How Long Can Netflix Last?

Carlos is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you've been paying attention, then you have probably noticed that last week was almost unreal for Netflix (NASDAQ: NFLX). Their earnings report can only be described as spectacular, seeing as it destroyed all expectations: Their Q4 EPS was a $0.13 profit compared to the expectation of a loss of $0.13. Their revenues totaled around $954 million, beating expectations by $11 million. In their letter to shareholders, they provide very strong Q1 guidance, as seen in the table below:

<table> <tbody> <tr> <td><strong>Domestic Streaming</strong></td> <td><strong>Q4 Results</strong></td> <td><strong>Q1 Guidance</strong></td> </tr> <tr> <td>Total subscriptions</td> <td>$27.15 Million</td> <td>$28.5 - $29.2 Million</td> </tr> <tr> <td>Paid subscriptions</td> <td>$25.47 Million</td> <td>$27.2 - $27.9 Million</td> </tr> <tr> <td>Revenue</td> <td>$589 Million</td> <td>$633 - $641 Million</td> </tr> <tr> <td>Contribution Profit</td> <td>$109 Million</td> <td>$122 - $130 Million</td> </tr> <tr> <td> </td> <td> </td> <td> </td> </tr> <tr> <td><strong>Domestic DVD</strong></td> <td><strong>Q4 Results</strong></td> <td><strong>Q1 Guidance</strong></td> </tr> <tr> <td>Total subscriptions</td> <td>$8.22 Million</td> <td>$7.06 - $8.05 Million</td> </tr> <tr> <td>Paid subscriptions</td> <td>$8.05 Million</td> <td>$7.45 - $7.85 Million</td> </tr> <tr> <td>Revenue</td> <td>$254 Million</td> <td>$239 - $246 Million</td> </tr> <tr> <td>Contribution Profit</td> <td>$128 Million</td> <td>$101 - $112 Million</td> </tr> <tr> <td> </td> <td> </td> <td> </td> </tr> <tr> <td><strong>International Streaming</strong></td> <td><strong>Q4 Results</strong></td> <td><strong>Q1 Guidance</strong></td> </tr> <tr> <td>Total subscriptions</td> <td>$6.12 Million</td> <td>$6.6 - $7.3 Million</td> </tr> <tr> <td>Paid subscriptions</td> <td>$4.89 Million</td> <td>$5.8 - $6.4 Million</td> </tr> <tr> <td>Revenue</td> <td>$101 Million</td> <td>$132 - $144 Million</td> </tr> <tr> <td>Contribution profit</td> <td>$105 Million</td> <td>$80 - $94 Million</td> </tr> <tr> <td> </td> <td> </td> <td> </td> </tr> <tr> <td><strong>Consolidated Global</strong></td> <td><strong>Q4 Results</strong></td> <td><strong>Q1 Guidance</strong></td> </tr> <tr> <td>Revenues</td> <td>$945 Million</td> <td>$1,004 - $1,031 Million</td> </tr> <tr> <td>Net Income</td> <td>$8 Million</td> <td>$0 - $14 Million</td> </tr> <tr> <td>EPS</td> <td>$0.13</td> <td>$0.00 - $0.23</td> </tr> </tbody> </table>

As a result of all this good news, Netflix stock shot up around 70%. Their YTD return is, at the time of this post, 95.45%.

In summary: Netflix made bank last quarter, the stock shot up by an enviable amount, the company is predicting a stellar next quarter, and Carl Icahn is probably doing this to all short sellers/doubters.

An unexpected turnaround

How on Earth did Netflix achieve such a remarkable turn around in such a short period of time?

There is no single reason, from what I can tell. Rather, it seems to have been a number of reasons.

Domestically, Netflix managed to add around 2 million more subscribers. A successful free trial campaign that lured in new subscribers (as well as former ones). Increasing the amount of content carried also seems to have been a benefit. Internationally, there is Netflix's seemingly successful expansion into Scandinavia and elsewhere abroad, though this comes at a cost to the company.

In terms of competition, Netflix does face threats on the horizon:

  1. Coinstar (NASDAQ: OUTR), which owns Redbox, a network of game & movie rental kiosks, has recently partnered with Verizon (NYSE: VZ) to create Redbox Instant, a joint effort to stream movies online. The companies hopes that this service, which charges only $8 a month (half the cost of Netflix's lowest cost plan of $16 a month), will successfully challenge Netflix. This effort has so far failed to materialize, due to the service possessing too few movies and absolutely no TV shows. This gives Netflix a reprieve from facing a new competitor, at least for now.
  2. Hulu Plus, a service (created as a joint venture by various media companies) that steams movies, TV shows, webisodes, clips, trailers, and behind-the-scenes footage, attracts customers by offering a great deal of content for free. Furthermore, it is pioneering various original series, similar to Netflix's House of Cards. The service, however, is currently limited only to the United States and Japan, due to licensing reasons.
  3. Amazon Instant, a service by online retail giant Amazon (NASDAQ: AMZN), offers television shows and films for rental and purchase. As of last September, it partnered wth pay-TV channel Epix to offer more movies, a move seen as a direct challenge to Netflix. With the backing of such a powerful company, Amazon Instant could grow to be a great challenger to Netflix (though currently, Netflix seems to hold the lead).

Finally, it cannot be a happy coincidence that Netflix's stock rose during the exact time that Apple's stock crashed down back to reality. It wouldn't be too bold to claim that as people were selling their shares of Apple, they may have bought into Netflix upon seeing it going up.

So, Netflix seems to have a lot of good things going for it. But the question we now face is what do we do about it?

Short it

Too blunt? Probably. But I think this is the right move, due to numerous reasons:

  1. Such a spectacular rise, over 70% in a matter of days, demands a pullback at one point or another in order to consolidate. It did just break it's 52-week high after all.
  2. By setting up such a hopeful Q1 guidance, the company has set itself a pretty high bar. If they fail to meet those expectations, then the company's share price could come crashing back down again.
  3. The company announced it would float $500 million in senior notes. As Anders Bylund at the Motley Fool can tell you, that's pretty risky. The company is restricting itself financially, which is not a reassuring thing.
  4. For the last few quarters, margins have been decreasing. Even if things were to turn around and stay that way, it would take a long time in order for the business to be truly profitable again:
<table> <tbody> <tr> <td><strong>Margins</strong></td> <td> <p>1Q 2011</p> </td> <td>2Q 2011</td> <td>3Q 2011</td> <td>4Q 2011</td> <td>1Q 2012</td> <td>2Q 2012</td> <td>3Q 2012</td> <td>4Q 2012</td> </tr> <tr> <td>Gross Margins</td> <td>39.02%</td> <td>37.87%</td> <td>34.71%</td> <td>34.315</td> <td>28.27%</td> <td>27.64%</td> <td>26.79%</td> <td>26.38%</td> </tr> <tr> <td>Operating Margins</td> <td>14.23%</td> <td>14.60%</td> <td>11.78%</td> <td>7.07%</td> <td>-0.22%</td> <td>1.82%</td> <td>1.78%</td> <td>2.08%</td> </tr> <tr> <td>Profit Margins</td> <td>8.38%</td> <td>8.65%</td> <td>7.60%</td> <td>4.02%</td> <td>-0.53%</td> <td>0.69%</td> <td>0.85%</td> <td>0.84%</td> </tr> </tbody> </table>


Finally, my last reason may be the most compelling.

Carl Icahn (probably still celebrating with his fellows) has a large stake in the company, totaling around 10%. However, disclosures show that only 2.25% is in stock. That means that the other 7.75% are in call options, which expire on Sept. 4, 2014. In other words, Icahn wants the share price to go up as high as he can so he can exercise his options and make an enormous amount of money.

It's an ingenious strategy, as hedge fund manager Whitney Tilson noted last year:

It’s a very bullish, leveraged bet, in which he wanted to maximize his reported stake while minimizing the capital at risk, but he didn’t go too crazy by buying and selling short-dated options – he gave himself some time so that he can win in two ways: either the business gets sold, or he has two years for the performance of the business to drive the stock higher.

The latter seems to have come true. Now Icahn can make off with all the proceeds and not worry. After all, what are the odds that he's going to wait and hold until 2014 now that he's made a lot? If I was him, I'd be severely tempted to cash out while the going was good. That is the first rule of investing: Don't get greedy.

Halios has no position in any stocks mentioned. The Motley Fool recommends and Netflix. The Motley Fool owns shares of and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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