would be about 2.33 million, or about 4% of their current number.

At the end of the third quarter, Netflix had 53.87 million fully diluted shares. At the end of the first quarter, it was up to 55.456 million fully diluted shares. Add the 2.3 million more, if converted (the conversion price was around $85, so conversion not as likely now as it was yesterday), plus additional shares from exercised options, and we could see 58-60 million fully diluted shares by the end of 2012. To see what impact that has, let's just look at 2011, when the company made $226.126 (net income).

On the 53.87 million shares, the earnings per share number is $4.20. On 59 million shares, it would be just $3.83. That is a 37 cent difference, and that is with net income over $200 million. With net income for this year (and future years) expected to be much less, the additional share count will severely impact the earnings per share number, which will affect Netflix's valuation, if you are using price to earnings as your valuation method.

Strangely enough, Netflix's balance sheet will actually look better if those bonds are converted, as the $200 million will slide from the liabilities section to the equities section. The debt ratio for the company will improve. However, it will mean more outstanding shares, and I've clearly demonstrated the negatives around that issue.

The Ugly:

Okay, so why did Netflix drop? Well, again, it was the guidance. Netflix's forecast for the second quarter was not impressive. On the headline, they forecast a revenue range of $873 million to $895 million. Wall Street was looking for more than $897 million. Last year's number was $788.6 million. So we are looking at 10.7% to 13.5% revenue growth year over year. Hardly the 20%, 30%, 40% or higher Netflix has been growing in the past.

On the earnings side, Netflix gave a range from a 10 cent loss to a 14 cent gain, which was much better than the 17 cent loss the street was expecting. Still, it is much lower than the $1.26 Netflix earned in the same time a year ago.

I've summarized their guidance below, and compared it to the Q1 numbers for your convenience.

Domestic Streaming Q1 Actual Q2 Guidance
Total Subscriptions 23.41m 23.6m to 24.2m
Paid Subscriptions 22.02m 22.3m to 22.9m
Revenue $507m $526m to $534m
Contribution Profit $67m $72m to $84m
Domestic DVD Q1 Actual Q2 Guidance
Total Subscriptions 10.09m 8.95m to 9.35m
Paid Subscriptions 9.96m 8.9m to 9.3m
Revenue $320m $287m to $294m
Contribution Profit $146m $126m to $138m
International Streaming Q1 Actual Q2 Guidance
Total Subscriptions 3.07m 3.45m to 4.0m
Paid Subscriptions 2.41m 2.8m to 3.25m
Revenue $43m $60m to $67m
Contribution Profit ($103m) ($98m) to ($86m)
Consolidated Global Q1 Actual Q2 Guidance
Revenues $870m $873m to $895m
Net Income ($5m) ($6m) to $8m
EPS ($0.08) ($0.10) to $0.14

Domestic streaming numbers are forecasted to be up slightly, and domestic DVD numbers are expected to keep declining. International growth should remain strong, but that segment is still losing plenty of money, and profitability is several quarters away. The contribution profit gains quarter over quarter from streaming will be wiped away by the contribution profit losses from DVD. If Netflix can keep their costs under control, they should have a profitable quarter. If not, it will be another quarterly loss.

Now, to be even more confusing, and to try to appease investors who might seem upset with the lack of growth, Netflix threw in a 2 page, 3 model explanation of why their business is impacted by seasonality and Q2 is the lowest quarter of the year, in terms of net subscriber additions. The tables are at the end of the investor letter that I gave the link to in the beginning of my article. Feel free to read them, although you may need some very advanced education to figure them out. I think I kind of get where Netflix is going, but I think they are just trying to figure out an elaborate way to say it will be a sluggish quarter. They've done stuff like that in the past.

Conclusion - Netflix is still doomed:

Netflix is having a hard time growing right now, but it was a decent first quarter. Revenue growth for Q2 is going to be less than originally expected, but Netflix might in fact turn a profit. The Q1 loss was less than expected as well. Now, because Netflix is returning to profitability, they are planning on expanding into more international markets later this year. That will again push them into negative territory in terms of earnings.

Netflix is still in trouble because they are choosing to focus on a lower margin business for the near term. Streaming just doesn't generate the profits that the DVD business does, so Netflix will have to keep costs in check just to remain where they are now. Given all of their competition, I'm not sure if that is possible. I haven't even mentioned any impact from the major cable companies, like Comcast (NASDAQ:CMCSA) and BSKYB in the UK. Netflix also has billions of content liabilities that will be added to the balance sheet over the next few years, and additional content deals could strap them for cash.

My overall opinion is that Netflix will continue to provide conservative guidance, so that they can beat estimates when they report. However, if content costs continue to rise, and revenues struggle to, they will have a tough time making money. Also, they will need to raise extra funds to bring in new and fresh content to make subscribers happy. That will be in either debt, which will increase interest costs, or equity, which will further dilute shareholders. The share count is already increasing each quarter, and until Netflix starts buying back stock, more dilution will occur. That will lower earnings per share numbers going forward.

I'm not sure the $17 plunge in after-hours was totally warranted, but I'm still a long-term bear in the name. I just don't think that they have a great business model, and management has made some really questionable decisions in the past. The next one may just do them in for good, once and for all.

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