Do You Believe?

By Chad Henage - August 1, 2012 | Tickers: AMZN, CSTR, NFLX, VZ | 0 Comments

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In all honesty, Netflix (NASDAQ: NFLX) is either a good investment or not. It really comes down to, do you believe in the company's ability to make money on a consistent basis offering streaming video? If you do, then watching Netflix constantly expand into new markets, is similar to watching Amazon.com (NASDAQ: AMZN) spend billions of dollars to establish itself as the go to Internet retailer. However, if you believe that movie studios and television stations will constantly require higher licensing fees for their content, then Netflix is going to be fighting a long uphill battle. Pretty simple right?

In real life, things are really never that simple. In the most recent earnings release, the company focused more on the number of subscribers than revenue, earnings, or cash flow. This I'm sure was intentional with revenue up just 12.75%, and EPS down over 90%. Looking at subscriber counts at this point is a useless exercise. Each market that Netflix operates in has different dynamics and different competition. Currently, the two profitable markets the company already has up and running are the United States and Canada. The issue in the United States is, Netflix has essentially given up on its most profitable division which is DVDs.

While some have heralded this as forward thinking and expect DVDs to disappear, it seems as though this choice was made far too early. Domestic DVD members total 9.24 million and Netflix made $134 million in profits from these subscribers. This division contributed the lion's share of the company's income and cash flow. This is particularly apparent when you consider that domestic streaming has 159% more subscribers, yet generates 38% less profits for the company. The company has said multiple times that they expect to use profits from DVD subscribers, and domestic streaming, to pay for international expansion. The question is, will DVD subscribers stick around long enough for the company to continue expanding?

While DVD subscriber losses are slowing down, you can see that the company is still shedding significant numbers each quarter:

What should be a little scary to investors, is the company's guidance for DVD losses going into the 3^rd quarter. At best the company expects a 6.39% decline, at worst the company said it could lose up to 9.63% of the subscriber base. No matter which number is correct, it becomes incrementally less profitable to keep the remaining customers. Considering the company was barely cash flow positive including all of these subscribers, another decline of between 6% and 9%, is going to make positive free cash flow even more difficult to achieve. In addition, while these challenges remain, new competition is emerging.

One of the primary arguments against investing in Netflix has consistently been their competition. With companies such as Amazon, Hulu, and the upcoming streaming offering from Coinstar (NASDAQ: CSTR) and Verizon (NYSE: VZ), the company certainly has its work cut out for it. Where Amazon Prime is concerned, while it is cheaper per month than Netflix, the service is not as ubiquitous or as easy to use. In addition, Amazon is going to have to make a choice. It simply won't be economically feasible for the company to charge the equivalent of $6.58 per month for streaming of an expanding catalog and give free two day shipping on all orders. Licensing costs are sure to rise as more subscribers sign up for the service. If Netflix will run into a challenge with higher licensing fees, then Amazon will have the same issue, but at a less profitable price point.

Where Hulu is concerned, the service offers a queue system similar to Netflix and has a much better current television catalogue. However, the service has a terrible movie selection and doesn't really overlap Netflix. This is a case where many households may choose to subscribe to Hulu to get caught up on current run TV shows, and subscribe to Netflix for better movies and past TV seasons.

With the upcoming Redbox Instant offering from Coinstar and Verizon, it sounds like Netflix is underestimating this competitor. While we don't know a lot of information, Netflix earnings release said that this service, “will face a big challenge to break into the top three subscription services.” This doesn't make sense, as Redbox is a well-known movie name and offers a much better selection than Netflix at their over 30,000 kiosks. In addition, with Verizon as the majority partner, the company has a lot riding on the success of this venture. Given that Verizon generated over $7 billion in free cash flow during their last quarter, Netflix should be careful not to underestimate this competitor.

As Netflix grows streaming subscribers, and continues to see DVD defections, it will get more difficult for the company to maintain positive free cash flow. You can see this challenge in the company's gross margin compression over the last year. With more DVD subscribers, last year's gross margin was nearly 38%, versus this year with millions less DVD subscribers, gross margin is down to 27.64%. In addition, Netflix grew its share count by over 9% in the last year. With a lower gross margin comes lower cash flow, and with more shares comes lower EPS. Neither of these trends is a positive for investors. If the company continues to aggressively enter new international markets, profitability will be elusive. Analysts expect just $1.22 of EPS for all of 2013. Even after the massive selloff, the stock still sells for over 46 times next year's earnings. For a company expected to grow at less than 17%, this seems excessive. Until Netflix proves that they can turn additional international markets profitable, investors would be wise to avoid the shares.

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