8 Reasons Not to Buy Netflix Today

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

On Oct. 23, Netflix Inc (NASDAQ: NFLX) disappointed the market with its earnings and outlook, causing its stock to tumble as much as 16% the following day.

On Friday, Oct. 26, rumors circulated that Microsoft (NASDAQ: MSFT) was interested in acquiring Netflix, apparently based on Mr. Hastings' comment during the conference call that he was resigning from Microsoft's board. This caused the stock to rise as much as 14% that day.

And on Halloween, Carl Icahn disclosed that he had taken an effective 9.98% position in Netflix stock, propelling it up nearly 13% intraday.

Let's step back and examine Netflix the business, the likelihood that Microsoft or any of its competitors would be interested in buying it, and finally, what Mr. Icahn's stake may or may not mean for Netflix shareholders.

Netflix—The Business

1. Sales Growth is Slowing

Third quarter 2012 sales were up 10.1% vs. the year ago period. While this sounds good, as the following graph shows, year over year (Y/Y) sales growth has been steadily falling each quarter this year.


<img src="/media/images/user_13066/yoy-sales_html_7c61fff9_large.gif" />

September's Y/Y sales growth was 78% less than last December's.

2. Growth of Domestic Streaming Customers Is Slowing

Netflix's domestic streaming subscriber count increased 17.0% Y/Y. Hastings had forecasted Netflix would add 7 million domestic streaming customers this year, an annual growth rate of 32.3%. In the Oct. 23 Letter to Shareholders, this estimate was reduced to 4.7 to 5.4 million, for an annual growth rate of 21.7 to 24.9%.

The fourth quarter is a seasonally better one for Netflix and last year its Q4 domestic streaming growth rate was 8%. If it matches that this year, Netflix will reach the high end of guidance. The low end implies just 5% growth, which would be very disappointing.

3. Prices Cannot Be Raised

During the Q&A for the Oct. 23 conference call, the last email question was about pricing:

And finally, there has been increasing talk that Netflix will eventually have to raise prices to increase ARPU. We've heard from management that this option is off the table, with the brand seemingly recovering from 2011's event. Is this something that is being discussed? Would it be unrealistic to expect an increase before 2014? Obviously, it cannot stay $7.99 forever.

Hastings responded:

Well, we're very excited about the $7.99 price point, and we have no plans to change that. Consumers valued the incredible bargain that, that is and that helps our growth. So we see increased monetization from increased growth rather than any change in price.

So, Netflix cannot raise its current prices without jeopardizing growth. This is unfortunate for the company because the operating contribution (gross profit – marketing expense) per unique domestic subscriber has been falling.

<img src="/media/images/user_13066/contrib-per-sub_html_24ce6a4e_large.gif" />

4. The Competition is Fierce

In his most recent letter to shareholders, Hastings carefully dismissed Netflix's competition: Comcast Corporation (NASDAQ: CMCSA), Hulu, which is jointly owned by News Corp, Disney and Comcast, Amazon (NASDAQ: AMZN) and HBO, which is owned by Time Warner Cable (NYSE: TWC). But are they so lame?

Although people are dropping cable, according to a study by Ericsson ConsumerLab, only 7% of consumers have actually cancelled their service since 2011 and 60% of them watch on-demand offerings weekly. Comcast charges $3.99 to $6.99 to watch one movie and people pay it, maybe because it offers new movies before they are available on Netflix.

Hulu offers both free and paid services. Hulu Plus costs $7.99/month, the same as Netflix and although it has commercials, it provides access to a large number of live broadcast TV channels, both domestic and international. Although it doesn't carry CBS, it offers many other channels, which Comcast only provides in its pricier Digital Preferred service for an extra $17.95/month. And Hulu Plus has movies.

True Amazon Prime with only about 5000 titles can't compete with Netflix for selection, but it's only $79/year, includes free 2-day shipping (who doesn't buy stuff from Amazon?) and a free Kindle book to borrow each month. Amazon also provides instant streaming of individual movies for $3.99.

HBO has been around for years and has produced some very popular original content, attracting customers. HBO is also planning on entering Scandinavia, which will directly threaten the profitability of Netflix's fledging Nordic expansion.

Other than Hulu, cost should be driving people to Netflix. So, why aren't they signing up faster? Is it really still their tarnished reputation? Will it take people 3 years to forget as Hastings said in the call? Or is its 4 week delay in being able to offer the newest movies that important?

5. Netflix's Financial Condition Is Deteriorating

Netflix is contractually obligated for $4.97 billion in streaming content, of which $2.69 billion is off balance sheet, including $828 million due this year. Add these off balance sheet obligations to the balance sheet, and total debt & obligations to equity rises from 3.8 to 7.5.

Interest coverage in the most recent quarter was 3.8 vs. 20 a year ago.

Unfortunately, the money to pay the $828 million is not coming from the business. As the following graph shows, trailing 12 months (TTM) Cash Flow from Operations (CFO) has fallen off sharply.

<img src="/media/images/user_13066/yoy-ttm-cfo_html_m12819dfa_large.gif" />

CFO for the most recent quarter was only $150,000. In its latest 10-Q, Netflix admitted its content costs in the coming quarter and in 2013 may cause it to have negative CFO's, use cash and possibly have to borrow. They have also suspended stock buybacks to conserve cash.

As the following graph shows, the quick ratio has also been falling. The $200 million of 8.50% senior notes issued in November, 2009 and the $200 million in non-interest bearing convertible debt issued last November have helped somewhat.

<img src="/media/images/user_13066/quick-ratio_html_2b98eb22_large.gif" />

The fact Netflix had to pay 8.50% in September, 2009 when the prime was just 3.25% tells you what lenders think of its finances. Consider that Google is paying just 0.1% on $2.7 billion of short-term debt and a weighted average of 1.25% on its total debt of $6.2 billion (but then its quick ratio is 3.7 and its total debt to equity just 0.1)

6. Their Competition is Much Healthier Financially

While Netflix may struggle to finance its content purchases and originations, its competition is not as disadvantaged. Amazon is debt free. The total debt & obligations to equity ratios for Comcast and Time Warner are just 0.8 and 3.7.

7. Why Microsoft, Amazon, Apple and Google Are Unlikely to Want Netflix

Julia Boorstein of CNBC very nicely stated the reasons why none of these proposed matches make sense. Microsoft already benefits from traffic from Netflix to its Xbox (plus Hulu). Amazon and Apple are builders not buyers. And Netflix's subscription model doesn't fit with Google's YouTube's ad model.

In addition, Microsoft is quite busy with its own initiatives: Windows 8, Surface and new, all-in music services. It doesn't need the distraction of Netflix.

8. The Icahn Factor is Iffy

Based on Icahn's SEC filing, he paid $27.4 million for 500,000 shares of Netflix on Sep. 4 at a price of $54.75. Between then and Oct. 25, he made call purchases on 5 dates at various prices for an average price per share of $21.93 and an average strike price of $36.05, resulting in an effective share price of $57.98. So, he optioned 4.29 million shares for $94.1 million. Excluding his previous purchase, he has just $121.5 million at risk. Since he has not exercised his options, he has voting rights on about 2.2% of the shares, not 10%. So, his influence is not as great as one might think. He would have to spend another $155 million to really control 10%. But will he?

Right now, he could just sell his stock and options and pocket a nice profit. If he discovers that Netflix can't be sold for much more than its current price, he could walk at any time. Plus, Icahn's history is spotty when it comes to finding buyers for his prey.

Bottom Line

Netflix's growth is slowing. Its current and long-term debt & obligations are large relative to its ability to meet them without financing which could come with strict covenants restricting how it operates. None of the so-called suitors has any realistic reason to want Netflix. Icahn is speculating and has already made a nice score. Finally, about 25% of the share price is based on rumor and Icahn and Netflix is fighting Icahn. In my opinion, the downside risk outweighs the upside.

Know What You Own 

The precipitous drop in Netflix shares since the summer of 2011 has caused many shareholders to lose hope. While the company's first mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep pocketed, rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These kinds of issues are a must know for investors, which is why The Motley Fool released a brand new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to both buy and sell the stock. They’re also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.

p366 is long DEC 2012 puts on Netflix. The Motley Fool owns shares of Amazon.com, Microsoft, and Netflix. Motley Fool newsletter services recommend Amazon.com, Microsoft, 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.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus