Netflix: 7 Million New Viewers?

| About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX) has had its ups and downs in recent times and the latest chapter of the story was the disappointing earnings for the first quarter of 2012 and the guidance reported by the company. Netflix has posted its first quarterly loss in seven years for the first quarter of 2012.

Even though the loss was less than expected, the second-quarter estimate which warned of slowing subscriber growth through the summer weighed heavily on investing sentiment. As a result, analysts issued warnings about the stock which promptly tanked more than 13%. It is true that summer is historically a slow business period for Netflix because people tend to spend more time outdoors in preference to watching TV and videos indoors. However, the future outlook for the company is cloudy.

It certainly seems as if the subscriber growth story that made Netflix such an investor's favorite is now beginning to run out of steam. Against the consensus estimate of adding about one million viewers to its services in the current quarter, the guidance of 190,000 to 790,000 viewers is disappointingly well below expectations. This has rattled investors because this disappointment comes on top of a number of problems that have started to surface. Though the company has said that it expects to add approximately 7 million viewers in the U.S. market in 2012, the target has been considered unrealistic and even ambitious.

A number of customers have already joined and then left because sales of video game consoles, which has been crucial to growth in the past, have now started to slow down. In addition, competition for video services in the shape of (NASDAQ:AMZN) and Wal-Mart (NYSE:WMT) has begun to take its toll. Netflix blotted its copy book by first increasing the prices of subscriptions to its most popular plans. It then proceeded to enrage customers and investors by announcing a spin-off of its DVD rental business to a new company called Qwiskter. The anger that followed forced the company to withdraw the plan.

Netflix has more than 26 million subscribers in North America, Latin America and the U.K. and is regarded as the leading subscription service on the Internet for watching movies and TV. For under the equivalent of about $8 a month, the subscriber can watch an unlimited amount of movies and TV episodes that are streamed to more than 700 different devices. Apart from computers and TVs, the services that utilize the streaming service include Microsoft Xbox 360, Nintendo (OTCPK:NTDOF) Wii and Sony (NYSE:SNE) PS3 consoles as well as iPhones, iPads and iPod touch. The company has acknowledged that it needs to rectify its past mistakes but says that it is now six months into a three-year process of rectification. 2 1/2 years is a long time for investors many of whom, it now appears, do not have the patience to give the company the benefit of the doubt.

Since the announcement, some clarifications have emerged as the announcement itself was not entirely satisfactory. Netflix raised about $200 million in convertible debt at a price of just over $85 and this conversion could further dilute equity by adding more than 2 million shares to the outstanding shares. These are zero-coupon securities so that there is no cost implication and it now seems a little unlikely that the conversion option is going to be exercised because the strike price is below the current market price.

In addition, there has been some concern about the decline in the cash holdings from just over $500 million to just under $400 million. Netflix has never had great cash flow but it appears that short-term investments have increased by an almost identical amount so that the money actually hasn't vanished. Moreover, the company has had substantial off-balance-sheet obligations particularly in relation to the streaming content but these obligations have declined from over $4.7 billion to around $4.5 billion.

In order to determine what Netflix hopes for the future, it is necessary to revisit in brief how the company has evolved. Though management recognized the importance of streaming, the bandwidth did not then exist and the business had of necessity to start as a DVD rental business like Blockbuster. DVD by mail was long regarded as a staple which is why investors reacted adversely to the proposed spin-off.

The spin-off plans also raised doubts about whether management truly appreciated why they had been successful and whether customers would be confused as a result of the move. Streaming, meanwhile, has advanced by leaps and bounds and high definition quality and surround sound are now available on almost any device including hardware from third parties. Bandwidth has grown to support the quality of streaming but, to my mind, one problem has been that the customers of Netflix have been forced to acquire bandwidth from its competitors such as AT&T's (NYSE:T) U-Verse and Comcast (NASDAQ:CMCSA).

As if this were not enough, the entire streaming operation of Netflix is based on rented capacity from Amazon in the form of Amazon Web Services and Netflix makes its money on the difference between what it earns from subscriptions and what it pays Amazon. The problem arises because Amazon is not merely a vendor of capacity but also sells DVDs and has its own streaming media service which is cheaper than Netflix.

It is now time to consider the prospects of an investment in Netflix. I must confess that I was confused whether to recommend a hold or a sell on the stock. The prospects don't seem great and, what is worse, the recent fumbles have highlighted what could be deficiencies in the quality of the management and their understanding of the customer and the business.

On the other hand, the company has met expectations in terms of performance and it is the subscriber outlook that has turned investors jittery. Given its past performance and growth record, I would recommend a hold if you have an existing investment in the stock. The near future will tell what kind of prospects the stock offers.

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

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Tagged: , Music & Video Stores, Earnings
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